Fed 101: What is the role of the Federal Reserve in the US economy?

1. The Federal Reserve

2. Federal Open Market Committee

3. Monetary Policy Tools

Figure 1: The Corridor System
Figure 2: Depository Institutions’ Reserves at the Fed, 2000–2021 [4]
Figure 3: The Floor System
Figure 5: The Impact of Forward Guidance on the Market for Investment

4. Policy Rules and Loss Functions

  1. Inflation rising above its 2% target means the ‘inflation gap’ is positive, which results in higher short-term interest rates
  2. Growth falling below its target (i.e., falling below its trend) means the ‘growth gap’ is negative and short-term interest rates fall
  • Interest rates need to quickly respond to economic shocks. The Taylor Rule waits for the economic shock to feed into inflation or unemployment before changing the nominal interest rate, but monetary policy can be a pre-emptive measure to prevent the shock’s undesirable outcomes. For example, the Fed cut interest rates in March 2020 in anticipation of the economic shock resulting from the COVID-19 pandemic.
  • The Taylor Rule gives unclear results when inflation is high and growth is poor. A positive inflation gap and negative output gap seemingly cancel one another out, so under stagflation (for instance the 1973–75 recession) the Taylor Rule offers little guidance.
  • The Taylor Rule includes no parameters on other economic variables. Interest rates significantly affect financial stability through exchange rates, asset prices, credit or leverage, and credit spreads [8]. Without these considerations, a nominal interest rate based exclusively on the Taylor Rule could have unintended consequences in the financial sector.





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LSE SU Central Banking Society

LSE SU Central Banking Society

LSE's first society focused on Central Banking research.

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