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handle is hein.crs/goverzq0001 and id is 1 raw text is: Congressionol Research Service Informing the Iegisl9tive debate since 1914 Updated January 2, 2025 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 short-term interest rates. When it wants to make policy more contractionary or tighter, it raises rates. Since September 2024, the Fed has been reducing interest rates, reversing some of the early interest rate hikes it had implemented in an attempt to reduce inflation. For background on the Fed and its other responsibilities, see CRS In Focus IF10054, Introduction to Financial Services: The Federal Reserve. Federa 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 statutorily mandated to set monetary policy to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. The first two goals are referred to as the dual mandate. The dual mandate provides the Fed with discretion on how to interpret maximum employment and stable prices and how to set monetary policy to achieve those goals. There are no formal repercussions when goals are not met. Since 2012, the FOMC has explained how it carries out its mandate in its 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 FOMC'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 2025, the Fed will conduct a review of the Statement. Some have questioned whether 2020 revisions to the Statement contributed to the Fed's slow response to high post-pandemic inflation. 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. The FOMC sets a target range for the FFR that is 0.25 percentage points wide and uses its policy tools (discussed below) to keep the actual FFR within that range. (The current FFR target can be found on the Fed's website.) Monetary Policy and 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- and lower 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 workers are hired to meet increased demand for goods and services. An increase in spending also puts upward pressure on inflation. Contractionary monetary policy has the opposite effect on GDP, employment, and inflation. The Fed chooses whether to make monetary policy expansionary or contractionary based on how employment and inflation are performing compared to its statutory goals-expansionary policy can boost employment but risks spurring inflation, while contractionary policy can constrain inflation but risks decreasing employment. Most economists believe that although monetary policy can permanently change the inflation rate, it cannot permanently change the level or growth rate of GDP, because long-run GDP is determined by the economy's productive capacity (the size of the labor force, capital stock, and so on). If monetary policy pushes demand above what the economy can produce, then inflation should eventually rise to restore equilibrium. The Fed can preemptively change interest rates to take into account the

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