An Introduction to U.S. Monetary Policy

Most people find economics complicated to the point of being impenetrable. Of all the subject areas within economics, monetary theory and policy may be the most challenging for the general public. Money itself is a bit puzzling. After all, how did it happen that we give other people real goods and services and are willing to accept little pieces of paper or metal, or even bits and bytes on a computer, in return? When we expand that set of issues to include the workings of banks and other financial institutions, matters become even more abstract and complex. Few people understand how banks shift funds around and buy and sell sophisticated financial instruments. Adding monetary policy and the Federal Reserve System makes matters more complicated by an order of magnitude. The average citizen does not understand how the Fed makes its decisions, what it is trying to accomplish, or how it executes its plans.

In the text that follows, I hope to demystify many of these issues in monetary economics and monetary policy. Understanding what the Federal Reserve System (“the Fed”) does today and how it attempts to achieve macroeconomic policy goals requires some knowledge of where the Fed came from, what tools it has at its disposal, and what various objectives it might be trying to accomplish. I will explore the history of monetary institutions in the United States to put the Fed’s role in context and then look at the tools it can use to affect the money supply and, in turn, the macroeconomy. There are a variety of indicators that monetary policy makers might choose to affect, and which ones they target depends on their beliefs about the state of the economy and, more importantly, the particular macroeconomic theory they subscribe to. I will critically assess several of those frameworks and offer a superior alternative.

Monetary policy is important to understand, and to understand correctly, because mistakes can cause enormous problems. On the one hand, not creating enough money can lead to the kind of massive deflation we saw in the early 1930s that turned a severe recession into the Great Depression. On the other hand, creating too much money can lead to serious inflation like the United States saw in the 1970s and early 1980s and to the far worse inflation that other countries have experienced in the last few decades. Those high rates of inflation damage not just the macroeconomy, but also many of the households it comprises. Finally, I will consider some alternatives to the Federal Reserve System and evaluate their potential for providing a stable monetary framework for sustainable economic growth by avoiding both deflation and inflation.

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