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Monetary Policy and Fiscal Stabilization

Monetary Policy and Fiscal Stabilization

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The Fed's operation has evolved over time in response to major events. The Congress established the Federal Reserve System in 1913 to strengthen the supervision of the banking system and stop bank panics that had erupted periodically in the previous century. As a result of the Great Depression in the 1930s, Congress gave the Fed authority to vary reserve requirements and to regulate stock market margins (the amount of cash people must put down when buying stock on credit).

Still, the Federal Reserve often tended to defer to the elected officials in matters of overall economic policy. During World War II, for instance, the Fed subordinated its operations to helping the U.S. Treasury borrow money at low interest rates. Later, when the government sold large amounts of Treasury securities to finance the Korean War, the Fed bought heavily to keep the prices of these securities from falling (thereby pumping up the money supply). The Fed reasserted its independence in 1951, reaching an accord with the Treasury that Federal Reserve policy should not be subordinated to Treasury financing. But the central bank still did not stray too far from the political orthodoxy. During the fiscally conservative administration of President Dwight D. Eisenhower (1953-1961), for instance, the Fed emphasized price stability and restriction of monetary growth, while under more liberal presidents in the 1960s, it stressed full employment and economic growth.

During much of the 1970s, the Fed allowed rapid credit expansion in keeping with the government's desire to combat unemployment. But with inflation increasingly ravaging the economy, the central bank abruptly tightened monetary policy beginning in 1979. This policy successfully slowed the growth of the money supply, but it helped trigger sharp recessions in 1980 and 1981-1982. The inflation rate did come down, however, and by the middle of the decade the Fed was again able to pursue a cautiously expansionary policy. Interest rates, however, stayed relatively high as the federal government had to borrow heavily to finance its budget deficit. Rates slowly came down, too, as the deficit narrowed and ultimately disappeared in the 1990s.

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Next Article: The Growing Importance of Monetary Policy

This article is adapted from the book "Outline of the U.S. Economy" by Conte and Carr and has been adapted with permission from the U.S. Department of State.

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