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Monetary policy consists of the efforts of the Federal
Reserve ("the Fed," for short), the central
bank of the United States, to influence money and credit
conditions in the economy in order to achieve the country’s
macroeconomic goals.
Those goals include stable prices, high employment, and maximum sustainable
growth in the economy. Prices are considered stable when they change slowly
enough so that people pay little attention to price changes in making
economic decisions.
Growth can be measured by the rate of change of real gross domestic product
(GDP) -- that is, the output of the economy adjusted for changes in prices.
The level of sustainable growth, the rate at which the economy can grow
without causing the inflation rate to accelerate, is determined by how
fast the hours worked by the U.S. labor force and output per worker grow.
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The Fed formulates monetary policy by setting a target
for the federal funds rate, the interest rate that banks
charge one another for very short-term loans.
Because the fed funds rate is what banks pay when they borrow, it affects
the rates they charge when they lend. Those rates, in turn, influence
other short-term interest rates in the economy, and, with a lag, economic
activity and the rate of inflation.
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The Fed uses open market operations, the sale or purchase
of previously issued U.S. government securities, to influence
the amounts that banks can lend, thereby raising or lowering
the federal funds rate. When the Fed buys securities,
it injects funds into the banking system, giving banks
more to lend and putting downward pressure on the fed
funds rate; when it sells securities, it does the opposite.
The results of the Fed’s monetary policy actions cannot be predicted
with precision. The Federal Reserve’s influence over short-term interest
rates can create conditions conducive to economic growth, but ever-changing
market and political conditions, here and abroad, also heavily influence
the millions of economic and financial decisions of households and businesses.
When was the most recent change in monetary policy?
What did the Fed do on that occasion? Find the answers
at: Open
Market Operations  |
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The Federal Reserve sets the discount rate, which is the
interest rate that banks pay on short-term loans from
the Fed. The Fed often makes identical changes in its
target for the federal funds rate and in the discount
rate. Thus, discount rate cuts typically reflect the Fed’s
desire to stimulate the economy, and increases in the
discount rate often reflect the Fed’s concern over the
threat of inflation.
For monetary policy purposes, the discount rate is not as important as
the federal funds rate, because banks don’t borrow very much from the
Fed.
The Federal Reserve stresses that it is a "lender of last resort."
That means the banks have to try to borrow elsewhere before they come
to borrow from the Fed, and it means also that a bank should not ask to
borrow from the Fed too often.
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