Divorcing Money from Monetary Policy

onetary policy has traditionally been viewed as the process by which a central bank uses its influence over the supply of money to promote its economic objectives. For example, Milton Friedman (1959, p. 24) defined the tools of monetary policy to be those “powers that enable the [Federal Reserve] System to determine the total amount of money in existence or to alter that amount.” In fact, the very term monetary policy suggests a central bank’s policy toward the supply of money or the level of some monetary aggregate. In recent decades, however, central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States, for example, the Federal Reserve’s Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target. For this reason, we follow the common practice of using the term monetary policy to refer to a central bank’s interest rate policy. It is important to realize, however, that the quantity of money and monetary policy remain fundamentally linked under this approach. Commercial banks hold money in the form of reserve balances at the central bank; these balances are used to meet reserve requirements and make interbank Todd Keister, Antoine Martin, and James McAndrews