Federal monetary policy exerts a powerful influence on aggregate demand for goods and services and thus on output, prices, interest rates, and foreign-exchange rates.

Before 1914, federal monetary policy involved the monetary standard, banks, and paper currency. The Coinage Acts of 1792 and 1834 provided for gold, silver, and copper coins. Congress chartered the First Bank of the United States (1791-1811) and Second Bank of the United States (1816-1841), which provided high-quality banknotes and performed some rudimentary central banking functions, but antagonism from President Andrew Jackson put an end to these experiments.Monetary policy

In 1862, during the U.S. Civil War, U.S.;currencyCivil War, Congress authorized issue of legal-tender United States notes called GreenbacksLegal Tender Act of 1862greenbacks. They were paid out to employees and suppliers. Their value was not fixed in terms of precious metals, and they depreciated substantially as prices escalated. Efforts to withdraw them after the war were blocked in an effort to keep prices from falling–but they fell anyway. The National Banking Acts of 1863 and 1864 created a safe and uniform national banknote currency.

Both types of currency became convertible at par into precious metals, beginning in 1879. Deflation generated strong political pressure for monetary expansion through Free silver movement“free coinage of silver,” advocated by Democratic presidential candidate William Jennings Bryan, William JenningsBryan in 1896. After his defeat, the Gold standardGold Standard Act of 1900 linked the dollar to gold alone.

The Federal ReserveFederal Reserve Act of 1913 was intended to eliminate bank panics, which had plagued the economy for a century. It authorized the Federal Reserve banks to issue Federal Reserve notes, expected to provide an “elastic currency.” In a panic, the Federal Reserve (the Fed) could lend newly created Federal Reserve notes to distressed banks. The notes were convertible into gold at the par value of $20.67 an ounce. The Federal Reserve was also authorized to buy and sell U.S. government securities through “open-market operations.” Only gradually did people discover that the Federal Reserve had the power to create bank reserves when it made loans or purchased securities.

This 1900 campaign poster for William McKinley and Theodore Roosevelt mentions their support for the gold standard.

(Library of Congress)

When the United States entered World War I in 1917, the Department of the Treasury had to issue bonds to finance the big rise in expenditures. The Federal Reserve helped by buying Treasury securities and by lending newly created reserves to the banks so that they could buy more Treasury securities. Between 1914 and 1920, both the money supply and the price level approximately doubled. When new bond issues ceased in November, 1919, the Federal Reserve tightened policy to put an end to the inflation, raising its interest charge on loans to banks. Beginning in May, 1920, a sharp recession set in. The Federal Reserve began lowering its interest rate in May, 1921, and recovery was achieved by 1922.

During the rest of the decade, Federal Reserve authorities undertook to counter business cycle fluctuations. They maintained some degree of credit restraint during the stock market boom of the late 1920’s but felt obligated to meet the expanding demand for credit by banks.

Beginning in 1929, expenditures for national output declined precipitously, falling by about half by 1933, when the downswing ended. During the Great Depression;monetary policyGreat Depression (1929-1939), the money supply declined from $27 billion in 1929 to $20 billion in 1933. The Federal Reserve did not cause this, but it could have prevented it. The economy was swept by an epidemic of bank failures beginning in 1930. Had the Federal Reserve been willing to buy securities more aggressively, it could have alleviated this deflationary process. However, it was constrained by fear that international gold withdrawals would endanger the par convertibility of the dollar.

When Franklin D. Roosevelt was inaugurated president in March, 1933, he suspended the convertibility of the dollar into gold. A national “bank holiday” restored confidence in the surviving banks. When the price of gold was raised in 1934 to $35 an ounce, gold began to flow into the United States from other countries, leading to a rapid increase in bank reserves and the money supply and gradual economic recovery.

When the United States entered World War II[World War 02];monetary policyWorld War II in December, 1941, unemployment stood at 10 percent. The expansion of government expenditures stimulated increased production without serious inflationary pressure. To maintain the extremely low interest rates from the Depression era, the Federal Reserve pegged the prices of Treasury securities by standing ready to buy them if their prices fell. Federal Reserve security holdings increased from $2 billion in 1940 to $24 billion in 1945; these purchases greatly expanded bank reserves, bank lending, and the money supply. Price controls helped limit wartime inflation to about 30 percent, but when controls were lifted in 1946, prices leaped further. Most important, however, was that there was no postwar deflationary disaster.

A new bout of inflation accompanied the outbreak of the Korean War in the summer of 1950. Tax increases and restoration of price controls helped end the price run-up in mid-1951. The Federal Reserve then reached an accord with the Treasury, which gave it greater leeway to permit interest rates to increase, as it did.

After 1966, increasing U.S. involvement in the Vietnam War brought a renewed acceleration of monetary growth and inflation. Conditions worsened when international petroleum prices escalated in 1973. Federal Reserve authorities felt obligated to expand money and credit to try to alleviate the resulting unemployment. However, this aggravated Inflation;monetary policyinflation, which reached double digits in 1974 and again in 1979-1981. Fed officials misinterpreted high interest rates to indicate a restrictive policy, when the high rates actually reflected expectations of high inflation. The episode convinced many economists that the money supply was the underlying source of inflation, with Fed open-market operations the key instrument of control.

The appointment of Paul Volcker to the Federal Reserve chair in 1979 and Ronald Reagan’s victory in the presidential election of 1980 brought a reversal of Federal Reserve policy. The monetary growth rate was slowed, causing a painful but brief recession beginning in January, 1980. Both inflation and interest rates soon declined. In 1987, Alan Greenspan became chair of the Federal Reserve. Skillful open-market operations targeting the federal-funds interest rate enabled the economy to avoid either serious inflation or serious depression for the next twenty years.

The Financial crisis of 2008financial crisis of 2008 led the Federal Reserve outside its customary role. Normally the Federal Reserve would try to combat a business recession by lowering its target interest rates and aggressively buying securities in the open market. In 2008, it tried to address the breakdown of tightly integrated financial markets. These markets were accustomed to short-term lending arrangements that could be concluded in a matter of minutes with minimal transactions costs.

Because the Federal Reserve has the power to create money, it could provide emergency funding in large amounts on short notice. In March, 2008, it played a major role in the merger of Bear StearnsBear Stearns into JPMorgan Chase. This was a preemptive move to prevent default on Bear’s large outstanding short-term debt. In September, 2008, the government allowed Lehman BrothersLehman Brothers, another huge investment bank, to fall into bankruptcy. This demonstrated the kind of chain reaction the authorities wanted to avoid. Lehman’s huge amount of short-term debt went into default, spreading the crisis to other firms that held those debts, notably money-market mutual funds.

The experience clearly led top officials to avoid a repetition. A few days later the Federal Reserve Bank of New York loaned $85 billion to AIGAIG (American International Group) to keep it operating.

As private short-term lending froze up in fear of borrower defaults, the Federal Reserve developed a number of innovative lending options. Traditionally, its direct lending had been confined to commercial banks. However, in March, 2008, the Federal Reserve created a primary dealer credit facility, to accommodate investment banking firms. By mid-October, this facility had over $100 billion in loans outstanding. Its lending to banks also reached very high levels, so that its total direct lending exceeded $400 billion in October. To offset inflationary effects, the Federal Reserve reduced its holdings of U.S. government securities (which traditionally made up more than 90 percent of its assets). The Federal Reserve also created a commercial paper funding facility to make loans for this very extensive form of short-term credit. At the same time, it entered into agreements with other major central banks to provide them with dollar exchange.

By mid-November, 2008, Federal Reserve assets were more than double their level of the previous September. Over the same period, commercial-bank reserves ballooned from $47 billion in September to an unheard-of $653 billion in mid-November. In late November, 2008, the Federal Reserve committed itself to buying up to $600 billion of debt issued by or backed by Fannie Mae, Freddie Mac, and other mortgage agencies. They also committed to lending up to $200 billion to investors holding securities based on student loans, car loans, credit card debt, and small-business loans.

In October, 2008, the Fed began to pay interest on bank reserve deposits held by Federal Reserve banks. This created a new instrument for monetary policy. By lowering this interest rate, the Fed effectively encouraged banks to hold smaller reserves and expand their lending.

• Hester, Donald D. The Evolution of Monetary Policy and Banking in the U.S. Berlin: Springer, 2008. Traces the history of U.S. monetary policy as it affected banking.
• Hetzel, Robert L. The Monetary Policy of the Federal Reserve: A History. New York: Cambridge University Press, 2008. Examines the agency’s monetary policy from its inception through Greenspan’s chairmanship.
• Meltzer, Allan H. A History of the Federal Reserve. Chicago: University of Chicago Press, 2003. A leading monetary economist presents the definitive account of the history of monetary policy.
• Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 7th ed. New York: Pearson/Addison-Wesley, 2004. Chapters 14-18 deal at length with monetary policy of the 1970’s and later.
• Trescott, Paul B. Money, Banking, and Economic Welfare. New York: McGraw-Hill, 1960. Chapters 14-17 give a thorough exposition of the evolution of U.S. monetary policy to 1958.

First Bank of the United States

Second Bank of the United States

Banking

Currency

Federal Reserve

Financial crisis of 2008

Gold standard

Great Depression

Alan Greenspan

Inflation

Interest rates