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A dramatic change in the conduct of monetary policy that occurred in 1979 can shed some light on the current confusion over the role of reserves in bank lending.
In the fall of 1979, inflation was running at more than 10 percent a year. Paul Volcker, the Fed chairman, believed that the usual procedure of gradual interest rate increases were inadequate. In the first place, it was proving difficult—perhaps impossible—to determine the “right” level of interest rates that would stem inflation. And some at the Fed believed interest rate manipulation had just become ineffective.
So Volcker dramatically changed how monetary policy was implemented.
On October 6, 1979, the Federal Reserve announced that it would begin targeting bank reserves rather than the federal funds rate in order to curb inflation and “speculative excesses in financial, foreign exchange, and commodity markets.” This meant that the Fed would allow interest rates to vary much more widely and climb much higher in reaction to changes in demand for money and bank reserves.
A Timely Banking Lesson From the Paul Volcker Era
by John Carney | Senior Editor
Explains why the Fed doesn't target quantity and let price float anymore.