Why does the Fed focus on the federal funds rate rather than directly targeting the money supply?

Question

BlackTom AI · Accepted Answer

Because the relationship between a targeted money aggregate and real economic activity (real GDP) proved unstable, the Fed found it more practical to control a short-term interest rate—the federal funds rate.

Relevant concepts: monetary policy has two operational targets—monetary aggregates (M1, M2) or an interest rate. The central bank controls bank reserves via open market operations; reserves influence the money multiplier and thereby the money supply. But this requires a stable money demand function (a predictable relation between money balances, income, and interest rates). If money demand (or the velocity of money) shifts unpredictably, a fixed money-supply target yields large, unintended swings in interest rates and economic activity.

Step-by-step reasoning:
1. Historically the Fed experimented with targeting monetary aggregates. That approach assumes a stable demand for money so changes in the money supply produce predictable effects on interest rates and GDP.
2. Financial innovation, deregulation, new payment technologies, and changes in asset preferences made money demand volatile and the velocity of money unstable in the 1970s–1980s.
3. With unstable money demand, targeting a monetary aggregate forced the Fed to accept large and unpredictable fluctuations in interest rates (or to frequently change the money target), undermining policy effectiveness.
4. By contrast, targeting the federal funds rate (the interbank overnight rate) gives the Fed a direct and observable operational target. Open market operations are used to supply the appropriate quantity of reserves so the federal funds rate stays near the target, and that rate then influences other short- and long-term rates affecting investment and consumption.

Why the correct answer is correct: the core reason is the unreliability of the money–GDP link (unstable money demand), which made monetary-aggregate targeting ineffective.

Why the other options are incorrect:
- Banks still hold reserves at the Fed; reserve accounts are central to operations.
- The Fed can and does influence the money supply via open market operations; that is how it adjusts reserves.
- Interest rates are highly relevant for investment and consumption decisions; they are the transmission channel of monetary policy.

Thus the correct choice is: "The link between money supply and real GDP became unreliable." This matches the provided answer.

Why does the Fed focus on the federal funds rate rather than directly targeting the money supply?单项选择题

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