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The Fed should ensure that that overall level of prices moves is a stable and predictable fashion, i.e., inflation should be a steady 2 – 3 percent per year. Volatile inflation adds risk to financial markets, and will ultimately reduce the quantity of savings and investment in the economy. This is the fed’s primary goal!
The Fed would like to maintain unemployment rate at its natural rate.
The Fed’s ultimate goal is maximum sustainable economic output in the long-run. Here the point is that the Fed works to achieve stable economic growth in the short-run as well.
Stability of financial markets
The Fed needs to maintain stability in financial markets in order to maintain its other goals.
Interest rate stability
Rapid fluctuations in interest rates can wreak havoc on the financial system.
What are the Fed’s monetary policy tools?
- 1. Open Market Operations:
- 2. Discount Policy:
- 3. Reserve Requirements:
- 4. Interest of Reserves:
- 5. Term Deposit Facility:
1. Open Market Operations:
With an open-market purchase the Fed buys U.S. treasuries from commercial banks, which increases the monetary base. An open-market sale is the reverse.
Changes in the discount rate affect how much commercial banks borrow from the Fed, which in turn affects the monetary base. (See text discussion of how the Fed enhanced discount lending during the financial crisis.)
An increase in the reserve require decreases the money multiplier (and vice versa).
Interest of Reserves:
The interest rate that the Fed pays on reserves affects excess reserve holdings.
Term Deposit Facility:
Since the 2008 financial crisis, the Fed has periodically auctioned term deposits to banks, at interest rates that are typically slightly higher than that paid on reserves.