The goal of monetary policy is to promote price stability, full employment, and economic growth. The Fed, a monopolist over the money supply, is in a unique position to influence aggregate demand in the economy. Fed policy affects excess reserves in the banking system, which directly influences the money supply, which, in turn, changes interest rates. These changes in interest rates lead to changes in aggregate demand via consumption, investment, and net exports. The resulting change in AD affects GDP, inflation, and unemployment.
The Federal Reserve influences the economy by applying pressure to interest rates and talking to the public. In the case of economic growth, the Fed can warn against inflation by ever so slightly raising interest rates whenever the economy seems to be growing too quickly. During periods of inflation, the Fed can mash down on the interest rate brake pedal, give a stern warning to the driver, and bring the economy back under control.
In the case of recession, the most the Fed can do is let off the brake pedal, or lower interest rates and encourage the driver to hit the gas. The Fed’s power is asymmetrical; it is capable of stopping inflation, but only capable of encouraging full employment.
A bank’s reserve requirement is the percentage of checking account balances that the bank is not able to lend against. If the Fed were to raise the requirement, banks would have fewer excess reserves from which they could lend. This would reduce the money supply and result in higher interest rates, discouraging capital investment and durable goods consumption. This decrease in investment and consumption lowers AD and leads to less real GDP, higher unemployment, and a reduction in inflation. Lowering the reserve requirement would have the exact opposite effect.
The problem with changing the reserve requirement is that it is easy to lower, but much more difficult to raise. If the Fed lowers it, banks are able to lend more of their reserves and no real problem is created. However, raising the reserve requirement during periods of inflation would be nearly impossible for banks, as they probably have no excess reserves not already lent. The increase in the reserve requirement would precipitate an immediate liquidity crisis in the banking sector. Banks would call in loans and do whatever they could to meet the new higher requirement.
The discount rate is the interest rate that member banks pay the Fed to borrow money overnight, usually when they are in financial distress. Raising the discount rate discourages borrowing, but lowering the discount rate encourages it. If the Fed wants to reduce inflation, it raises the discount rate. When the Fed does this, the following chain of events is set into motion: The Fed announces an increase in the discount rate; banks are discouraged from borrowing; excess reserves are less likely to be lent; the money supply does not grow; interest rates rise; consumption, investment, and net exports fall; AD decreases; GDP falls; unemployment rises; and inflation falls. Lowering the discount rate would have the exact opposite effect.
The problem with the discount rate is that banks are reluctant to borrow directly from the Fed. The reluctance stems from the fact that other forms of borrowing are available at lower rates, so going to the Fed’s discount window is a public admission that something is wrong with the borrowing bank. A bank in good financial position will usually borrow to cover its short-term needs in the interbank lending market. The principal decision-makers at a bank do not want to scare away investors or current shareholders by borrowing from the Fed.
The discount rate is useful as a signal of future interest rate policy. This signaling function is important, as financial markets do not like surprises.
The primary way that the Fed enacts monetary policy is through the process known as open market operations (OMO). OMO is the buying and selling of U.S. Treasury securities (Treasuries) between the Federal Reserve Bank of New York’s open market desk and a select group of eighteen primary security dealers. The dealers include most of the world’s major banks and securities broker-dealers. They are expected to participate as counterparties to the Fed’s open market operations and share market information with the Fed. OMO transactions have the effect of either increasing excess reserves in the banking system when the Fed buys Treasuries from the primary security dealers, or reducing excess reserves in the banking system when the Fed sells Treasuries to the primary dealers.
Federal Reserve policy does not exist in a political vacuum. Instead, monetary policy functions alongside government’s fiscal policies. At times the two are at odds, but most of the time monetary policy is used to accommodate fiscal policy. For this to work, the Fed chairman, the president, the Treasury secretary, and key members of Congress communicate to create a coherent policy that addresses the fundamental goals of price stability, full employment, and economic growth.
The use of the federal budget in order to reduce unemployment or stabilize prices.
During periods of recession, expansionary fiscal policy is reinforced with expansionary monetary policy. As government spending increases and taxes decrease, upward pressure is placed on interest rates. Expansionary monetary policy offsets the upside pressure on interest rates by expanding the money supply and lowering short-term interest rates.
Inflationary periods are more problematic for presidents and lawmakers. The contractionary fiscal policy prescription calls for reduced spending and increased taxes, which are politically unpopular. Contractionary monetary policy is effective at stopping inflation, and the Fed’s insulation from political pressure makes it perfectly suited for the task. Former Fed chairman Paul Volcker was credited with whipping inflation when government was unable to do so.
Monetary policy has different effects in the short run and the long run. Expansionary monetary policies designed to reduce short-term interest rates and spur full employment and economic growth eventually lead to higher interest rates as they induce inflation. This means that monetary policy must be carefully applied. If the Fed introduces a monetary stimulus, they must also plan to remove the stimulus in order to prevent future inflation. The problem for policymakers is in timing the policy. Early removal of monetary stimulus might result in a protracted recession, but maintaining low interest rates for too long will almost certainly lead to higher inflation.
Too much reliance on monetary policy to reduce inflation can also lead to problems. Over the business cycle, if government uses expansionary fiscal policy to offset recessions and then relies on the Fed to contain periods of inflation, interest rates will ratchet up and long-term economic growth will be stymied. At some point government must reign in its spending and/or raise taxes to keep long-term interest rates from rising too high.