FED Monetary Policy

The Fed's Contractionary Monetary Policy

Let's go over how the Fed uses contractionary monetary policy to address an inflationary period. We will begin by looking at a graph below:

Figure 1. Contractionary Monetary Policy, StudySmarter Originals

What does the graph above tell us? At points P1 and Y1, the economy is in an inflationary period. In order for the Fed to address this, they must lower aggregate demand with contractionary monetary policy — decreasing the money supply and raising interest rates. This will decrease aggregate demand by lowering the output and price level to points P2 and Y2 — restoring equilibrium.

The Fed's Expansionary Monetary Policy

Let's now go over how the Fed uses expansionary monetary policy to address a recessionary period. We will begin by looking at a graph below:

Figure 2. Expansionary Monetary Policy, StudySmarter Originals

What does the graph above tell us? At points P1 and Y1, the economy is in a recessionary period. In order for the Fed to address this, they must increase aggregate demand with expansionary monetary policy — increasing the money supply and lowering interest rates. This will increase aggregate demand by increasing the output and price level to points P2 and Y2 — restoring equilibrium.

The Fed's Monetary Policy Tools

The Fed has three main policy tools it uses to alter the level of aggregate demand in the economy: the reserve requirement, the discount rate, and open-market operations. We will go over each policy tool to understand how they influence aggregate demand in the economy.

The Fed's Monetary Policy Tools: Reserve Requirement

The reserve requirement is the amount of reserves that banks need to hold on to. The Fed can change the reserve requirement to make banks hold more or fewer reserves, depending on the state of the economy. If the reserve requirement is lower, then banks can loan out more of their capital to consumers, increasing the money supply. If the reserve requirement is higher, then banks cannot loan out as much of their capital to consumers, decreasing the money supply.

The Fed's Monetary Policy Tools: Discount Rate

The Discount Rate is the interest rate that the Fed charges banks when banks borrow from the Fed. The Fed can alter the discount rate to affect a bank's decision to borrow from the Fed. If the discount rate is lower, then banks are more likely to borrow from the Fed and subsequently loan more of their capital to consumers, increasing the money supply. If the discount rate is higher, then banks are less likely to borrow from the Fed and subsequently loan less of their capital to consumers, decreasing the money supply.

The Fed's Monetary Policy Tools: Open-Market Operations

Open-Market Operations occur when the Fed buys and sells government securities from commercial banks. The Fed can purchase or sell securities to alter the money supply in the economy. If the Fed buys securities from commercial banks, then banks will be given money in exchange for the securities they sold to the Fed. The money banks receive from the Fed will be used to loan out to consumers, increasing the money supply. If the Fed sells securities to commercial banks, then banks will have less capital since they have to pay for the securities that the Fed is selling them. The less capital banks have, the fewer loans will be made to consumers, decreasing the money supply.

The Fed's Monetary Policy Importance

The Fed's monetary policy is critical to our economy. Monetary policy action can make recessionary or inflationary periods transient and less damaging to the economy. Let's go over a scenario in which there is no Fed in the United States to provide economic stability.

With a central bank, recessions can be addressed as soon as possible. Consumers and producers do not have to endure the recession until it fixes itself; instead, the Fed can buy securities, lower the discount rate, and lower the reserve requirement to shorten the recession. The Fed provides much-needed stability during recessions and inflation alike!

Economic Recession, pixabay

Current Monetary Policy of The Fed

Let's discuss what the current Fed monetary policy is in the United States. Recall that the Fed acts based on the current state of the economy. To understand the Fed's monetary policy decisions, let's first look at what the economy currently looks like.

Figure 3. U.S. CPI for May, StudySmarter Originals. Source: U.S. Bureau of Labor Statistics¹

The chart above shows the United States' yearly consumer price index (CPI) for the month of May. As you can see, the United States has unprecedented levels of inflation for 2022: 6.0%!

Based on this, how might the Fed act?

The Fed should be decreasing the money supply and raising interest rates to address this inflationary period; as of June 28th, 2022, this is precisely what the Fed is doing. The Fed raised the discount rate, the federal funds rate, and is holding back on selling government securities.² This all matches with what the Fed should conceptually do when implementing its monetary policy! Decrease the money supply and increase the interest rates during inflationary periods.