Monetary Policy and Economic Activity

The Federal Reserve System uses monetary policy to support the nation’s primary economic goals: high employment, stable prices, economic growth, and balance in international accounts. While the System alone cannot achieve these goals, it can do a great deal to foster a monetary and credit climate conducive to their achievement. Promoting these economic goals and creating economic stability are the Federal Reserve System’s most important functions.

The Federal Reserve System conducts monetary policy by influencing the nation’s supply of money and credit. For example, a stable price level is a feature of the best possible environment for sustainable economic growth, continuing high employment, and balance in international accounts. Price level stability is closely related to the money supply in the long term. The Federal Reserve System controls the money supply and therefore it can focus its monetary policy to create long-term price stability that will foster the nation’s primary economic goals.

The level of economic activity and the price level are tied to the volume of spending in the economy. Increased spending requires either more money or for existing money to change hands more often (this is called velocity — the rate at which money is spent). Increases or decreases in the supply of money can result in shifts in spending that have important impacts on the price level and the level of economic activity.

A major responsibility of the Federal Reserve System is to provide the total amount of reserves consistent with the needs of the economy at reasonably stable prices. Changes in the volume of reserves influence the money supply, the availability of credit, interest rates, and as a result, the volume of spending. Depository institutions feel the impact of changes initially, but the effects quickly spread to the entire domestic economy, and often to the international economy as well.

Key Role of Depository Institutions. Narrowly defined, money consists of currency, coin and checkable deposits. Because they can affect the amount of checkable deposits by making loans, banks and other depository institutions play a vital role in determining the supply of money. Their actions can increase or decrease the volume of money in the economy through their lending activities.

Suppose the Federal Reserve System purchases government securities from a New York bond dealer. The Fed will credit the dealer’s bank’s reserve account at the Fed for the amount of the purchase. The dealer’s bank will then have excess reserve funds and can use them to make loans. If the bank makes a loan, it credits the checking account of the borrower. This creates new money in the form of additional checkable deposits for the borrower. But the process does not stop there. The borrower will spend the funds from the loan and they will become additional new deposits. Part of the new deposits must be held as reserves, but the rest can become a new loan. The bank credits the checking account of a new borrower, and more new money is created. By the time the process stops, checkable deposits usually have risen by several times the amount of the reserves created by the Fed’s original action. Conversely, a decline in reserves in the banking system can bring about a widespread decrease in the money supply.

The figure on the adjacent page shows an example of how a $10,000 purchase of government securities by the Fed will "create" $100,000 in deposits in the banking system. A reserve requirement of 10% (banks are required to keep 10% of their new deposits as reserves) means that the $10,000 securities purchase will have a multiple effect on deposits of (1/.1) or 10 times.

How Reserves Fit into the Picture. To a large extent, changes in the volume of reserves in the banking system determine the amount of money depository institutions can create. By increasing or decreasing the volume of reserves, the Federal Reserve System can influence the money supply as well as the availability of credit, interest rates, the level of economic activity and the price level. By stepping up the rate of increase in reserves, the System can stimulate spending. By slowing down the rate of increase in reserves, the System can reduce the rate of spending.