Monetary policy is controlling the MONEY SUPPLY to achieve policy makers’ goals. Most often these goals include ECONOMIC GROWTH with stable prices. In the United States, the primary goal of monetary policy is to attain and maintain price stability. Monetary policy is based on monetarism, a school of macroeconomic thought emphasizing the impact of changes in the SUPPLY of MONEY on the aggregate economy. Monetarism is closely associated with economic thought from the University of Chicago, most notably with the Nobel Prize winner Milton Friedman. Monetary theory and policy is based on the quantity theory of money, expressed by the equation MV = PQ, where M = money supply, V = velocity of money, the average number of times each dollar is spent on final goods and services in a year, P = price level, and Q = the quantity of output (real GROSS DOMESTIC PRODUCT [GDP]). According to the quantity theory, if the velocity of money (V) is constant (an economic assumption), then changes in the money supply (M) will cause changes in the price level (INFLATION or DEFLATION) and/or changes in real output in the economy (Q). If the money supply is increased, it will result in an increase in nominal GDP. If an economy is already operating at maximum output (potential GDP), an increase in M will result in an increase in P, inflation. If, instead, the economy is operating at less than potential GDP, an increase in the money supply will cause an increase in Q and/or an increase in P. During the 1950s, KEYNESIAN ECONOMICS, based on the ideas of John Maynard Keynes, dominated macroeconomic theory. Keynesian theory emphasized aggregate DEMAND, the spending on goods and services in an economy by households, businesses, and government. Keynesians argued that during a RECESSION, government should step in as a source of aggregate demand to stimulate the economy (FISCAL POLICY). During the GREAT DEPRESSION, Franklin Roosevelt’s “New Deal” administration followed Keynes’s recommendations by becoming an employer of last resort, implementing a variety of programs known as the alphabet agencies, including the WPA (WORKS PROGRESS ADMINISTRATION) and CCC (CIVILIAN CONSERVATION CORPS). Modern Keynesian economists (also known as neo-Keynesians) recommend using the monetary policy, in addition to fiscal policy, to influence the level of aggregate demand. Keynesians believe increases in the money supply will primarily affect aggregate demand by decreasing INTEREST RATES and stimulating INVESTMENT. This is known as the “Keynesian transmission mechanism.” Monetarists believe monetary policy has a powerful impact on an economy, much more than just affecting investment, and also suggest when and how much monetary policy will impact an economy are difficult to predict. Due to these uncertainties, most monetarists advocate a monetary rule—an agreed-upon constant rate of increase in the money supply—suggesting that, since the primary function of money is to facilitate exchanges, and more money is needed as an economy grows, a constantly rising money supply equal to the growth rate in the economy will fuel economic growth without fueling inflation. Policies regarding the control of the money supply are often referred to as “tight money” or “easy money” plans. Generally the goal of American monetary policy makers is to increase the money supply, but the question is the rate at which to do this. To increase the money supply, monetary authorities (in the United States, the Federal Open Market Committee of the FEDERAL RESERVE SYSTEM, known as the Fed) have three tools: RESERVE REQUIREMENTS, DISCOUNT RATE, and OPEN-MARKET OPERATIONS. Like a builder changing construction plans, changing the discount rate—the rate charged by the Federal Reserve to member banks for short-term LOANS—is a Fed signal that encourages or discourages banks to make more loans. Changing the reserve requirement, the percentage of bank deposits (liabilities) a bank is required to keep on reserve, is a powerful but rarely used tool of monetary policy. In construction it would be analogous to bringing in the heavy equipment to weed a flowerbed. Increasing the reserve requirement would reduce a bank’s reserve funds, drastically reducing their ability to make loans and slowing the rate of growth in the money supply. The Fed’s most frequently used tool to implement monetary policy is open-market operations, the buying and selling of government BONDS in order to increase and decrease the nation’s money supply. People often think money consists of only coins and currency, but money is anything people will accept as a means of payment. For example, most Americans pay for a majority of their purchases using checks. Checking-account balances, called demand deposits, are money. People also think that the government is printing more money, but in fact money is created in the BANKING SYSTEM. The process of banks creating money is called the depositexpansion multiplier. The deposit-expansion process begins with an open-market operation in which the Fed buys bonds from a bank, paying it by an electronic transfer of funds called an injection. The bank now has more funds, a portion of which it has to keep in reserve (the reserve requirement). The bank would not have agreed to sell the bond to the Fed unless it had something better to do with the funds, i.e., loan them to a customer, which is done by either giving the customer a check or adding the loan amount to the customer’s checking account. This new checking-account balance is money. Customers usually borrow money in order to buy things, which they pay for by writing checks. Their checks are deposited in the accounts of the businesses they paid. This adds to those businesses’ checking-account balances, and they will write checks to workers and other businesses to pay for the materials that went into producing the products they sold. These checks will become additions to workers’ and vendors’ checking-account balances. This process will repeat itself quite rapidly through the economic system. Each time new money is deposited, the bank receiving it will hold a portion, the reserve requirement, and then lend most of the rest of the funds. The amount of money created by the Fed’s initial injection of funds is expressed by the equation 1/(reserve requirement ratio) x amount of initial injection. Until the late 1980s, monetary policy was primarily followed by WALL STREET investors. Once, in the mid-1980s, a rumor spread among Wall Street traders that then-Federal Reserve Chairman Paul Volcker had suffered a heart attack. The STOCK MARKET fell precipitously, and Mr. Volcker, who was well and in a meeting, came out before news cameras to announce, like Mark Twain, “The reports of my death are premature!” In the last decade, monetary policy has become widely recognized and even closely followed by individuals, investors, and policy makers. Alan Greenspan, chairman of the Fed since 1987, has become a well-known nearcelebrity to Americans. Often referred to as the second most powerful person in Washington, Mr. Greenspan is widely credited with managing a 10-year-plus period of sustained economic growth. Many people refer to the Fed chairman as the most important individual affecting the U.S. economy, a statement implying the significance of monetary policy.