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Monetary Policy: Rules vs. Discretion


Monetary Policy - Monetary policy is about the management of the money supply in the economy by a central bank. In the United States, that central bank is called the Federal Reserve. Central banks often target interest rates as a way to influence prices, full employment, and stable economic growth.

The Federal Reserve - The Federal Reserve is the central bank of the United States. The Fed, as it is commonly known, regulates the U.S. monetary and financial system. 

Rules-Based Monetary Policy - A rules-based policy is a monetary policy in which the central bank rarely deviates from established norms. However, it does provide flexibility for the central bank to adjust to economic developments, but in a predictable way. In this way, it creates transparency that allows businesses, families, and workers to make long-term economic decisions without worrying about what the central bank might do in the future.

Central Banks - A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. The central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.

Inflation - Inflation is the increase in the prices of goods and services over time.

Federal Funds Rate - The federal funds rate refers to the interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis. By law, banks must maintain a reserve equal to a certain percentage of their deposits in an account at a Federal Reserve bank. Any money in their reserve that exceeds the required level is available for lending to other banks that might have shortfalls.

Taylor Rule – The Taylor Rule, introduced by John B. Taylor, is a proposed guideline for how central banks such as the Federal Reserve should alter interest rates in response to changes in economic conditions. It was established to adjust and set prudent rates for the short-term stabilization of the economy, while still maintaining long-term growth.