In order to discuss how monetary policy should be conducted in the U.S. it is first necessary to briefly summarize the unique power of the Federal Reserve and policy prescriptions suggested by alternative schools of thought. The foundation of the power of the Federal Reserve comes from its unique role in controlling the nation's supply of "base money;" the sum total of the currency in the hands of the public and the reserves that banks are legally required to hold to bank their deposits. Banks can withdraw their reserves in the form of cash, or deposit cash with the Fed to add to their reserves. But the total quantity of base money cannot be changed except by the Fed's action. (Woolley, 1984)
By injection or withdrawing base money from the system the Fed has immense influence over the economy. If the Fed puts more cash in - which it usually does by buying U.S. government debt from a select group of commercial banks. These banks then find themselves with more reserves than they are legally required to hold. They can then choose (although they don't have to) to lend out the excess, expanding credit and driving down interest rates. Furthermore, most of the money they lend out ends up being deposited back in the banking system, allowing a second wave of lending, a third and so on. The result is the Fed's injection of base money supposedly has a multiplier effect, expanding credit throughout the economy. The rise in credit and the fall in interest rates in turn, stimulates the economy through a variety of channels: housing starts rise, the dollar falls (stimulating exports), business investment rises, consumer credit gets easier. Conversely, if the Federal Reserve withdraws base money from the economy, the process runs in reverse: credit contracts, and the whole economy is restrained (See Woolley, 1984; Clifford, 1965).
Taken this brief description of what the Federal Reserve "does" the question then becomes how should the ...