Objectives of this Chapter

This chapter describes the history and implementation of monetary policy in the United States. The first section provides a very brief overview of the history of central banking in the United States. This section concludes with a discussion of the stated objectives of the Federal Reserve System. Specifically, the “dual mandate” of monetary policy is discussed – the idea that the Federal Open Market Committee (FOMC) (which is one component of the Federal Reserve System) has been directed by Congress to set monetary policy with an eye towards the dual goals of full employment and stable prices.

In the second section of the chapter, we describe an approximation to the method by which the Federal Open Market Committee has implemented monetary policy to satisfy its dual mandate for the past 20 years. Specifically, we discuss the “Taylor rule” for monetary policy. The Taylor rule specifies that the FOMC sets the Federal Funds Rate – the overnight rate at which banks borrow reserves from each other – as a function of data on GDP (full employment) and inflation (stable prices). We compare the predicted Federal Funds Rate based on the Taylor rule to the actual Federal Funds Rate as set by the FOMC and show that the predictions of the Taylor rule imperfectly align with the data.

The third and final section of this chapter discusses the “quantity theory of money,” which links growth in the stock of money to growth in real GDP and inflation.