THE FEDERAL RESERVE ACT LAYS OUT the goals of monetary policy. It specifies that, in conducting monetary policy, the Federal Reserve System and the Federal Open Market Committee should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

Many analysts believe that the central bank should focus primarily on achieving price stability. A stable level of prices appears to be the condition most conducive to maximum sustained output and employment and to moderate long-term interest rates; in such circumstances, the prices of goods, materials, and services are undistorted by inflation and thus can serve as clearer signals and guides for the efficient allocation of resources. Also, a background of stable prices is thought to encourage saving and, indirectly, capital formation because it prevents the erosion of asset values by unanticipated inflation.

The Humphrey-Hawkins Act has something to say about the guides for monetary policy: It specifies that each February the Federal Reserve must announce publicly its objectives for growth in money and credit and that at midyear it must review its objectives and revise them if appropriate. This provision of the act was based on the presumption of a reasonably stable relation between growth of money and credit, on the one hand, and the goals of monetary policy, on the other-a relation that could be fruitfully exploited in achieving those goals. Control over the money stock, it was thought, could in effect anchor the price level in much the same way that the former gold standard was thought to have anchored the price level.

As the preceding discussion illustrates, monetary policy works through the market for reserves and involves the federal funds rate. A change in the reserves market will trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and levels of employment, output, and prices. For ex-ample, if the Federal Reserve reduces the supply of reserves, the resulting increase in the federal funds rate tends to spread quickly to other short-term market interest rates, such as those on Treasury bills and commercial paper. Because interest rates paid on many deposits in the money stock adjust only slowly, holding balances in money (that is, in a form counted in the money stock) becomes less attractive. As the public pursues higher yields available in the market (for example, on Treasury bills), the money stock declines. Moreover, as bank reserves and deposits shrink, the amount of money available for lending may also decline. Higher costs of borrowing and possible restraints on credit supply will damp growth of both bank credit and broader credit measures.

Arguing against giving interest rates a key role in guiding monetary policy is the uncertainty about what level or path of interest rates is consistent with the more basic goals. The appropriate level or path will vary with the stance of fiscal policy, changes in pat-terns of business and household spending, the productivity of capital, and economic developments abroad. It is difficult not only to gauge the strength of these various forces at any time but also to translate them into an appropriate level of interest rates. More-over, real interest rates-that is, interest rates net of expected inflation-drive spending decisions. Expected inflation is not readily measured; thus, assessing what the level of real interest rates hap-pens to be is difficult. However, failing to account for inflation expectations can result in misleading signals coming from nominal interest rates. For example, if the public expected more inflation, nominal interest rates would tend to rise, as investors sought protection for the greater loss of purchasing power, and might lead to the belief that monetary policy had become tighter and more disinflationary when, in fact, just the reverse had occurred.

Some depository institutions choose to hold reserves even beyond those needed to meet their reserve and clearing requirements. These additional balances, which provide extra protection against overdrafts and deficiencies in required reserves, are called excess reserves; they are the second component of the demand for re-serves (a third component if required clearing balances are included). In general, depositories hold few excess reserves because these balances do not earn interest; nonetheless, the demand for these reserves can fluctuate greatly over short periods, complicating the Federal Reserve's task of implementing monetary policy.

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