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1 1 (February 2, 2021)

handle is hein.crs/govebmz0001 and id is 1 raw text is: $ o rssioa erh Servic February 2, 2021 Introduction to U.S. Economy: Monetary Policy The Federal Reserve (Fed), the nation's central bank, is responsible for monetary policy. This In Focus explains how monetary policy works. Typically, when the Fed wants to stimulate the economy, it makes policy more expansionary by reducing interest rates. When it wants to make policy more contractionary or tighter, it raises rates. For background on the Fed and its other responsibilities, see CRS In Focus IF10054, Introduction to Financial Services: The Federal Reserve. Federal Open Market Committee Monetary policy decisions are made by the Federal Open Market Committee (FOMC), whose voting members are the Fed's seven governors, the New York Federal Reserve Bank president, and four other Reserve Bank presidents, who vote on a rotating basis. The FOMC is chaired by the Fed chair. FOMC meetings are regularly scheduled every six weeks, but the chair sometimes calls unscheduled meetings. After these meetings, the FOMC statement announcing any changes to monetary policy is released. Statutory Goals In 1977, the Fed was mandated to set monetary policy to promote the goals of maximum employment, stable prices, and moderate long-term interest rates (12 U.S.C. §225a). The first two goals are referred to as the dual mandate. Statement on Longer-Run Goals Since 2012, the FOMC has explained its mandate in the Statement on Longer-Run Goals. It defines stable prices as 2% inflation, measured as the annual percent change in the personal consumption expenditures price index. In the Fed's view, maximum employment is not directly measurable and changes over time owing largely to nonmonetary factors that affect the structure and dynamics of the labor market. In response to the low inflation and low growth environment that dates back to the 2007-2009 financial crisis, the FOMC made significant changes to the statement in 2020. First, monetary policy would aim to make up for periods of inflation below 2% with periods of inflation above 2%, so that inflation would average 2% over time. Second, monetary policy would respond only if unemployment is high, not if it is low. For more information, see CRS Insight IN 11499, The Federal Reserve's Revised Monetary Policy Strategy Statement. Federal Funds Rate In normal economic conditions, the Fed's primary instrument for setting monetary policy is the federal funds rate (FFR), the overnight interest rate in the federal funds market, a private market where banks lend to each other. ttps://crsreport,, The FOMC sets a target range for the FFR and uses its tools to keep the actual FFR within that range (see Figure 1). Figure I. Federal Funds Rate 2020-2021 Qa s oil o so o sB - I FR. FFR target OR Source: Federal Reserve. Notes: FFR=federal funds rate; IOR=interest rate on bank reserves. How Does Monetary Policy Affect the Economy? Changes in the FFR target lead to changes in interest rates throughout the economy, although these changes are mostly less than one-to-one. Changes in interest rates affect overall economic activity by changing the demand for interest- sensitive spending (goods and services that are bought on credit). The main categories of interest-sensitive spending are business physical capital investment (e.g., plant and equipment), consumer durables (e.g., automobiles, appliances), and residential investment (new housing construction). All else equal, higher interest rates reduce interest-sensitive spending, and lower interest rates increase interest-sensitive spending. Interest rates also influence the demand for exports and imports by affecting the value of the dollar. All else equal, higher interest rates increase net foreign capital inflows as U.S. assets become more attractive relative to foreign assets. To purchase U.S. assets, foreigners must first purchase U.S. dollars, pushing up the value of the dollar. When the value of the dollar rises, the price of foreign imports declines relative to U.S. import-competing goods, and U.S. exports become more expensive relative to foreign goods. As a result, net exports (exports less imports) decrease. When interest rates fall, all of these factors work in reverse and net exports increase, all else equal. Business investment, consumer durables, residential investment, and net exports are all components of gross domestic product (GDP). Thus, if expansionary monetary policy causes interest-sensitive spending to rise, it increases GDP in the short run. This increases employment, as more .congress.gov

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