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.
