onsider the long- and short-term effects of achieving any one goal. For example, in the long run, price stability complements efforts to achieve maximum output and employment; but in the short run, some tension can arise between efforts to reduce inflation and efforts to maximize employment and output. At times, the economy is faced with adverse supply shocks, such as a bad agricultural harvest or a disruption in the supply of oil, which put upward pressure on prices and downward pressure on output and employment. In these circum-stances, makers of monetary policy must decide the extent to which they should focus on defusing price pressures or on cushioning the loss of output and employment. At other times, policymakers may be concerned that the public’s expectation of more inflation will get built into decisions about wages and prices, become a self-fulfilling prophecy, and result in temporary losses of output and employment. Countering this threat of inflation with a more restrictive monetary policy could risk small losses of output and employment in the near term but might make it possible to avoid larger losses later should expectations of higher inflation become embedded in the economy. Beyond influencing the level of prices and the level of output in the near term, the Federal Reserve can contribute to financial stability and better economic performance by limiting the scope of financial disruptions and preventing their spread outside the financial sector. Modern financial systems are highly complex and interdependent and potentially vulnerable to wide-scale systemic disruptions, such as those that can occur during a plunge in stock prices. The Federal Reserve can help to establish for the U.S. banking system and, more broadly, for the financial system a framework that reduces the potential for systemic disruptions. More-over, if a threatening disturbance develops, the central bank can cushion its effects on financial markets and the economy by pro-viding liquidity through its monetary policy tools. MONETARY POLICY AND THE RESERVES MARKET The initial link between monetary policy and the economy occurs in the market for reserves. The Federal Reserve’s policies influence the demand for or supply of reserves at banks and other depository institutions, and through this market, the effects of monetary policy are transmitted to the rest of the economy. Therefore, to understand how monetary policy is related to the economy, one must first understand what the reserves market is and how it works. Demand for Reserves The demand for reserves has two components: required reserves and excess reserves. All depository institutions—commercial banks, saving banks, savings and loan associations, and credit unions—must retain a percentage of certain types of deposits to be held as reserves. The Federal Reserve under the Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirements. At the end of 1993, 4,148 member banks, 6,042 nonmember banks, 495 branches and agencies of foreign banks, 61 Edge Act and agreement corporations, and 3,238 thrift institutions were subject to reserve requirements. Since the early 1990s, reserve requirements have been applied only to transaction deposits (basically, interest-bearing and non-interest-bearing checking accounts). Required reserves are a fraction of such deposits; the Board of Governors within limits prescribed by law sets the fraction—the required reserve ratio—. Thus, total required reserves expand or contract with the level of transaction deposits and with the required reserve ratio set by the Board; in practice, however, the required reserve ratio has been adjusted only infrequently. Depository institutions hold required re-serves in one of two forms: vault cash (cash on hand at the bank) or, more important for monetary policy, required reserve balances in accounts with the Reserve Bank for their Federal Reserve District. Depositories use their a

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