Monetary policy is the branch of economic policy that attempts to achieve goals such as stabilizing employment and
prices as well as fostering economic growth through the manipulation of the monetary system; it achieves these goals by
employing certain variables, among them the supply of
money, the level and term structure of interest rates, and the
overall availability of credit in the economy. Modern central
banks, such as the Federal Reserve system (the Fed), have a
variety of policy goals. Although most focus on price stability, the Federal Reserve strives to meet six different, legislatively mandated goals: (1) price stability, (2) financial market
stability, (3) high employment, (4) economic growth, (5) foreign exchange stability, and (6) interest rate stability.
Money is anything generally accepted in exchange for
goods or services or in the payment of debts. Money also has
three functions: It serves as a medium of exchange, as a unit
of account, and as a store of value. A medium of exchange is
an item that facilitates exchange between parties; a unit of account is the standard for assessing value or price; and a store
of value is an asset function for money. Money fits into the
national economy in many ways. The government finances its
spending by taxing, by borrowing through the issuing of
bonds, and by printing money. There are other beneficial aspects to monetary policy as well, such as interest rate management. The goals of monetary policy were similar even before the existence of the Fed.
To understand monetary policy, one must understand interest rates. According to the relationship known as the Fisher
equation, nominal interest rates (the rates that are quoted in
the financial market) can be broken down into two separate
parts—the real interest rate (that is, the real cost of borrowing) and peoples’ expectations of inflation, with inflation defined as a sustained increase in the general level of prices.
Roughly speaking, the nominal interest rate is equal to the
real interest rate plus expected inflation.
For a substantial portion of its history, the United States
operated on a specie standard, with other currency (such as
banknotes or Treasury notes) being convertible into specie
(gold or silver). The price of gold was fixed in terms of dollars, which meant that any other countries that guaranteed
the convertibility of currency—that is, any other countries on
a gold standard—had a fixed exchange rate relationship with
the United States. The price-specie flow mechanism would
then keep the exchange rates balanced. A fall in prices in the
United States caused by an aggregate demand shock or an increase in aggregate supply meant that U.S. goods were relatively cheap compared to foreign goods. This situation resulted in an increase in foreign demand for U.S. goods and
larger flows of gold into the country to pay for larger purchases of goods. The increased gold stock in the United States
boosted the money supply, and as a result, the price level
would rise to its original level.
Policy goals are seldom achieved directly, and the enactment of monetary policy thus comes through the manipulation of the bank system. Specifically, the monetary policy authority changes the level of reserves in the banking system,
influencing the ability of banks to provide credit to customers. Increases in reserves lead to increases in credit availability, which is expansionary, and the reverse process leads to
contraction. Even without an official central bank, governments enact policy in this fashion.
The British North American Colonies
The North American colonies of England experienced several
changes in monetary policy. Specie was the legal tender for
international payments and was equated with wealth and
power. Each colony had its own pound (£) as the unit of account, with a mandated exchange rate of £133.33 colonial to
£100 sterling. The colonies did attempt to manage their exchange rates and attract gold to the borders by selling items
to foreign countries directly instead of through Britain. They
also experimented with paper money, which was considered
legal tender for domestic transactions only. Of course, the institutions developed to operate this policy were not the same
as the ones existing today. For instance, there was no central
bank, such as the Federal Reserve system, to oversee the colonial money supply. Instead, each colony ran its own independent policy, and as a result, the supply of paper notes in
any colony typically included the notes of bordering colonies;
this situation led to difficulties in defining the money supply
and problems in terms of price level in the region. The individuals responsible for operating fiscal policy, government
spending, and taxing decisions also made the monetary policy decisions. There was a perceived shortfall of media of exchange at this time, and the notes were to add liquidity to the
economy. The media included paper notes issued by the colonial government; any minted gold and silver coins in circulation, both foreign and domestic; and sterling bills of exchange. The notes were issued as mortgages, typically a loan
of up to one-half the value of pledged property. The government accepted the notes in payment for the loan but also imposed taxes at the same time, for which the notes were legal
tender. In this way, the government would be able to retire the
notes and avoid inflation. Unfortunately, retirements and issues were at times excessive, leading to large increases in the
value of notes in circulation and fluctuations in the price
level, though this was not universal. In fact, price-level fluctuations did not match well the changes in the stock of
money in many colonies. There is serious debate about why
this was the case, centering on the idea of the backing for the
currency. The future tax receipts were considered as the backing of the currency, much like gold is when the country is on
a gold standard. Disputes focus on the issues of exchange
rates and the credibility of taxing authorities.
The Revolutionary War provides another early lesson in
monetary policy. The Continental Congress acted as the government for the rebelling colonies and needed to finance the
war effort. Lacking the ability to tax and unable to issue
bonds, the Congress turned to a third option—printing
money, the now famous Continental. The Continental Congress issued excessive amounts of the notes, to the point that
they depreciated dramatically: thus the phrase “Not worth a
Continental.” In all, continental currency, state paper notes,
and quartermaster certificates totaled nearly $400 million,
which clearly contributed to inflation. The debate over this
currency can be cast in the same light as the one over the
colonial government note issues, in which the value of the
currency wildly fluctuated.
The First and Second Banks of the United States
With great effort and skill, Treasury Secretary Alexander
Hamilton convinced Congress to approve the First Bank of
the United States in 1791, with a 20-year charter. There were
serious political concerns about the operations of the First
Bank, particularly the lack of state control over a branch bank
operating within the state’s borders. It also seemed unfair to
many that state banks would be forced to compete against a
national commercial bank. Despite its name, the First Bank
was not to have the same functions and goals as a modern
central bank; instead, it would increase the productive capacity of the economy. The bank would be large and have operations in many states and therefore would provide a uniform
paper currency throughout the United States. At the same
time, it would also maintain the government’s credit. The
bulk of the bank’s capitalization took the form of government bonds, which provided an additional benefit to the government. By holding a portion of the debt as capital, the bank
helped keep government borrowing costs, or the interest
rates on government debt, low.
The First Bank did not realize its full potential as a commercial bank, but this was the result of a prudent strategy.
The complaints already mentioned would have multiplied if
the First Bank branches had made large numbers of loans,
taking business from state-chartered banks. The First Bank
did, however, take some actions that resembled those of a
central bank. For instance, if general financial market conditions dictated a reduction in available credit, the First Bank
would present accumulated notes of other banks for redemption in specie, forcing those banks to further reduce
their note issues because they now had a smaller reserve of
specie. If the First Bank deemed looser credit conditions were
necessary, it could expand its own lending operations, either
to businesses or to banks, and create a multiplied expansion
of bank credit. The First Bank could also affect this policy by
declining to present banknotes for redemption in specie. Its
government deposits and larger than normal reserve holdings allowed it to adopt this function. The First Bank then
conducted monetary policy by manipulating the specie holdings, or reserves, of other banks in the nation. The bank performed its functions well throughout its charter, but because
of the continued political controversy, particularly on the
constitutionality of the First Bank, its charter was not renewed upon expiration. The Treasury then became the primary economic policymaker for the U.S. government.
In the absence of the First Bank, the Treasury came to rely
on the state banks. Treasury deposits in state banks led to expansions of bank credit and eventually inflation and problems with the payment system in the United States. The financing of the War of 1812 increased the Treasury debt and
contributed to the expansion of bank credit. The Treasury
notes functioned as bank reserves, since they were a partial
legal tender and national money, and this led to a large expansion in available bank credit and in the number of banks.
The inflation caused problems with convertibility, an export
of gold and silver to other countries, and a concentration of
domestic deposits of gold and silver in the Northeast, as
banks in that region did not have such a high number of
banknotes in circulation.
The note issues were so excessive that the Treasury accepted banknotes as payment because a failure to do so
would lead to a financial crisis and bank failures. The supporters of a new national bank pointed to the improved security that would exist in the banking sector as a significant
reason to establish a new institution. The Treasury, in particular, endorsed the idea of a national bank to aid in a return to
more stable monetary and financial conditions.
The United States was concerned with resuming the specie
convertibility of banknotes in 1816, and it was into this policy era that the Second Bank of the United States entered.
Treasury Secretary William H. Crawford recognized the role
of the Treasury notes in the large issues of bank paper notes.
As government receipts increased in the period after the War
of 1812, the Treasury was able to retire a significant number
of its notes, which reduced bank reserves and led to a decrease in available bank credit and note issue. The deflation
that ensued moved the Second Bank toward the resumption
of specie payments. In this way, the Treasury was acting as a
modern central bank, directing monetary policy and using
the Second Bank as a scapegoat to take the complaints of
bankers, businesses, and debtors hurt by the decline in prices
and economic activity.
Initially, the Second Bank had the same role as the First
Bank—providing a source of demand for government debt.
The Treasury was the active player in monetary policy, adjusting its issues of debt and levels of deposits in the banking
system. Later in the life of the Second Bank, Nicholas Biddle
implemented monetary policy through the bank. He did not
come to the bank with these ideas but rather developed them
after examining the institution’s practices and the financial
conditions in the United States. The banking system at the
time was based on the convertibility of bank-issued paper
currency, or notes, into gold. In an effort to guarantee both
the security and the soundness of the banking system, as well
as control the level of currency in circulation, the Second
Bank undertook to control banknote issues. As the depository institution of the federal government, the Second Bank
had a larger source of funds to use than the rest of the banking system. As such, it came to hold a large number of commercial banknotes. If leaders of the Second Bank felt that the
note issues of any commercial bank were excessive (or nearly
excessive), they could threaten to present sufficient amounts
of the bank’s paper currency in their possession for payment
in specie. If the bank did not have a sufficient reserve of gold
available, they would be forced to suspend conversion—essentially, they would fail. Through this mechanism, the Second Bank was able to use its gold reserves to exert significant
control over the banking system, but it was exactly this ability that caught the attention of many legislators who abhorred this authority in general and especially in a nonelected official such as the president of the Bank of the United
States, who was appointed. The ability to conduct monetary
policy was also a political liability, as many were concerned
that there was the potential for much to go wrong with an
inept or “evil” person in control of the bank.
From the post–Civil war era to the founding of the Federal Reserve, the Department of the Treasury was responsible for monetary policy management in the United States. To
finance the Civil War, the Union had an option not truly
available to the Confederacy—issuing bonds. Unfortunately,
the large issues of bonds would drive up the costs of borrowing by raising the interest rate. As it had done with the
First and Second Banks, the government looked to create a
demand for its debt. It did this through the National Bank
system. The capital of the banks in this system could be U.S
government debt, which created a demand for the bonds. To
get banks to switch from state charters to national bank
charters required further legislation. The state banks were
doing fine and did not see any reason to adopt more stringent federal rules in their operations. To provide an incentive
for the banks to switch charters, the government imposed a
prohibitive tax of 10 percent on state banknote issues. The
costs were so high that many switched their charters. It was
through adjustments in the level of Treasury deposits in the
banking system that policy changes were enacted. These
changes also altered the level of reserves in the system and either expanded or contracted the available amount of bank
credit. This situation would lead to an adjustment throughout the entire banking sector, which would change the prevailing credit conditions and result, it was hoped, in achievement of the desired policy goal. A significant change in the
banking system came as part of the Union’s effort to finance
the Civil War.
The Federal Reserve System before the Great Depression
When members of Congress created the Federal Reserve system, they intended to reduce the seasonal fluctuations observed in the economy over the course of a year and to end
the cycle of panics in the financial system. (The system experienced major banking crises in 1873, 1884, 1890, 1893,
and 1907.) The Fed was to meet these goals by providing an
elastic currency. The credit flowing from the Federal Reserve
to the commercial banking sector would counter the normal
cyclical behavior of the economy and smooth out fluctuations in economic performance and activity. The only tool
available to the Fed was the discounting of eligible securities.
Through this process, banks would increase reserves and
have more credit available when needed (for example, during a recession).
World War I was an early challenge for the monetary policy of the Fed. Although initially not directly involved in the
conflict, the United States supplied the warring parties with
goods, which resulted in a large inflow of gold to the country.
The Fed did not have sufficient stocks of securities to sterilize, or offset, the increase in money supply. Sterilization
would involve the government selling securities for gold,
which would reduce the reserves in the system. The only option was to increase the discount rate, though the Fed did not
do that. The gold influx stopped when the United States entered the war and provided its Allies with credit for purchases. At this time, the young central bank agreed to an accommodation policy with the Treasury, wherein the Fed kept
government borrowing costs low in order to assist with the
war effort. The accommodation created an expansionary environment for bank credit, which led to acceleration of inflation. The gold standard eventually triggered an export of gold
from the United States, which reduced the supply of money.
The Fed did not take action until 1920, when outflows of gold
reached critical levels. The Fed raised the discount rate, which
stopped the exodus of gold but, in turn, led to a decrease in
the price level and economic activity and a recession in 1920
and 1921.
During the 1920s, the Fed discovered its second policy
tool—open market operations, or the purchase and sale of
government securities. Although these operations were
known before the 1920s, they were used only as a source
of revenue for the Fed, not as part of a monetary policy.
Gradually, the effect of purchases on interest rates was noticed. The connection between the bank reserves and a fractional reserve system led to the conclusion that if the Fed
purchased securities from commercial banks, that would
lead to an increase in bank reserves and the ability of banks
to increase credit in the economy through the multiple expansion of deposits and loans and thus lower interest rates.
Despite its importance, this understanding was not always
used appropriately in the 1920s to offset expansions in the
money supply.
The Federal Reserve System and the Great Depression
The Fed’s failure to end stock market speculation early in the
1920s led to a large run-up in stock prices, which it felt unable to stop. The Fed was not able to help strengthen the
weakening economy for fear of feeding the speculation in equities. Moral suasion proved ineffective, and eventually, the
Fed signaled its policy change by raising the discount rate.
The economic hardship of the Great Depression is well documented: nearly 25 percent unemployment; a reduction in
the U.S. capital stock; and a dramatic weakness in the banking sector, with thousands of bank failures and millions in
lost deposits. The inaction of the Fed at that time can be explained as the result of a battle between policy camps. Procyclical supporters urged no action; countercyclical advocates
urged an expansionary, countercyclical policy. International
conditions required the Fed to increase the discount rate in
order to return gold to the United States and increase the reserves in many banks. The banks held some of these reserves
as excess reserves—a cushion to ensure their ability to meet
depositor demands for liquidity. The Fed misinterpreted this
sign, believing that banks found inadequate lending opportunities, and it failed to adopt a policy stance that led to further expansion.
Many of the institutional changes that occurred during
the Great Depression affected monetary policy and the Fed
directly. Congress gave the Fed its last policy tool—the ability
to set reserve requirements. There were significant changes in
the banking sector, including the separation of commercial
bank activities, life insurance, and brokerage activities. The
Federal Deposit Insurance Corporation (FDIC) guaranteed
the deposits of customers up to a maximum amount. The
United States abandoned the gold standard and saw the price
of a troy ounce of gold in dollars increase nearly 70 percent
to $35. Gold flowed back into the United States, and as a result, the money supply expanded. The creation of deposit insurance also increased peoples’ confidence in the banking
system, and so cash flowed back into banks. In addition, the
expansion in reserves led to an increase in excess reserves, or
the funds the banks held to provide extra liquidity. The Fed
misinterpreted this increase as a sign of few acceptable lending options and decided to conduct open market sales in
order to reduce the risk of inflation in the future.
World War II presented a significant challenge for the Fed,
just as World War I had. Before America entered the hostilities, there was a buildup of gold in the United States as European nations and citizens sent gold overseas for purchases
and security. The Treasury also requested that the Fed adopt
an accommodation policy once again, though the effects on
the price level were less than those that occurred in World
War I. Inflation was low in this instance because of the entry
of the United States into the war in 1941. The inflationary
pressures did not have sufficient time to build, and the economy experienced a mix of price controls and public saving
because of a reduced availability of consumer goods. In addition, the Treasury’s efforts to finance the war led to patriotic
calls for sacrifice and saving, for example, through the purchase of war bonds.
After the war, several factors combined to increase the
level of inflation: People spent the accumulated savings and
wealth from the war period; the Fed continued to accommodate Treasury borrowing to keep the cost of funds low; and
the government adopted the Employment Act of 1946, making it the duty of the government, including the Fed, to maintain employment at a high level. The Bretton Woods system
of exchange rates, which centered on narrow bands for fluctuations with the U.S. dollar fixed in terms of gold, came into
existence and was thought to be strong enough to prevent the
transmission of crisis as had occurred in the 1930s. To help
maintain the system of exchange rates and keep international
financial flows moving, the International Monetary Fund
(IMF) was created.
Monetary policy became more active in the 1950s as inflation increased because of U.S. government buildup and expenditures for the Korean War. The Fed was certain that the
accommodation policy was at least partly to blame. The Fed
and the Treasury agreed to lift the accommodation policy,
though the Treasury made the Fed promise not to allow rates
to rise too quickly. The 1950s saw open market operations become the primary tool of monetary policy.
The Fed also became more concerned about targets for
monetary policy at this time and looked to measures such as
free reserves, or bank excess reserves less discount loans. High
levels of free reserves represented a relaxed policy conducive
to expansion, since banks had more reserves available to use
in making loans. The Fed’s other target, short-term interest
rates, functioned little better because of the increase in the
public’s inflationary expectations. As a result, the Fed was
constantly feeding the cycle rather than muting it. These concerns dogged the Fed over the entire course of the 1960s.
The Federal Reserve since the 1960s
The Fed’s policy record did not improve much in the early
1970s, despite the recognition by many economists that a
procyclical policy did not work. Arthur Burns became chair
of the Federal Reserve’s Board of Governors in 1970 and adjusted the Fed’s focus to monetary aggregates (that is, everything in the financial sector, including savings accounts and
money market accounts). Unfortunately, the Fed was about
to discover that some choices of targets were inconsistent and
would force policy to be procyclical once again. The Fed used
two sets of targets, one for the monetary aggregates and one
for short-term interest rates, the federal funds rate. The problem was the bandwidth adopted for the two separate targets.
The monetary aggregate growth rates were typically quite
large, whereas the bandwidth for the federal funds rate
tended to be smaller. The result was that although the Fed
thought it targeted the aggregates, it was actually focusing on
the short-term interest rates. As economic events caused
market rates to rise outside the prescribed bandwidth, the
Fed would conduct open market purchases to add credit to
the system and lower the interest rate. The side effect of this
policy was that it also increased the monetary base and reserves in the banking system. The multiple expansion of deposits led to larger levels of the monetary aggregates than targeted and an increase in inflation, which tended to result in
an increase in market interest rates again.
In 1979, with the appointment of Paul Volcker to the position of chair of the Board of Governors, the Fed began a
long fight against inflation and the expectations of inflation
in the economy. Volcker de-emphasized the interest rate targets of the Fed to allow them to rise. To slow inflation, the
economy needed to experience a slowdown. Part of the difficulty in this process was the lack of Federal Reserve credibility. Despite numerous previous attempts at reducing inflation, monetary policy did not seem capable of reaching this
goal. People were unsure whether the current Fed policy
would actually reduce the level of inflation permanently, and
consequently, adjustment was quite difficult. Also at question
was whether the Fed would stick to its policy or recant in the
face of public pressure and economic weakness. Additional
complicating factors at the time were financial innovation
and regulation.
The high interest rates of the 1970s led to a process known
as disintermediation, as people withdrew their deposits from
banks with rate ceilings set lower than the market rate or
completely disallowed, as on demand deposits. People and
companies attempted to hold as little in transactions accounts as possible. Money market mutual funds were a popular destination for these monies. Banks countered with negotiable order of withdrawal (NOW) and automatic transfer
from savings (ATS) accounts that paid market rates, but it
was not really enough. The 1982 Garn-St. Germain Depository Institutions Act introduced money market deposit accounts (MMDAs), which had no interest rate ceilings. The
Depository Institutions Deregulation and Monetary Control
Act (DIDMCA) of 1980 extended Fed reserve requirements
to all depository institutions and allowed nonmember banks
access to the Fed’s discount window. Financial and technological innovations diminished the predictive power of relationships between monetary aggregates and other economic
variables of interest to monetary policy makers.
The 1980s saw the adoption of a borrowed reserves target,
that is, discount loans. As interest rates rise, there is an incentive for banks to increase their borrowing from the central
bank to boost their levels of reserves available for lending. To
offset this upward pressure on interest rates, the Fed conducted open market purchases in an effort to increase the
available supply of credit and lower the interest rate. Although the interest rates were under tighter control, the open
market purchases resulted in an increase in the money supply. The large fluctuations in money supply caused by this
target led the Fed to abandon its M1 target in the late 1980s
and eventually its M2 in the 1990s. (M1 is a measure of the
U.S. money stock that consists of currency held by the public, travelers’ checks, demand deposits, and other checkable
deposits, including negotiable order of withdrawal [NOW]
and automatic transfer service [ATS] account balances and
share draft account balances at credit unions. M2 is M1 plus
savings accounts and small-denomination time deposits, plus
shares in money market mutual funds [other than those restricted to institutional investors], plus overnight Eurodollars
and repurchase agreements.)
The 1990s brought new challenges to the Fed. The
1990–1991 recession was an important economic event, and
the fear of a slow recovery or a prolonged recession resulted
in the Fed maintaining a low federal funds rate of 3 percent.
The easy credit policy provided banks with the reserves they
needed to make loans and expand economic activity. The Fed
was still wary of inflation expectations, however, and in the
mid-1990s, when it was clear that the economy was recovering, it increased the federal funds rate to 6 percent. This move
has been termed a preemptive strike against inflation. The
Fed was signaling to financial markets that it was still wary of
inflation and would take the necessary steps to prevent its return, so much so that it would not let expectations of inflation take root in the economy.
The stock market decline in the year 2000 and the terrorist
attacks of September 11, 2001, have posed additional problems for the Fed. To complicate matters, the accounting practices of American corporations and several large bankruptcies
resulted in instability in the financial markets for much of the
years 2001 and 2002. At this point, the Fed must attempt to
balance several of its goals, such as achieving financial market
stability and price stability. The federal funds rate stands at
historically low levels in an attempt to foster a sustained recovery in the American economy. The active and early response of the Fed to the problems of 2000–2001 prevented
prolonged recession and economic crisis. However, as the
economy expands, the Fed will keep a close eye on the market’s expectations of inflation and take action accordingly.
—David T. Flynn
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