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Monetary Policy and the Federal Reserve

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Two Words from Fed Chairman Jerome Powell Sent Markets Soaring
—New York Times, November 28, 20181

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Corporate America Lacks Faith in the Fed to Control Inflation as Prices Peak
—CNBC, June 28, 20212

Markets Await the Fed’s Meeting before Making the Next Big Move in the Week Ahead
—CNBC, June 11, 20213
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As Consumers Fret about Near-Term Inflation, the Fed Is Watching Closely
—New York Times, July 12, 20214

Few institutions are as closely watched in the United States as the Federal Reserve (Fed). The media,
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industry analysts, and business managers carefully monitor statements by members of the Fed leadership—
both formal statements about monetary policy and informal remarks at public events—for clues on the likely
trajectories of borrowing costs, employment rates, inflation, and asset prices.

What is monetary policy and what is the Fed’s role in determining monetary policy? How are changes in
monetary policy implemented and how do these changes affect firms, households, and other stakeholders? This
note addresses these questions by outlining the Fed’s legal mandate, the tools at its disposal to achieve that
mandate, and the mechanisms through which its policy choices affect macroeconomic outcomes.
No

1 Binyamin Applebaum, “Two Words from Fed Chairman Jerome Powell Sent Markets Soaring,” New York Times, November 28, 2018,
www.nytimes.com/2018/11/28/business/federal-reserve-rate-jerome-powell.html (accessed Aug. 2, 2021).
2 Eric Rosenbaum, “Corporate America Lacks Faith in the Fed to Control Inflation as Prices Peak,” CNBC, June 28, 2021,
www.cnbc.com/2021/06/28/corporate-america-lacks-faith-in-the-fed-to-control-inflation.html (accessed Aug. 2, 2021).
3 Patti Domm, “Markets Await the Fed’s Meeting before Making the Next Big Move in the Week Ahead,” CNBC, June 11, 2021,
www.cnbc.com/2021/06/11/markets-await-the-feds-meeting-in-the-week-ahead.html (accessed Aug. 2, 2021).
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4 Jeanna Smialek, “As Consumers Fret about Near-Term Inflation, the Fed Is Watching Closely,” New York Times, July 12, 2021,
www.nytimes.com/2021/07/12/business/inflation-federal-reserve.html (accessed Aug. 2, 2021).

This technical note was prepared by Kinda Hachem, Associate Professor of Business Administration, and Daniel Murphy, Associate Professor of
Business Administration. Copyright  2021 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order
copies, send an email to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted
in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Our goal is to publish
materials of the highest quality, so please submit any errata to editorial@dardenbusinesspublishing.com.

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History and Background

The Federal Reserve Act of 1913 created the central bank of the United States—the Fed—and charged it
with the pursuit of “maximum employment, stable prices, and moderate long-term interest rates.”5 In practice,
this charter has been summarized as a dual mandate of maximum employment and stable prices, since moderate

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long-term interest rates tend to be a cause and consequence of price stability.

The Fed is governed by the Board of Governors of the Federal Reserve System. Up to seven governors
comprise the board leadership. Governors are nominated by the president of the United States and confirmed
by the US Senate. Of the governors, one is also confirmed as chairperson and responsible for consulting with
other government officials regarding national economic policy. The board operates from Washington, DC, but
to ensure that economic interests from around the country would be represented in the Fed’s decision-making,
the writers of the Federal Reserve Act divided the United States into 12 geographical areas and assigned to each

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a regional Federal Reserve Bank (FRB). The Fed governors, along with a rotating subset of the FRB presidents,
make decisions on monetary policy as members of the Federal Open Market Committee (FOMC). The FOMC
meets regularly throughout the year to examine the state of the economy and to determine the appropriate
course for monetary policy.

Having been created by an act of Congress, the Fed is a government agency. However, it was designed to
hold an exceptional degree of independence within the government. Fed governors are appointed to
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nonrenewable fixed terms and therefore cannot be fired at will.6 Furthermore, the language of the Fed’s dual
mandate was sufficiently vague to allow Fed leadership substantial discretion over its interpretation of the
objectives. For example, in 2012, the Fed for the first time formally interpreted its mandate of price stability as
2% inflation through its “longer-run goals and policy strategy” statement, and it did so independent of any
formal consultation process with other government officials. The Fed updated this statement in 2018,
emphasizing that “inflation at the rate of 2% is most consistent over the longer run with the Federal Reserve’s
statutory mandate.”7 Two years later, after inflation had continued to fall below the 2% target, the Fed clarified
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that achieving its 2% target was consistent with letting inflation exceed the target for some time so that it would
achieve a 2% inflation rate on average:

The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual
change in the price index for personal consumption expenditures, is most consistent over the longer
run with the Federal Reserve’s statutory mandate. The Committee judges that longer-term inflation
expectations that are well anchored at 2 percent foster price stability and moderate long-term interest
No

rates and enhance the Committee’s ability to promote maximum employment in the face of significant
economic disturbances. In order to anchor longer-term inflation expectations at this level, the
Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that,
following periods when inflation has been running persistently below 2 percent, appropriate monetary
policy will likely aim to achieve inflation moderately above 2 percent for some time.8

The Fed viewed 2% as a desirable level of inflation over the long term. Historically, as inflation rose well
above 2%, so did inflation volatility, and volatile inflation injected uncertainty into market exchanges and
resulted in large economic costs. For example, companies were less likely to hire workers and invest in new
Do

equipment when the real value of these commitments was uncertain. Furthermore, high inflation could be self-
perpetuating as workers demanded higher wages in anticipation of rising aggregate prices. Finally, as inflation

512 U.S.C. §§221–522 (1913).

6Governors are appointed to 14-year terms. Accountability to the public occurs through the chairperson, who must be reconfirmed every 4 years.
7 Yair Listokin and Daniel Murphy, “Macroeconomics and the Law,” Annual Review of Law and Social Science 15 (October 2019): 377–96.
8 “Statement on Longer-Run Goals and Monetary Policy Strategy,” Federal Open Market Committee, January 26, 2021,
www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf (accessed Aug. 2, 2021).

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rose, so did the frequency with which firms had to update their prices and renegotiate wage contracts; changing
prices or renegotiating wages could be costly, both directly and indirectly through a chilling effect on long-
standing business relationships.9

If high inflation bore large economic costs, why did the Fed not target a lower (or even zero) inflation rate?

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Any inflation target will involve some episodes of above-target inflation and some episodes of below-target
inflation as the central bank navigates new shocks to achieve the inflation target on average. An average inflation
rate of zero would thus be associated with episodes of negative inflation (deflation), and policymakers have
worried that deflation also gives rise to large economic costs. For example, firms and households may delay
purchases of durable goods in anticipation of lower future prices, to the detriment of merchants who depend
on those purchases to keep the lights on. This could exacerbate an existing downturn and make it increasingly
difficult for the central bank to pull the economy out of the mud.10

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More generally, one can interpret the Fed’s objective as maintaining output at its potential level. Potential
output—or the full employment level of output ( )—is the level of aggregate output such that the factors of
production are utilized optimally; that is, “(1) there are no cyclically unemployed workers or idle machines, and
(2) workers and machines are not being overworked.”11 Low unemployment and low, stable inflation are
indicative of an economy with output at its potential level.
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Tools of Monetary Policy

When the Fed was first created, its primary policy tool was the discount rate, defined as the interest rate at
which commercial banks and other depository institutions can borrow from the Fed. This tool was rooted in a
view that the Fed could adequately guide the economy by acting as a lender of last resort. A bank in need of
emergency liquidity could go to the Fed and obtain a short-term loan at the discount rate by posting some of
its assets as collateral. If satisfied with the quality of the collateral, the Fed would print money to make the loan,
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but the aim was less about finessing the money supply and more about assisting good banks with nowhere else
to turn.12 Changes in the discount rate would then have an indirect effect on economic activity. A lower discount
rate made it less costly for a bank to find itself in need of emergency liquidity. In response, banks became less
conservative in extending loans to firms and households, which in turn led to firms and households becoming
less conservative in their spending. The Fed could therefore encourage (discourage) spending by setting a lower
(higher) discount rate.
No

In the 1920s, with revenues from discount loans stagnating, the Fed decided to purchase some interest-
bearing US government securities to cover its operating costs including staff and premises.13 Unlike other
government agencies, the Fed doesn’t receive annual appropriations from Congress and instead uses revenues
to cover its costs, remitting any profit to the US Treasury. From the Fed’s perspective, the essence of a securities
purchase was quite similar to that of a discount loan—print money and earn interest to cover basic expenses—
except that now the money wasn’t going to banks with an urgent need for liquidity. The Fed thought little of
this until it noticed a much larger effect on the money supply. For every dollar printed by the Fed to buy
securities on the open market, more than a dollar of new bank deposits was being created.
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9 This paragraph draws on material from Daniel Murphy, “Brazilian Stagflation,” UVA-GEM-0145 (Charlottesville, VA: Darden Business Publishing,

2017).
10 An exacerbated downturn may necessitate long periods of very low interest rates to counteract, which can lead to additional policy concerns such

as excessive risk-taking by the financial sector and corresponding macroeconomic instability. See David Martinez-Miera and Rafael Repullo, “Search for
Yield,” Econometrica 82, no. 2 (March 2017): 351–78.
11 Daniel Murphy, “Aggregate Demand and Aggregate Supply,” UVA-GEM-0127 (Charlottesville, VA: Darden Business Publishing, 2014).
12 To this point, once the principal on a discount loan was repaid, the Fed could retire the money it had printed to extend the loan.
13 “Discovering Open Market Operations,” Federal Reserve Bank of Minneapolis, August 1, 1988,
www.minneapolisfed.org/article/1988/discovering-open-market-operations (accessed Aug. 2, 2021).

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How could one dollar of printed money from the Fed create more than one dollar of spendable money for
the general public? This is the famous “money multiplier” process. To understand what’s happening, let’s start
with a quantity that the Fed fully controls: the size of its balance sheet (Table 1).

Table 1. Stylized Fed balance sheet.

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Securities Currency in circulation ( )
Discount loans Bank reserves ( )
Total assets Total liabilities
Source: All tables created by authors.

The liabilities side of the Fed’s balance sheet is what the Fed “prints.” Currency in circulation ( ) captures

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physical bills, which are literally printed. Bank reserves ( ) capture electronic bills, which are figuratively
printed. The Fed fully controls the sum, which it calls the monetary base ( ). Formally (Equation 1):

= + .

When the Fed creates a liability on its balance sheet—that is, when the Fed increases the monetary base—
it receives an asset in return. These assets (on the left-hand side of the stylized Fed balance sheet in Table 1)
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include both loans that the Fed makes to banks at the discount rate and securities that the Fed purchases on
the open market.

It may be tempting to assume that the monetary base is the economy’s money supply. But closer inspection
reveals that the Fed’s liabilities are not quite the same as what members of the nonbank public (i.e., firms,
households, and the government) use to purchase goods and services. While cash as captured by is certainly
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used, payments are more frequently made with deposits in a checking account ( ). The money supply—
that is, the stock of liquid assets that can be easily exchanged for goods and services—is then better defined as
Equation 2:

= + .

Immediately, we notice that the difference between the Fed’s liabilities (as captured by the monetary base
) and the money we use in transactions (as captured by the money supply ) stems from a distinction between
No

reserves and deposits. If every dollar of reserves were to create exactly one dollar of deposits, there would be
no money multiplier; the monetary base would indeed be the economy’s money supply.

Commercial banks are the key players that connect reserves and deposits. Reserves are a liquid asset that
banks hold; deposits are a liquid liability that banks offer. When the Fed buys a US government security on the
open market, it is almost always purchasing that security from a bank. The purchase creates reserves (equal to
the value of the security) that the bank can lend out to a firm or household. This loan becomes a deposit in the
loan recipient’s bank account. And the bank that receives the deposit can then issue new loans, creating
additional deposits in the banking system. The process continues in this way, with new deposits used to create
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new loans and new loans leading to the creation of new deposits.

The use of deposits to create loans is feasible under one very important condition: not everyone needs to
use all their deposits at the same time. As long as this condition holds, a bank doesn’t need to match its liquid
liabilities (deposits) with an equivalent amount of liquid assets (reserves). It can instead make some income-
generating loans to firms or households, holding only a fraction of deposits as reserves to satisfy withdrawal
requests at any point in time. A banking system with $1 trillion of reserves from the Fed can then produce, for

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example, $10 trillion of deposits. For this reason, the monetary base is sometimes referred to as “high-powered
money.” A step-by-step account of the money multiplier process working through bank balance sheets is
presented in the Appendix.

The magnitude of the money multiplier (call it ) is now easy to define (Equation 3):

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= = = ,

where = / is the currency-to-deposit ratio (or currency ratio for short) and = / is
the reserve-to-deposit ratio (or reserve ratio for short).

Notice that the money multiplier satisfies > 1 only if < 1. This reinforces our intuition about the

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origin of the multiplier. When a bank not in urgent need of liquidity receives a deposit, it doesn’t hold 100% of
that money as reserves. Instead, it can use some of the funds from the deposit to make a loan, which ultimately
leads to a deposit at another bank, and so on. The Fed triggers this process by engaging in an open market
purchase of securities with a commercial bank. The purchase swaps securities for reserves on the bank’s balance
sheet, prompting that bank to rebalance its portfolio by either buying other securities or making new loans
(Appendix). Either way, a new deposit is created at another bank, kicking off the multiplier process.
Understanding this, the Fed can adjust bank reserves through purchases and sales of securities to achieve the
level of deposits that it believes is consistent with a healthy level of nominal spending.14
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Open market operations (OMOs) thus constitute a simple yet powerful instrument for changing the money
supply; in many ways simpler and more powerful than the discount rate.15 To be sure, the Fed continues to
serve as the lender of last resort to the US banking system, but OMOs have come to be much more closely
associated with monetary policy—that is, the management of the money supply to achieve the Fed’s
objectives—and replaced the discount rate as the Fed’s primary policy tool.
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The Fed’s OMOs are conducted by the trading desk at the FRB of New York. We can rearrange the
definition of the money multiplier to express the money supply as Equation 4:

= × .

An open market purchase of securities by the Fed increases the monetary base (through bank reserves ),
which then increases the money supply for a given level of the money multiplier . An open market sale of
No

securities by the Fed decreases (again through ), which then decreases for a given level of .

We can see from our definition of the money multiplier that the magnitude of the multiplier will depend
on both the currency ratio and the reserve ratio . The currency ratio has not exhibited sharp swings since

14 The money multiplier shouldn’t be confused with the concept of velocity. Economists sometimes write the identity × = × , where is
money supply, is the aggregate price level, is real GDP, and is velocity. Note that × is interpretable as nominal spending over the period that
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real GDP is measured, for example, over a year, whereas is the stock of money at a given point in time. Thus tells you how many times a money
supply of cycles through the economy over the year to fund nominal spending in the amount of × . Velocity is something you can calculate after
the fact—once you know , , and —not something we need to keep track of to understand the basic principles of IS/LM and AD/AS.
15 In principle, the money multiplier could still play out with discount loans once a bank that obtains a discount loan from the Fed uses the proceeds

to pay whomever it owes. That the Fed was surprised by the money multiplier after conducting open market operations in the 1920s suggests an
empirically small multiplier when the injection of reserves occurs through discount loans rather than open market operations. A bank that needs
emergency liquidity from the Fed is likely to simultaneously reduce lending to firms and households. The fact that the bank had to turn to the Fed (its
lender of last resort) also suggests other banks aren’t awash in liquidity. It is then reasonable that the money multiplier associated with discount loans
would not be very high.

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the introduction of federal deposit insurance in the 1930s. The same cannot be said of the reserve ratio, making
it the more interesting and relevant determinant of the magnitude of .

Fluctuations in the reserve ratio are driven by bank decisions. This can be better appreciated by categorizing
bank reserves according to why banks hold them. Some reserves are held by banks to satisfy legal requirements.

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These are called required reserves ( ) to distinguish them from excess reserves ( ), which are held for other
reasons, including, but not limited to, precautionary motives in crisis times. Thus we get Equation 5:

= + .

We can now rewrite the money multiplier as Equation 6:

= = =

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,

where is still the currency ratio, = / is the required reserve ratio, and = / is the excess
reserve ratio. The required reserve ratio is set by the Fed at roughly 10% and rarely altered.16 The excess reserve
ratio, in contrast, is a decision that banks make based on the economic environment around them. There will
be many considerations, but the decision is ultimately based on marginal thinking—a bank will hold excess
reserves up to the point where the marginal benefit equals the marginal cost.
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In a world where reserves don’t pay interest, the marginal cost of holding excess reserves stems from
forgone income on interest-bearing assets while the marginal benefit stems from not having to scramble for
liquidity as frequently or pay a premium when unforeseen circumstances arise. In 2006, Congress granted the
Fed the ability to pay interest on reserves (IOR) effective October 2011, later accelerating this date to
October 2008.17 The big-picture effect of IOR is easy to understand through the money multiplier. A higher
IOR augments the marginal benefit of holding excess reserves, so all else constant, the excess reserve ratio
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will rise, the money multiplier will fall, and the money supply will also fall for a given monetary base .18
An increase in IOR thus amounts to contractionary monetary policy.

Through its effect on the level of the money multiplier , the level of the excess reserve ratio also helps
distinguish conventional monetary policy from unconventional monetary policy. We can think of conventional
monetary policy as what the Fed does to manage the money supply when > 1. The contrast is a crisis where
precautionary motives in the banking sector cause to skyrocket, leading to < 1. The Fed continues to
No

increase the monetary base through open market purchases but has to do so much more vociferously to combat
headwinds from a depressed multiplier.19 Fundamentally though, monetary policy can always be understood as
changing the money supply in the economy to achieve the central bank’s objectives, namely maintaining output
at its potential level.
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16 The Fed has been gun-shy about raising reserve requirements after it did so in the late 1930s, and banks responded unexpectedly, calling in loans

in amounts well beyond anything that would have brought their reserves up to the new requirements; the result was a sharp recession (see Randall
Kroszner, “Central Banks Must Time a Good Exit,” Financial Times, August 11, 2009). The biggest change to reserve requirements since the 1930s
occurred in 2020, when the Fed temporarily removed the 10% requirement to encourage banks to keep lending amidst the COVID-19 pandemic.
17 “Interest on Reserve Balances,” Board of Governors of the Federal Reserve System, August 2, 2021,
www.federalreserve.gov/monetarypolicy/reqresbalances.htm (accessed Aug. 2, 2021).
18 IOR would not increase if financed by interest earned on the Fed’s assets (as opposed to newly printed money).
19 The Fed may also get creative with regards to the securities it receives in return for its liabilities. For a deeper dive into these issues, see Kinda

Hachem, “Unconventional Monetary Policy,” UVA-GEM-0196 (Charlottesville, VA: Darden Business Publishing, 2021).

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From Money Supply to Interest Rates

While the stance and implementation of monetary policy can always be understood through the money
supply, the financial press has long characterized the Fed as setting interest rates, specifically an interest rate
called the Federal Funds Rate (FFR).

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The FFR is the interest rate at which banks are willing to lend reserves to each other overnight and without
collateral. The level of the FFR is an outcome of the Fed’s actions, not the action itself. The FFR is just one of
many interest rates in the economy and certainly not the rate at which firms or households borrow. Nonetheless,
the Fed—and thus the financial press—looks to the FFR when conducting open market operations because it
provides a quick signal about whether the size of an operation is suitable, given prevailing economic conditions,
to affect the interest rates that will directly matter for real activity.

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By definition of being the interest rate at which banks lend reserves to each other, the FFR will be the first
interest rate to respond to changes in the supply of reserves following an open market operation. In this sense,
it can provide a quick signal to the Fed. The logic is grounded in basic microeconomics. Let’s abstract from
reserves for a moment and think about an arbitrary good (i.e., a widget). The equilibrium price of a widget is
the price at which the demand for widgets equals the supply of widgets. An increase in the supply of widgets
(formally, a rightward shift in the supply curve for widgets) triggers a decrease in the price of widgets to bring
the quantity demanded in line with the higher supply. Analogously, a decrease in the supply of widgets (formally,
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a leftward shift in the supply curve for widgets) triggers an increase in the price of widgets to bring the quantity
demanded in line with the lower supply. Replace widgets with reserves and we have all the intuition we need to
sketch how the price of reserves—as captured by the FFR—is determined. An open market purchase by the
Fed increases the supply of reserves, triggering a decrease in the FFR. An open market sale by the Fed decreases
the supply of reserves, triggering an increase in the FFR.

That said, no one borrows at the FFR except banks. The FFR may be a quick signal, but is it an informative
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one for the economy more broadly? The answer is yes because interest rates tend to move together.20 Exhibit 1
shows this comovement between the FFR, the yields on short-term (3 month) and long-term (10 year)
US Treasuries, the bank prime loan rate,21 the yields on high-grade (Aaa) and medium-grade (Baa) corporate
bonds,22 and the 30-year mortgage rate. Understanding these empirical relationships, the FOMC can instruct
the trading desk at the FRB of New York to conduct, say, an open market sale that increases the FFR by
25 basis points, leaving it to the desk to determine the dollar value of the sale that will deliver this increase given
the prevailing demand for reserves in the banking system.
No

Overall then, the FFR helps the Fed calibrate the size of its open market operations to affect the interest
rates that matter for real activity in the IS/LM model. Saying “the FFR increased” is equivalent to saying “the
Fed is being contractionary,” and the best way to understand this action operationally is as a decrease in the
money supply which then transmits through the money market to the representative interest rate that
enters the investment function (∙) in the IS/LM model.23
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20 The intuition is based on a simple “no arbitrage” argument. An arbitrage opportunity exists if interest rate differentials permit a riskless profit to be

made, for example, by borrowing at one rate and lending at another. Financial traders will quickly jump on such opportunities and in the process their
demand will bring rates more in line with each other. Differentials may still exist to compensate for risk, but the elimination of arbitrage opportunities
will result in a strong common component to most interest rates.
21 The bank prime loan rate is a base rate that many large commercial banks use to price short-term business loans.
22 Based on bonds with maturities of 20 years or more.
23 See Daniel Murphy, “The IS/LM Model,” UVA-GEM-0126 (Charlottesville, VA: Darden Business Publishing, 2014).

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From Interest Rates to the Real Economy24

When the Fed conducts contractionary monetary policy (e.g., reduces the rate of growth of the monetary
base), the reduction in the growth of the money supply leads to an increase in interest rates. Rising interest
rates, in turn, imply higher borrowing costs. And when firms face higher costs to borrow for their capital

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expenditure projects, they tend to cut back on investment spending. And as investment spending falls, so does
employment and GDP. Conversely, when the Fed conducts expansionary monetary policy, interest rates decline
and investment, employment, and GDP tend to increase.25

The link from the money supply to the real economy is far from immediate though (Exhibit 2). While
interest rates are quick to respond to changes in the money supply, investment and GDP respond with lags of
a year or more. This lag makes sense once one considers that firms evaluate only a limited subset of capital
expenditure projects on an infrequent basis, which implies that aggregate investment responds only over time

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as more firms adjust to the change in borrowing costs. So when interest rates change, it can take some time for
firms’ investment decisions to reflect the change in borrowing costs. And the lag in investment implies lags in
employment and GDP.

The lag between monetary policy changes and the real economy implies that in order for the Fed to achieve
its objectives, it must anticipate both the trajectory of the economy in the absence of policy changes and the
dynamic effects of such policy changes. Given the inherent uncertainty in economic forecasts, calibrating the
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monetary policy response to changing macroeconomic conditions can be as controversial as it is challenging.
If, in the face of rising inflation, the Fed tightens too much or too soon, it can risk causing a recession. Likewise,
if its policy is excessively expansionary, it can risk inflation above its target rate.

The Fed under Chairman Alan Greenspan (August 1987 to January 2006) exemplified the importance of
lags in the transmission of monetary policy. When Greenspan took the reins in August 1987, inflation was mild,
expectations were anchored and stable, and unemployment was low relative to its average during the 1970s.
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Inflation picked up through 1988, and as it did, the Greenspan Fed raised interest rates. This tightening by
Greenspan’s Fed contributed to a recession that began in July 1990. Two years later, George H. W. Bush lost
his reelection bid for president and later famously blamed Greenspan for his loss. In 1998, Bush lamented, “I
think that if the interest rates had been lowered more dramatically that I would have been re-elected president
because the [economic] recovery that we were in would have been more visible. I reappointed him, and he
disappointed me.”26
No

In the rest of the 1990s, the US economy experienced one of the longest periods of growth in history.
Much of this growth was due to supply-side innovations such as those in information technology, which helped
keep costs and prices low, thus limiting inflationary pressures that were often associated with economic
expansions. The strong growth of the 1990s also helped sustain high employment. Therefore, with low inflation
and high employment, the job of Greenspan’s Fed in the 1990s was akin to keeping monetary policy on cruise
control.

In 2000, inflation picked up and the Greenspan Fed engaged in open market sales that raised the FFR
above 6% (Exhibit 3). Rising interest rates and the bursting of the dot-com bubble caused a recession starting
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in March 2001 (Exhibit 4). To stimulate the economy in the face of recession, Greenspan reversed course, and

24 The latter three paragraphs of this section are adapted from Daniel Murphy, “Jerome Powell: Navigating a New Course?,” UVA-GEM-0165

(Charlottesville, VA: Darden Business Publishing, 2018).

25 For a formalization of the links between the money supply, interest rates, and investment, see Murphy, “The IS/LM Model” (UVA-GEM-0126).
26 “Bush Pins 1992 Election Loss on Fed Chair Alan Greenspan,” Wall Street Journal, August 25, 1998, www.wsj.com/articles/SB904002475770183000

(accessed Aug. 2, 2021).

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the Fed undertook open market purchases to cut the FFR sharply to below 2% by December 2001. Investment,
GDP, and employment increased over the subsequent few years (Exhibit 5).

Central Banks around the World

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The Fed is one of many central banks around the world, all of which have a mandate to pursue price
stability and some of which have mandates to pursue jointly other macroeconomic objectives such as
employment, GDP growth, or financial stability.27 For example, the European Central Bank (ECB), which
controls monetary policy for members of the European Monetary Union, is charged with a primary objective
of maintaining price stability.28 The Central Bank of Nigeria is further tasked with maintaining financial
stability.29 While explicit mandates may differ, each can be understood as sustaining output near its potential
level.

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Central banks also vary in their degree of independence from their home country’s central government.
The Maastricht Treaty, which created the ECB, forbids the ECB from seeking any instructions from national
governments or institutions. At the opposite end of the independence spectrum are central banks with
leadership that can be fired at will by the country’s president. For example, until recently the governor of the
Central Bank of Brazil could be fired by Brazil’s president,30 and Turkey’s president (Recep Tayyip Erdoğan)
has fired multiple central bank governors over monetary policy disagreements.31
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History has demonstrated the effectiveness of independent central banks. Politicians in charge of
governments may have incentives to pressure central banks to stimulate an economy and risk overheating it,
contrary to a central bank’s objectives. When central bank leadership is pressured to respond to the demands
of politicians, it is more likely to permit above-target inflation, which erodes its credibility. Indeed, there is a
strong empirical relationship between central bank independence and economic performance.32
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27 Kemal Derviş, “Should Central Banks Target Employment?,” Brookings, December 19, 2012, www.brookings.edu/opinions/should-central-banks-
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target-employment/ (accessed Aug. 2, 2021).

28 Treaty on European Union (Consolidated Version), Treaty of Maastricht, art. 127, 1992 O.J. (C 325/5) (February 7, 1992).
29 “Central Bank of Nigeria Act,” Federal Republic of Nigeria Official Gazette 94, no. 55 (June 2007),
www.cbn.gov.ng/OUT/PUBLICATIONS/BSD/2007/CBNACT.PDF (accessed Aug. 2, 2021).
30 Michael Pooler and Bryan Harris, “Brazil Passes Law Giving Autonomy to Central Bank,” Financial Times, February 10, 2021,

www.ft.com/content/d10ba61b-78b6-480c-9652-0cc7b06c1bbd (accessed Aug. 2, 2021).

31 “Turkey Shows Why a Central Bank’s Independence Is Central,” Christian Science Monitor, March 22, 2021, www.csmonitor.com/Commentary/the-

monitors-view/2021/0322/Turkey-shows-why-a-central-bank-s-independence-is-central (accessed Aug. 2, 2021).

32 “Central Bank Independence and Inflation,” Federal Reserve Bank of St. Louis, 2009, www.stlouisfed.org/annual-report/2009/central-bank-

independence-and-inflation#fig1 (accessed Aug. 2, 2021).

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Exhibit 1
Monetary Policy and the Federal Reserve
Selected US Interest Rates

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Source: FRED, Federal Reserve Bank of St. Louis.

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Exhibit 2
Monetary Policy and the Federal Reserve
Effect of a Contractionary Monetary Policy Shock

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Note: The horizontal axis in each figure represents quarters since the shock. One-standard-deviation error bands are shaded in
grey around the impulse responses.

Source: Created by authors using the data and methodology from Olivier Coibion, Yuriy Gorodnichenko, Lorenz Kueng, and
John Silvia, “Innocent Bystanders? Monetary Policy and Inequality,” Journal of Monetary Economics 88 (June 2017): 70–89. The
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authors are grateful to Yuriy Gorodnichenko for sharing the code and data.
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Exhibit 3
Monetary Policy and the Federal Reserve
Inflation and Federal Funds Rate around the 2001 Recession

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CPI-U: All Items
% Change - Annual Rate
Federal Funds [effective] Rate
% p.a.
8 8

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4 4

2 2
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0 0
94 95 96 97 98 99 00 01 02 03 04

Sources: BLS, FRB/Haver

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Exhibit 4
Monetary Policy and the Federal Reserve
Unemployment and GDP Growth around the 2001 Recession

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Civilian Unemployment Rate: 16 yr +
SA, %
Real Gross Domestic Product
% Change - Annual Rate SAAR, Chn.2012$
6.5 8

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6.0
6

5.5
4
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5.0

2
4.5
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0
4.0

3.5 -2
95 96 97 98 99 00 01 02 03 04 05

Sources: BLS, BEA/Haver

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Exhibit 5
Monetary Policy and the Federal Reserve
Consumption and Investment Growth around the 2001 Recession

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Gross Private Domestic Investment

Personal Consumption Expenditures

% Change - Year to Year SAAR, $
22.5 9

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8
15.0

7
7.5
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6

0.0
5
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-7.5
4

-15.0 3
95 96 97 98 99 00 01 02 03 04 05

Source: Bureau of Economic Analysis/Haver Analytics

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Appendix
Monetary Policy and the Federal Reserve
Mechanics of the Money Multiplier1

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This appendix walks through the steps that underlie the money multiplier formula in the main text. Two
simplifications will help keep the exposition as sharp as possible:
Simplification 1: Banks don’t hold reserves in excess of legal requirements ( = 0).
Simplification 2: The public doesn’t hold cash ( = 0).

After deriving the money multiplier under these simplifications, we will circle back and discuss the effect of

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allowing > 0 and > 0 on our derivations.

Consider an open market purchase where the Fed buys $10 worth of securities from BankOne. The
securities don’t have to be issued by BankOne. In practice, they are government securities previously issued by
the US Treasury to private investors (i.e., the Fed’s open market purchases do not “monetize the debt” because
they do not involve the purchase of new government debt). The effect of the open market purchase on the
Fed’s balance sheet is shown below (Table A1). On the asset side, the Fed increases its security holdings by
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$10, funded on the liabilities side by an injection of $10 into BankOne’s reserve account.

Table A1. Fed’s balance sheet after open market purchase.

Securities  $10 Currency in circulation

Discount loans Bank reserves  $10
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Total assets  $10 Total liabilities  $10

That’s it for the effects of the purchase on the Fed’s balance sheet. All the effects left for us to explore
occur on bank balance sheets, so let’s turn to those now.2 The immediate effect of the Fed’s open market
purchase on BankOne’s balance sheet is simple (Table A2). BankOne has sold $10 worth of securities that it
previously had in its possession to the Fed in exchange for $10 of reserves. Thus:

Table A2. BankOne’s balance sheet after the Fed’s open market purchase.
No

Reserves  $10 Deposits

Securities  $10 Capital
Loans
Total assets Total liabilities
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1 This appendix draws on material from Frederic Mishkin, “The Money Supply Process,” in The Economics of Money, Banking and Financial Markets, 11th

ed. (New York: Pearson, 2016), 316–40.

2 If you’re worried about the Fed’s operation changing the demand for the security and thus its yield, don’t be. Normally, open market operations are

small compared to the size of the market for that security, so the effect of the operation is squarely through the money multiplier. The exception is
quantitative easing, where the Fed deliberately scales the size of the operation to affect yields, but that’s a topic for another time (e.g., UVA-GEM-0196).

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Appendix (continued)

There would be no money multiplier if the story stopped here, so let’s keep going. If BankOne does
nothing, then the average return on BankOne’s assets will fall because it traded an interest-bearing security for
zero-interest (or at least lower-interest) reserves. Accordingly, BankOne will want to rebalance its portfolio

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toward higher earning assets (e.g., by buying another security or by making a loan).

Legal requirements in the United States forbid a bank from holding less than a certain fraction (say 10%)
of its checkable deposits as reserves. BankOne’s deposits haven’t changed, so the $10 injected into its reserve
account by the Fed is entirely excess reserves. Thus, invoking Simplification 1, BankOne lends $10 to a
borrower (call her Alice). Alternatively, BankOne could buy a security from an issuer named Alice. It won’t
make a difference for the end result—after all, buying a security issued by Alice is just another form of lending
to her—so we’ll use loans to track changes and leave the decrease in securities on BankOne’s balance sheet as

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a reminder of the Fed’s open market purchase. BankOne’s balance sheet becomes Table A3:

Table A3. BankOne’s final balance sheet.

Reserves  $10  $10 Deposits

Securities  $10 Capital
Loans  $10
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Total assets Total liabilities

Invoking Simplification 2, the funds that Alice obtains from BankOne are held as deposits. For ease of
reference, let’s use a different bank name to refer to the bank where the deposits are held (e.g., BankTwo). This
is without loss of generality since we will later consolidate the balance sheets of all the banks to compute the
money multiplier. For brevity, we’ll say Alice makes the deposit. In practice, Alice may use the funds to purchase
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an item, with the merchant then depositing the proceeds. Either way, BankTwo receives a $10 deposit. The
balancing item on the asset side at the moment of deposit is a $10 increase in reserves (Table A4):

Table A4. BankTwo’s balance sheet after Alice’s deposit.

Reserves  $10 Deposits  $10

Securities Capital
No

Loans
Total assets  $10 Total liabilities  $10

If we pause to sum the balance sheets of BankOne and BankTwo at this point, we notice that the banking
system has experienced a net increase of $10 in deposits, which balances its net increase of $10 in reserves from
the Fed. There is no “multiplication” of reserves into deposits as of yet, but now is when things are really going
to start happening. With an increase in deposits of $10, BankTwo only needs an increase in reserves of $1 to
satisfy the 10% reserve requirement. BankTwo thus has $9 of excess reserves, which it lends out to a borrower
(call him Bob) under Simplification 1. BankTwo’s balance sheet is then Table A5:
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Table A5. BankTwo’s final balance sheet.

Reserves  $10  $9 Deposits  $10

Securities Capital
Loans  $9
Total assets  $10 Total liabilities  $10

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Appendix (continued)

Bob deposits the entirety of his loan into a bank (call it BankThree) under Simplification 2. BankThree’s
deposits and reserves both increase by $9 (Table A6):

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Table A6. BankThree’s balance sheet after Bob’s deposit.

Reserves  $9 Deposits  $9
Securities Capital
Loans
Total assets  $9 Total liabilities  $9

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With an increase in deposits of $9, BankThree only needs an increase in reserves of $0.90 to satisfy the
10% reserve requirement. It thus has $8.10 of excess reserves which it lends out to a borrower (call her Carol)
under Simplification 1. BankThree’s balance sheet is then Table A7:

Table A7. BankThree’s final balance sheet.

Reserves  $9  $8.10 Deposits  $9

Securities Capital
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Loans  $8.10
Total Assets  $9 Total Liabilities  $9

The process continues in this way: Carol deposits $8.10 at BankFour under Simplification 2, BankFour
keeps $0.81 as reserves and lends out $7.29 under Simplification 1, and so on. Table A8 summarizes the final
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effect on each bank, then consolidates these effects into the aggregate effect:

Table A8. Bank effects (in US dollars).

 Reserves  Securities  Loans  Deposits  Capital

BankOne 0 10 10 0 0
BankTwo 1 0 9 10 0
No

BankThree 0.90 0 8.10 9 0

BankFour 0.81 0 7.29 8.10 0
⋮ ⋮ ⋮ ⋮ ⋮ ⋮
Aggregate 10 -10 100 100 0

We recall that the initial shock was a $10 decline in securities held by BankOne. No other banks in our
example experienced a change in security holdings, so the “ Securities” column in Table A8 (where the
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symbol  is used to denote change) trivially sums to $10.

To see why the “ Loans” column sums to $100, notice that this column is the sum of a geometric
sequence. In particular:

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Page 18 UV8330

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Appendix (continued)

 Loans = $10 + $9 + $8.10 + $7.29 + ⋯

= (1 + 0.9 + 0.92 + 0.93 + ⋯)  $10

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=  $10
.
= $100

Under Simplification 1, banks only hold required reserves, so  Reserves = 0.1   Deposits. Under
Simplification 2, no one holds currency, so  Deposits =  Loans. Having seen that the “ Loans” column
sums to $100, it follows immediately that the “ Deposits” column also sums to $100 while the “ Reserves”

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column sums to $10.

Our conclusion of  Deposits = $100 is exactly what we would get by using = × with = 0
(Simplification 1) and = 0 (Simplification 2) in the money-multiplier definition = that appears
in Equation 6 of the main text. Formally, = 0 and = 0 imply = . = 10 when the reserve
requirement is = 0.1, so increasing by $10 will increase by $100, as we just derived in long form.
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What happens if we relax Simplification 2 and allow > 0? When a borrower gets a new loan, less will
flow into new deposits, so the money multiplier will be weaker.

What happens if we relax Simplification 1 and allow > 0? When a bank gets a new deposit, less will flow
into new loans, so the money multiplier will be weaker.
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This appendix has exposited the money multiplier using an open market purchase. An open market sale
would work through the same steps but in the opposite direction. To take a concrete example, suppose the Fed
sells $10 worth of securities to BankOne. In our simple setting where banks hold no excess reserves, BankOne
will need to replenish its reserves to avoid violating reserve requirements.3 As soon as one of BankOne’s
borrowers repays a loan, the bank will lock those funds in reserves instead of issuing a new loan. Assuming
BankOne’s borrower drew the repayment from a deposit account at BankTwo, the latter will experience equal
declines in deposits and reserves, putting it in a situation where it also needs to replenish its reserves. BankTwo
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then does the same thing as BankOne, locking up the proceeds from a repaid loan instead of lending those
funds out again. The process continues in this way. The total amount of loans outstanding shrinks, as does the
total amount of deposits in the economy.

Notice that the banks aren’t calling in loans in response to the Fed’s open market sale; loans can be allowed
to mature as scheduled, with banks borrowing from financial markets to cover any reserve shortfalls in the
meantime. Since the Fed conducts open market sales when there is sufficient liquidity in the economy,
borrowing from such markets should be feasible for the banks involved. The money supply thus gradually
shrinks in response to an open market sale, in the same way that it gradually expands in response to an open
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market purchase.

3 Even without reserve requirements, BankOne would need to replenish its reserves at some point in order to be able to honor a basic amount of

withdrawals.

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