FRBSF Economic Letter
99-01; January 1, 1999
U.S. Monetary Policy: An Introduction
Special Issue. This Special issue is a reprint of a pamphlet
prepared by the Economic Research Department of the Federal Reserve Bank
of San Francisco as part of our economics education program.
U.S. monetary policy affects all kinds of economic
and financial decisions people make in this country--whether to get a
loan to buy a new house or car or to start up a company, whether to expand
a business by investing in a new plant or equipment, and whether to put
savings in a bank, in bonds, or in the stock market, for example. Furthermore,
because the U.S. is the largest economy in the world, its monetary policy
also has significant economic and financial effects on other countries.
The object of monetary policy is to influence the performance of the
economy, as reflected in such factors as inflation, economic output, and
employment. It works by affecting demand across the economy--that is,
the population's willingness to spend on goods and services.
While most people are familiar with the fiscal policy tools that affect
demand--such as taxes and government spending--many are less familiar
with monetary policy and its tools. Monetary policy is conducted by the
Federal Reserve System, the nation's central bank, and it influences demand
mainly by raising and lowering short-term interest rates.
This Economic Letter is an introduction to U.S. monetary policy
as it is currently conducted, and it answers a series of questions:
- How is the Fed structured to make monetary policy decisions?
- What are the Fed's goals?
- What tools does it use to implement its policies?
- How does monetary policy affect the U.S. economy?
- How does the Fed formulate strategies to reach its goals?
How Is the Federal Reserve Structured?
The Federal Reserve System (called the Fed, for short) is the nation's
central bank. It was established by an Act of Congress in 1913 and consists
of the seven members of the Board of Governors in Washington, D.C., and
twelve Federal Reserve District Banks (for a discussion of the Fed's overall
responsibilities, see The
Federal Reserve System: Purposes and Functions).
The Congress structured the Fed to be independent within the government--that
is, although the Fed is accountable to the Congress, it is insulated from
day-to-day political pressures. This reflects the conviction that the
people who control the country's money supply should be independent of
the people who frame the government's spending decisions. Most studies
of central bank independence rank the Fed among the most independent in
What makes the Fed independent?
Three structural features make the Fed independent:
the appointment procedure for governors, the appointment procedure for
Reserve Bank Presidents, and funding.
Appointment procedure for Governors. The seven Governors on
the Federal Reserve Board are appointed by the President of the United
States and confirmed by the Senate. Independence derives from a couple
of factors: First, the appointments are staggered to reduce the chance
that a single U.S. President could "load" the Board with appointees; second,
their terms of office are 14 years--much longer than elected officials'
Appointment procedure for Reserve Bank Presidents. Each Reserve
Bank President is appointed to a five-year term by that Bank's Board of
Directors, subject to final approval by the Board of Governors. This procedure
adds to independence because the Directors of each Reserve Bank are not
chosen by politicians but are selected to provide a cross-section of interests
within the region, including those of depository institutions, nonfinancial
businesses, labor, and the public.
Funding. The Fed is structured to be self-sufficient in the
sense that it meets its operating expenses primarily from the interest
earnings on its portfolio of securities. Therefore, it is independent
of Congressional decisions about appropriations.
How is the Fed "independent within government"?
Even though the Fed is independent of Congressional appropriations and
administrative control, it is ultimately accountable to Congress and comes
under government audit and review. The Chairman, other Governors, and
Reserve Bank Presidents report regularly to the Congress on monetary policy,
regulatory policy, and a variety of other issues and meet with senior
Administration officials to discuss the Federal Reserve's and the federal
government's economic programs.
Who makes monetary policy?
The Fed's FOMC (Federal Open Market Committee) has primary responsibility
for conducting monetary policy. The FOMC meets in Washington eight times
a year and has twelve members: the seven members of the Board of Governors,
the President of the Federal Reserve Bank of New York, and four of the
other Reserve Bank Presidents, who serve in rotation. The remaining Reserve
Bank Presidents attend the meetings and contribute to the Committee's
discussions and deliberations.
In addition, the Directors of each Reserve Bank contribute to monetary
policy by making recommendations about the appropriate discount rate,
which are subject to final approval by the Governors. (See "What
Are the Tools of Monetary Policy?")
What Are the Goals of U.S. Monetary
Monetary policy has two basic goals: to promote "maximum" output and
employment and to promote "stable" prices. These goals are prescribed
in a 1977 amendment to the Federal Reserve Act.
What does "maximum" output and employment mean?
In the long run, the level of output and employment in the economy depends
on factors other than monetary policy. These include technology and people's
preferences for saving, risk, and work effort. So, "maximum" employment
and output means the levels consistent with these factors in the long
But the economy goes through business cycles in which output and employment
are above or below their long-run levels. Even though monetary policy
can't affect either output or employment in the long run, it can affect
them in the short run. For example, when demand contracts and there's
a recession, the Fed can stimulate the economy--temporarily--and help
push it back toward its long-run level of output by lowering interest
rates. Therefore, in the short run, the Fed and many other central banks
are concerned with stabilizing the economy--that is, smoothing out the
peaks and valleys in output and employment around their long-run levels.
If the Fed can stimulate the economy out of a recession, why
doesn't it stimulate all the time?
Consistent attempts to expand the economy beyond its long-run level will
result in capacity constraints that lead to higher and higher inflation,
without producing lower unemployment or higher output in the long run.
In other words, not only are there no long-term gains from consistently
pursuing expansionary policies, but there's also a price--higher inflation.
What's so bad about higher inflation?
High inflation can hinder economic growth. For example, when inflation
is high, it also tends to vary a lot, and that makes people uncertain
about what inflation will be in the future. That uncertainty can hinder
economic growth in a couple of ways--it adds an inflation risk premium
to long-term interest rates, and it complicates the planning and contracting
by business and labor that are so essential to capital formation.
High inflation also hinders economic growth in other ways. For example,
because many aspects of the tax system are not indexed to inflation, high
inflation distorts economic decisions by arbitrarily increasing or decreasing
after-tax rates of return to different kinds of economic activities. In
addition, it leads people to spend time and resources hedging against
inflation instead of pursuing more productive activities.
So that's why the other goal is "stable prices"?
Yes. Although monetary policy cannot expand the economy or reduce unemployment
in the long run, it can stabilize prices in the long run. Price "stability"
is basically low inflation--that is, inflation that's so low that people
don't worry about it when they make decisions about what to buy, whether
to borrow or invest, and so on.
If low inflation is the only thing the Fed can achieve in the
long run, why isn't it the sole focus of monetary policy?
Because the Fed can determine the economy's average rate of inflation,
some commentators--and some members of Congress as well--have emphasized
the need to define the goals of monetary policy in terms of price stability,
which is achievable. However, volatility in output and employment also
is costly to people. In practice, the Fed, like most central banks, cares
about both inflation and measures of the short-run performance of the
Are the two goals ever in conflict?
Yes, sometimes they are. One kind of conflict involves deciding which
goal should take precedence at any point in time. For example, suppose
there's a recession and the Fed works to prevent employment losses from
being too severe; this short-run success could turn into a long-run problem
if monetary policy remains expansionary too long, because that could trigger
inflationary pressures. So it's important for the Fed to find the balance
between its short-run goal of stabilization and its longer-run goal of
maintaining low inflation.
Another kind of conflict involves the potential for pressure from the
political arena. For example, in the day-to-day course of governing the
country and making economic policy, politicians may be tempted to put
the emphasis on short-run results rather than on the longer-run health
of the economy. The Fed is somewhat insulated from such pressure, however,
by its independence, which allows it to achieve a more appropriate balance
between short-run and long-run objectives.
Why don't the goals include helping a region of the country that's
Often enough, some state or region is going through a recession of its
own while the national economy is humming along. But the Fed can't concentrate
its efforts to expand the weak region for two reasons. First, monetary
policy works through credit markets, and since credit markets are linked
nationally, the Fed simply has no way to direct stimulus to any particular
part of the country that needs help. Second, if the Fed stimulated whenever
any state had economic hard times, it would be stimulating much of the
time, and this would mean higher inflation.
But this focus on the well-being of the national economy doesn't mean
that the Fed ignores regional economic conditions. Extensive regional
data and anecdotal information are used, along with statistics that directly
measure developments in the regional economy, to fit together a picture
of the national economy's performance. This is one advantage to having
regional Federal Reserve Bank Presidents sit on the FOMC: They are in
close contact with economic developments in their regions of the country.
The Fed can't control inflation or influence output and employment directly;
instead, it affects them indirectly, mainly by raising or lowering short-term
interest rates. The Fed affects interest rates mainly through open market
operations and the discount rate, and both of these methods work through
the market for bank reserves, known as the federal funds market.
What are bank reserves?
Banks and other depository institutions (for convenience, we'll refer
to all of these as "banks") are legally required to hold a specific amount
of funds in reserve. These funds, which can be used to meet unexpected
outflows, are called reserves, and banks keep them as cash in their vaults
or as deposits with the Fed. Currently, banks must hold 3-10% of the funds
they have in interest-bearing and non-interest-bearing checking accounts
as reserves (depending on the dollar amount of such accounts held at each
What is the federal funds market?
From day to day, the amount of reserves a bank has to hold may change
as its deposits change. When a bank needs additional reserves on a short-term
basis, it can borrow them from other banks that happen to have more reserves
than they need. These loans take place in a private financial market called
the federal funds market.
The interest rate on the overnight borrowing of reserves is called the
federal funds rate or simply the "funds rate." It adjusts to balance the
supply of and demand for reserves. For example, an increase in the amount
of reserves supplied to the federal funds market causes the funds rate
to fall, while a decrease in the supply of reserves raises that rate.
What are open market operations?
The major tool the Fed uses to affect the supply of reserves in the banking
system is open market operations--that is, the Fed buys and sells government
securities on the open market. These operations are conducted by the Federal
Reserve Bank of New York.
Suppose the Fed wants the funds rate to fall. To do this, it buys government
securities from a bank. The Fed then pays for the securities by increasing
that bank's reserves. As a result, the bank now has more reserves than
it is required to hold. So the bank can lend these excess reserves to
another bank in the federal funds market. Thus, the Fed's open market
purchase increases the supply of reserves to the banking system, and the
federal funds rate falls.
When the Fed wants the funds rate to rise, it does the reverse, that
is, it sells government securities. The Fed receives payment in reserves
from banks, which lowers the supply of reserves in the banking system,
and the funds rate rises.
What is the discount rate?
Banks also can borrow reserves from the Federal Reserve Banks at their
"discount windows," and the interest rate they must pay on this borrowing
is called the discount rate. The total quantity of discount window borrowing
tends to be small, because the Fed discourages such borrowing except to
meet occasional short-term reserve deficiencies (see The
Federal Reserve: Purposes and Functions for a discussion of other
types of discount window borrowing that are unrelated to monetary policy).
The discount rate plays a role in monetary policy because, traditionally,
changes in the rate may have "announcement effects"--that is, they sometimes
signal to markets a significant change in monetary policy. A higher discount
rate can be used to indicate a more restrictive policy, while a lower
rate may signal a more expansionary policy. Therefore, discount rate changes
are sometimes coordinated with FOMC decisions to change the funds rate.
What about foreign currency operations?
Purchases and sales of foreign currency by the Fed are directed by the
FOMC, acting in cooperation with the Treasury, which has overall responsibility
for these operations. The Fed does not have targets, or desired levels,
for the exchange rate. Instead, the Fed gets involved to counter "disorderly"
movements in foreign exchange markets, such as speculative movements that
may disrupt the efficient functioning of these markets or of financial
markets in general. For example, during some periods of disorderly declines
in the dollar, the Fed has purchased dollars (sold foreign currency) to
absorb some of the selling pressure.
Intervention operations involving dollars, whether initiated by the Fed,
the Treasury, or by a foreign authority, are not allowed to alter the
supply of bank reserves or the funds rate. The process of keeping intervention
from affecting reserves and the funds rate is called the "sterilization"
of exchange market operations. As such, these operations are not used
as a tool of monetary policy.
The point of implementing policy through raising or lowering interest
rates is to affect people's and firms' demand for goods and services.
This section discusses how policy actions affect real interest rates,
which in turn affect demand and ultimately output, employment, and inflation.
What are real interest rates and why do they matter?
For the most part, the demand for goods and services is not related to
the market interest rates quoted on the financial pages of newspapers,
known as nominal rates. Instead, it is related to real interest rates--that
is, nominal interest rates minus the expected rate of inflation.
Variations in expected inflation can make a big difference in interpreting
the stance of monetary policy. In 1978, the nominal funds rate averaged
8%, but the rate of inflation was 9%. So, even though nominal interest
rates were high, monetary policy actually was stimulating demand with
a negative real funds rate of minus 1%.
By contrast, in early 1998, the nominal funds rate was 5% and the inflation
rate was running at about 2%. This implied a positive 3% real funds rate.
So the nominal funds rate of 8% in 1978 was more stimulative than the
5% nominal funds rate in early 1995.
How do real interest rates affect economic activity in the short
Changes in real interest rates affect the public's demand for goods and
services mainly by altering borrowing costs, the availability of bank
loans, the wealth of households, and foreign exchange rates.
For example, a decrease in real interest rates lowers the cost of borrowing
and leads to increases in business investment spending and household purchases
of durable goods, such as autos and new homes. In addition, lower real
rates and a healthy economy may increase banks' willingness to lend to
businesses and households. This may increase spending, especially by smaller
borrowers who have few sources of credit other than banks. Lower real
rates make common stocks and other such investments more attractive than
bonds and other debt instruments; as a result, common stock prices tend
to rise. Households with stocks in their portfolios find that the value
of their holdings has gone up, and this increase in wealth makes them
willing to spend more. Higher stock prices also make it more attractive
for businesses to invest in plant and equipment by issuing stock. In the
short run, lower real interest rates in the U.S. also tend to reduce the
foreign exchange value of the dollar, which lowers the prices of the exports
we sell abroad and raises the prices we pay for foreign-produced goods.
This leads to higher aggregate spending on goods and services produced
in the U.S.
The increase in aggregate demand for the economy's output through these
various channels leads firms to raise production and employment, which
in turn increases business spending on capital goods even further by making
greater demands on existing factory capacity. It also boosts consumption
further because of the income gains that result from the higher level
of economic output.
How does monetary policy affect inflation?
Wages and prices will begin to rise at faster rates if monetary policy
stimulates aggregate demand enough to push labor and capital markets beyond
their long-run capacities. In fact, a monetary policy that persistently
attempts to keep short-term real rates low will lead eventually to higher
inflation and higher nominal interest rates, with no permanent increases
in output or decreases in unemployment. As noted earlier, in the long
run, output and employment cannot be set by monetary policy. In other
words, while there is a trade-off between higher inflation and lower unemployment
in the short run, the trade-off disappears in the long run.
Policy also can affect inflation directly through people's expectations
about future inflation. For example, suppose the Fed eases monetary policy.
If consumers and business people expect higher inflation in the future,
they'll ask for bigger increases in wages and prices. That in itself will
raise inflation without big changes in employment and output.
Doesn't U.S. inflation depend on worldwide capacity, not just
In this era of intense global competition, it might seem parochial to
focus on U.S. capacity as a determinant of U.S. inflation, rather than
on world capacity. For example, some argue that even if unemployment in
the U.S. drops to very low levels, U.S. workers wouldn't be able to push
for higher wages, because they're competing for jobs with workers abroad,
who are willing to accept much lower wages.
This reasoning doesn't hold up too well, however, for a couple of reasons.
First, a large proportion of what we consume in the U.S. isn't affected
very much by foreign trade. One example is health care, which isn't traded
internationally, and which amounts to about 14% of GDP.
Second, even when we consider goods that are traded internationally,
the effect on U.S. prices is largely offset by flexible foreign exchange
rates. Suppose the price of steel, or some other good, is lower in Japan
than in the U.S. When U.S. manufacturers buy Japanese steel, they have
to pay for it in yen, which they buy on the foreign exchange market. As
a result, the value of the yen will climb relative to the dollar, and
the cost of Japanese steel to U.S. firms will go up--even though the Japanese
have not changed the (yen) price they charge.
How long does it take a policy action to affect the economy and
The lags in monetary policy are long and variable. The major effects
of a change in policy on growth in the overall production of goods and
services usually are felt within three months to two years. And the effects
on inflation tend to involve even longer lags, perhaps one to three years,
Why are the lags so hard to predict?
Since monetary policy is aimed at affecting people's demand, it's dealing
with human responses, which are changeable and hard to predict.
For example, the effect of a policy action on the economy will depend
on what people think the Fed action means for inflation in the future.
If people believe that a tightening of policy means the Fed is determined
to keep inflation under control, they'll immediately expect low inflation
in the future, so they're likely to ask for smaller wage and price increases,
and this will help to achieve that end. But if people aren't convinced
that the Fed is going to contain inflation, they're likely to ask for
bigger wage and price increases, and that means that inflation is likely
to rise. In this case, the only way to bring inflation down is to tighten
so much and for so long that there are significant losses in employment
The Fed's job of stabilizing output in the short run and promoting price
stability in the long run is made more difficult by two main factors:
the long and variable lags in policy, and the uncertain influences of
factors other than monetary policy on the economy.
What problems do lags cause?
The Fed's job would be much easier if monetary policy had swift and sure
effects. Policymakers could set policy, see its effects, and then adjust
the settings until they eliminated any discrepancy between economic developments
and the goals.
But with the long lags and uncertain effects of monetary policy actions,
the Fed must be able to anticipate the effects of its policy actions into
the distant future. To see why, suppose the Fed waits to shift its policy
stance until it actually sees an increase in inflation. That would mean
that inflationary momentum already had developed, so the task of reducing
inflation would be that much harder and more costly in terms of job losses.
Not surprisingly, anticipating policy effects in the future is a difficult
What problems are caused by other influences on the economy?
Output, employment, and inflation are influenced not only by monetary
policy actions, but also by such factors as our government's taxing and
spending policies, the availability and price of key natural resources
(such as oil), economic developments abroad, financial conditions at home
and abroad, and the introduction of new technologies.
In order to have the desired effect on the economy, the Fed must take
into account the influences of these other factors and either offset them
or reinforce them as needed. This isn't easy because sometimes these developments
occur unexpectedly and because the size and timing of their effects are
difficult to estimate.
The recent currency crisis in East Asia is a good example. Over the past
year or so, economic activity in those countries has either slowed or
declined, and this has reduced their demand for U.S. products. In addition,
the foreign exchange value of most of their currencies has depreciated,
and this has made Asian-produced goods less expensive for us to buy and
U.S.-produced goods more expensive in Asian countries. By themselves,
these factors would reduce the demand for U.S. products and therefore
lower our output and employment. As a result, this is a factor that the
Fed has had to consider in setting monetary policy.
Another example is the spread of new technologies that can enhance productivity.
When workers and capital are more productive, the economy can expand more
rapidly without creating inflationary pressures. In the last few years,
there have been indications that the U.S. economy may have experienced
a productivity surge, perhaps brought on by computers and other high-tech
developments. The issue for monetary policymakers is how much faster productivity
is increasing and whether those increases are temporary or permanent.
With all these uncertainties, how does the Fed know how and when
its policies will affect the economy?
The Fed looks at a whole range of indicators of the future course of
output, employment, and inflation. Among the indicators are measures of
the money supply, real interest rates, the unemployment rate, nominal
and real GDP growth, commodity prices, exchange rates, various interest
rate spreads (including the term structure of interest rates), and inflation
expectations surveys. Economic forecasting models help give structure
to understanding the interplay of these indicators and policy actions.
But these models are far from perfect--so policymakers rely on their own
less formal judgments about indicators as well. Indeed, policymakers often
disagree about how important one indicator is rather than another--and
this isn't surprising, because the indicators can be hard to interpret,
and they can even give contradictory signals.
To illustrate the difficulties of interpreting these indicators, consider
the problems with three of the most prominent: the money supply measures
(M1, M2, and M3), real interest rates, and the unemployment rate.
What are the problems of using the money supply as an indicator of
future economic performance? Before much of the deregulation of the
financial markets in the 1980s, measures of the money supply were pretty
reliable predictors of aggregate spending; moreover, they could be controlled
relatively well by the Fed. So the Fed paid special attention to them
and to their annual target ranges during the 1970s and 1980s. In fact,
from late 1979 to late 1982 the Fed explicitly targeted money on a short-term
But the predictable relationship between the money supply and aggregate
spending began to fall apart once financial markets were deregulated and
new financial instruments were introduced. For example, consider M1, the
narrowest monetary measure, which includes only currency and (fully) checkable
deposits. Before deregulation, banks couldn't pay explicit interest on
the deposits in M1, so people tended to keep only as much in them as they
needed for their transactions; that made those deposits track spending
Once banks were allowed to pay explicit interest nationwide on checkable
deposits, M1 no longer reflected spending so well because people started
to leave money in those deposits over and above what they needed for transactions.
Furthermore, once private financial markets started introducing instruments
that competed with M1 deposits, some people shifted their funds to those
instruments, and that also weakened the relationship between M1 and spending.
Ultimately, the same kinds of deterioration occurred with the broader
money supply measures, M2 and M3.
The Fed still establishes annual ranges for M2 and M3, as well as for
total nonfinancial debt, as required by Congress. However, given the problems
with the reliability of the aggregates, they have come to play a less
central role in the formulation of monetary policy in the 1990s.
What are the problems with using real interest rates as indicators
of future economic performance? Real interest rates are natural variables
to consider as policy indicators, since they are influenced by the Fed
and they are a key link in the transmission mechanism of monetary policy.
But real interest rates are problematic as indicators of real GDP for
at least two reasons.
First, it is not always obvious when real rates are "high" or "low."
The reason is that real rates are figured as the nominal rate minus expected
future inflation. The level of expected future inflation may be hard to
estimate. Second, it also is not obvious how to determine the equilibrium
real interest rate--that is, the rate that would be consistent with the
full employment of labor and with real GDP being at its long-run level.
This rate is needed as a benchmark to judge whether a given real interest
rate is expansionary or contractionary.
The equilibrium real rate varies over time in ways that are difficult
to measure or predict, and it depends on many factors, such as the productivity
of investment, fiscal policy, tax rates, and preferences for risk and
saving. So, unless real interest rates are extremely high or low relative
to historical experience, it can be difficult to interpret the implications
of observed market interest rates for future economic developments.
Why is it hard to pinpoint the natural rate of unemployment? The
unemployment rate sometimes is used as an indicator of future inflation.
In judging the inflationary implications of the unemployment rate, some
economists focus on the so-called "natural rate" of unemployment as a
benchmark. The natural rate is the unemployment rate that would occur
when short-run cyclical factors have played themselves out--that is, when
wages have had time to adjust to balance labor demand and supply. All
else equal, if unemployment is below the natural rate, inflation would
tend to rise; likewise, if unemployment is above the natural rate, inflation
would tend to fall. But it is difficult to know what the natural rate
of unemployment is, because it can change if the structure of the labor
market changes. For example, the natural rate rose temporarily in the
1970s as more women sought jobs. And in recent years, some economists
have argued that the natural rate has fallen because of worker "insecurity"
stemming from rapid changes in the job skills needed by firms as computers
and other new technologies were introduced.
Is that why policymakers look at so many indicators?
Although all of the indicators mentioned above provide some useful information,
none is reliable enough to be used mechanically as a sole target or guide
As a result, each FOMC policymaker must process all the available information
according to his or her own best judgment and with the advice of the best
research available. They then discuss and debate the policy options at
FOMC meetings and try to reach a consensus on the best course of action.
Capital market. The market in which corporate equity and longer-term
debt securities (those maturing in more than one year) are issued and
Central bank. Principal monetary authority of a nation, which
performs several key functions, including issuing currency and regulating
the supply of money and credit in the economy. The Federal Reserve is
the central bank of the United States.
Depository institution. Financial institution that obtains its
funds mainly through deposits from the public; includes commercial banks,
savings and loan associations, savings banks, and credit unions.
Discount rate. Interest rate at which an eligible depository
institution may borrow funds, typically for a short period, directly from
a Federal Reserve Bank. The law requires that the board of directors of
each Reserve Bank establish the discount rate every fourteen days subject
to the approval of the Board of Governors.
Excess reserves. Amount of reserves held by an institution in
excess of its reserve requirement and required clearing balance.
Equilibrium real interest rate. The level of the real interest
rate that is consistent with the level of long-run output and full employment.
Federal funds rate. The interest rate at which banks borrow
surplus reserves and other immediately available funds. The federal funds
rate is the shortest short-term interest rate, with maturities on federal
funds concentrated in overnight or one-day transactions.
Fiscal policy. Federal government policy regarding taxation
and spending; set by Congress and the Administration.
Foreign currency operations. Purchase or sale of the currencies
of other nations by a central bank for the purpose of influencing foreign
exchange rates or maintaining orderly foreign exchange markets. Also called
foreign-exchange market intervention.
Foreign exchange rate. Price of the currency of one nation in
terms of the currency of another nation.
Government securities. Securities issued by the U.S. Treasury
or federal agencies.
Gross Domestic Product (GDP). The total market value of a nation's
output of goods and services. GDP may be expressed in terms of product--consumption,
investment, government purchases of goods and services, and net exports--or,
it may be expressed in terms of income earned--wages, interest, and profits.
Inflation. A rate of increase in the general price level of
all goods and services. (This should not be confused with increases in
the prices of specific goods relative to the prices of other goods.)
Inflationary expectations. The rate of increase in the general
price level anticipated by the public in the period ahead.
Long-term interest rates. Interest rates on loan contracts--or
debt instruments, such as Treasury bonds or utility, industrial, or municipal
bonds--having maturities greater than one year. Often called capital
M1. Measure of the U.S. money stock that consists of currency
held by the public, travelers checks, demand deposits, and other fully
M2. Measure of the U.S. money stock that consists of M1, certain
overnight repurchase agreements and certain overnight Eurodollars, savings
deposits (including money market deposit accounts), time deposits in amounts
of less than $100,000, and balances in money market mutual funds (other
than those restricted to institutional investors).
M3. Measure of the U.S. money stock that consists of M2, time
deposits of $100,000 or more at all depository institutions, term repurchase
agreements in amounts of $100,000 or more, certain term Eurodollars, and
balances in money market mutual funds restricted to institutional investors.
Market interest rates. Rates of interest paid on deposits and
other investments, determined by the interaction of the supply of and
demand for funds in financial markets.
Monetary policy. A central bank's actions to influence short-term
interest rates and the supply of money and credit, as a means of helping
to promote national economic goals. Tools of U.S. monetary policy include
open market operations, discount rate policy, and reserve requirements.
Natural rate of unemployment. The rate of unemployment that
can be sustained in the long run and that is consistent with constant
Nominal interest rates. Current stated rates of interest paid
Open market operations. Purchases and sales of government securities
and certain other securities in the open market, through the Domestic
Trading Desk at the Federal Reserve Bank of New York as directed by the
Federal Open Market Committee, to influence short-term interest rates
and the volume of money and credit in the economy. Purchases inject reserves
into the banking system and stimulate growth of money and credit; sales
do the opposite.
Productivity. The level of output per hour of work.
Real GDP. GDP adjusted for inflation. Real GDP provides the
value of GDP in constant dollars, which is used as an indicator of the
volume of the nation's output.
Real interest rates. Interest rates adjusted for the expected
erosion of purchasing power resulting from inflation. Technically defined
as nominal interest rates minus the expected rate of inflation.
Short-term interest rates. Interest rates on loan contracts--or
debt instruments such as Treasury bills, bank certificates of deposit,
or commercial paper--having maturities less than one year. Often called
money market rates.
Total nonfinancial debt. Includes outstanding credit market
debt of federal, state, and local governments and of private nonfinancial
sectors (including mortgages and other kinds of consumer credit and bank
loans, corporate bonds, commercial paper, bankers acceptances, and other
For an overview of the Federal Reserve System and its functions, see:
The Federal Reserve
System: Purposes and Functions, 8th ed. Washington, DC: Board
of Governors, Federal Reserve System, December 1994.
The Federal Reserve
System in Brief. Federal Reserve Bank of San Francisco.
For further discussion on several of the topics covered here, see the
following issues of the FRBSF Economic Letter:
Overview of monetary policy
94-27 "A Primer on Monetary Policy, Part I: Goals and Instruments," by
94-28 "A Primer on Monetary Policy, Part II: Targets and Indicators,"
by Carl Walsh.
Goals of monetary policy
93-21 "Federal Reserve Independence and the Accord of 1951," by Carl
93-44 "Inflation and Growth," by Brian Motley.
94-05 "Is There a Cost to Having an Independent Central Bank?" by Carl
95-16 "Central Bank Independence and Inflation," by Robert T. Parry.
95-25 "Should the Central Bank Be Responsible for Regional Goals?"
by Timothy Cogley and Desiree Schaan.
97-01 "Nobel Views on Inflation and Unemployment,"
by Carl Walsh.
97-27 "What Is the Optimal Rate of Inflation?"
by Timothy Cogley.
98-04 "The New Output-Inflation Trade-off,"
by Carl Walsh.
Monetary policy transmission mechanism
95-05 "What Are the Lags in Monetary Policy?" by Glenn Rudebusch.
95-23 "Federal Reserve Policy and the Predictability of Interest
Rates," by Glenn Rudebusch.
97-05 "Job Loss During the 1990s," by Rob
97-18 "Interest Rates and Monetary Policy,"
by Glenn Rudebusch.
97-29 "A New Paradigm?" by Bharat Trehan.
97-34 "Job Security Update," by Rob Valletta
and Randy O'Toole.
Monetary policy strategies
93-01 "An Alternative Strategy for Monetary Policy," by John Judd
and Brian Motley.
93-12 "Interest Rate Spreads as Indicators of Monetary Policy,"
by Chan Huh.
93-38 "Real Interest Rates," by Bharat Trehan.
93-42 "Monetary Policy and Long-Term Real Interest Rates," by Timothy
94-13 "Monetary Policy in a Low-Inflation Regime," by Timothy Cogley.
97-35 "NAIRU: Is It Useful for Monetary Policy?"
by John Judd.
98-07 "Is It Time to Look at
M2 Again?" by Kelly Ragan and Bharat Trehan.
98-17 "Central Bank Inflation
Targeting," by Glenn Rudebusch and Carl Walsh.
98-18 "U.S. Inflation Targeting:
Pro and Con," by Glenn Rudebusch and Carl Walsh.
98-28 "The Natural Rate, NAIRU, and
Monetary Policy," by Carl Walsh.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120