The standard workhorse models of monetary policy now commonly in use, both for teaching macroeconomics to students and for supporting policymaking within many central banks, are incapable of incorporating the most widely accepted accounts of how the 2007-9 financial crisis occurred and incapable too of analyzing the actions that monetary policymakers took in response to it. They also offer no point of entry for the frontier research that many economists have subsequently undertaken, especially research revolving around frictions in financial intermediation. This paper suggests a simple model that bridges this gap by distinguishing the interest rate that the central bank sets from the interest rate that matters for the spending decisions of households and firms. One version of this model adds to the canonical “new Keynesian” model a fourth equation representing the spread between these two interest rates. An alternate version replaces this reduced-form expression for the spread with explicit supply and demand equations for privately issued credit obligations. The discussion illustrates the use of both versions of the model for analyzing the kind of breakdown in financial intermediation that triggered the 2007-9 crisis, as well as “unconventional” central bank actions like large-scale asset purchases and forward guidance on the policy interest rate.

Much of the experience of the U.S. Federal Reserve System, during the institution’s first hundred years, has revolved around controversies that fit squarely within the classical debate over rules versus discretion in economic policymaking. This paper looks back at the major episodes in this history since World War II, including the initial freeing of monetary policy from war-related interest-pegging, the Federal Reserve’s delayed but ultimately successful response to the inflation of the 1970s and early 1980s, the brief experiment with monetary aggregate targets, the extraordinary actions prompted by the 2007-9 financial crisis, and the current tentative exploration of inflation targeting. The paper concludes that the tension between the desire for rule-based policymaking and the practicalities that lead central bankers to preserve discretion in actual policy decisions does not admit of any easy, straightforward solution, and therefore that this tension is likely to persist into the Federal Reserve’s next century too.