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Making Sense of the Federal Reserve

Conducting Monetary Policy

Conducting Monetary Policy

Keeping our economy healthy is one of the most important jobs of the Federal Reserve. The Federal Reserve System has been given a dual mandate—pursuing the economic goals of price stability and maximum employment. It does this by managing the nation's system of money and credit—in other words, conducting monetary policy.

The first part of the Fed's dual mandate is price stability, which means that the economy is not experiencing high or variable inflation or deflation. Experience has shown that the economy performs well when inflation is low—and is expected to remain low—because interest rates are usually low as well.

"Economists like to argue that money belongs in the same class as the wheel and the inclined plane among ancient inventions of great social utility. Price stability allows the invention to work with minimal friction."

Former Chairman Ben Bernanke
Feb. 24, 2006, speech at Princeton University

Low interest rates allow businesses to borrow money for expansion and hiring additional workers. Such an environment promotes low unemployment and allows the economy to achieve its growth potential. Free from the disruptive effects of high and variable inflation, consumers and producers make economic decisions with confidence.

The ability to maintain stable prices is a long-term measure of the Fed's success. To achieve this, the Fed sets a variety of targets, including:
• the amount of money circulating in the economy,

• the level of reserves held by banks, and

• the level of interest rates.
The Fed constantly measures the effects of its policies on the economy. The Federal Reserve System has set a long-run goal for inflation at the rate of 2 percent. So, the inflation rate may fluctuate a bit, but it should average 2 percent over the long run.

The actions that the Fed takes today influence the economy and the inflation rate for some time to come. Policymakers must be forward-looking and take action to head off inflation or deflation before either becomes a problem.

Inflation isn't healthy for the economy, but neither is deflation.

Deflation occurs when the average price level is falling throughout the economy, so the inflation rate is negative. While this might sound good for consumers, it can cause some major problems for the economy. Note that this is different from disinflation.

Disinflation is a decrease in the inflation rate—say, from 4 percent to 3 percent a year. Notice that the economy still has a 3 percent inflation rate—the inflation rate is just lower than before.

The goal of the Federal Reserve System is to promote stable prices. When prices are stable, consumers and producers can make their spending and investing decisions without worrying that the value of their money will change dramatically—up or down—in the near future.

Next: More about Monetary Policy and the Dual Mandate »