A treatment of interest rate determination and bond pricing has to take into account the impact of monetary policy on interest rates. In this chapter we briefly review the Federal Reserve System (the Fed) and the tools of monetary policy. In particular, we discuss the way the Federal Reserve sets its main instrument of monetary policy, namely, the Federal funds rate. The importance of the Federal funds rate, which is an overnight rate, in affecting other short-term interest rates is apparent in Panel A of Figure 7.1, which plots the Fed funds rate along with other short term interest rates, such as the three month T-bill rate and the three month Eurodollar rate.1


The Federal Reserve is in charge of conducting U.S. monetary policy. The goals of the monetary policy are spelled out in the Federal Reserve Act (Section 2a), which states that the Federal Reserve should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Federal Reserve has only limited power in affecting prices, employment, and interest rates, and the mechanism by which it can do so is far from perfect. Indeed, although nowadays most economists agree that the Federal Reserve is able to affect prices and real economic activity, there is still a large disagreement on the exact economic mechanism at work, as well as the size of the impact of the Federal Reserve’s ...

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