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The Implementation of Monetary Policy

The Federal Reserve exercises considerable control over the demand for and supply of balances that depository institutions hold at the Reserve Banks. In so doing, it influences the federal funds rate and, ultimately, employment, output, and prices.
The Federal Reserve implements U.S. monetary policy by affecting conditions in the market for balances that depository institutions hold at the Federal Reserve Banks. The operating objectives or targets that it has used to effect desired conditions in this market have varied over the years. At one time, the FOMC sought to achieve a specific quantity of balances, but now it sets a target for the interest rate at which those balances are traded
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A predetermined target path for nonborrowed reserves was based on the FOMC’s objectives for M1. If M1 grew faster than the objective, required reserves, which were linked to M1 through the required reserve ratios, would expand more quickly than nonborrowed reserves. With the fixed supply of nonborrowed reserves falling short of demand, banks would bid up the


The Implementation of Monetary Policy

federal funds rate, sometimes sharply. The rise in short-term interest rates would eventually damp M1 growth, and M1 would be brought back toward its targeted path. By late 1982, it had become clear that the combination of interest rate deregulation and financial innovation had weakened the historical link between M1 and the economic objectives of monetary policy. The FOMC began to make more discretionary decisions about money market conditions, using a wider array of economic and financial variables to judge the need for adjustments in shortterm interest rates. In the day-to-day implementation of open market operations, this change was manifested in a shift of focus from a nonborrowed-reserve target to a borrowed-reserve target. The Federal Reserve routinely supplied fewer nonborrowed reserves than the estimated demand for total reserves, thus forcing depository institutions to meet their remaining need for reserves by borrowing at

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