Imagine this: a recession has hit your country, and you are laid off and unable to find a job. This is a reality for you and thousands of others in your country. This scenario is, unfortunately, not uncommon. Every country will likely go through a recession at some point, causing people to lose jobs and diminish their quality of life. Thankfully, the Fed's Monetary Policy is helpful in stabilizing any major fluctuations in the economy. Continue reading to learn more about the Federal Reserve and its Monetary Policy, its tools, and more!
The Fed's Monetary Policy in Economics
Let's go over what The Federal Reserve's (The Fed's) monetary policy means for economics. The Fed is the central bank of the United States in charge of controlling the money supply. The Fed provides stability to the United States' economy with two tools: the money supply and interest rates. Let's go over two brief examples of how the Fed would use monetary policy to help an economy.
The United States is currently in a recession and aggregate demand is decreasing. The Fed has two options available to address the situation: altering the money supply and/or interest rates. During a recession, aggregate demand is decreasing in the economy. The Fed will increase the money supply and lower interest rates to increase aggregate demand.
In contrast, during inflation, aggregate demand is increasing too much and needs to be addressed. The Fed will decrease the money supply and increase interest rates to lower aggregate demand. In this way, the Fed can help bring stability to the economy when problems occur!
The Federal Reserve is the United States' central bank in charge of controlling the money supply.
Value of Dollar, pixabay
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.
Reserve requirement is the amount of reserves that banks need to hold on to.
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 discount rate is the interest rate that the Fed charges banks when banks borrow from the Fed.
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.
Open-Market Operations are the Fed's most used tool for monetary policy!
Open-market operations are the buying and selling of government securities to commercial banks.
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.
The United States is undergoing a recession and unemployment keeps rising. Consumers can't purchase as many products if they don't have a job, and producers can't sell their products to consumers who can't afford them. Without a central bank, consumers and producers will have to wait out the recession until the market reorients itself to equilibrium — who knows how long that will take!
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.
FED Monetary Policy - Key takeaways
- The Federal Reserve is the United States' central bank in charge of controlling the money supply.
- The Federal Reserve uses the money supply and interest rates to alter aggregate demand.
- Reserve Requirement is the number of reserves that banks need to hold on to.
- The discount rate is the interest rate that the Fed charges banks when banks borrow from the Fed.
- Open-Market Operations are the buying and selling of government securities to commercial banks.
References
- U.S. Bureau of Labor Statistics, CPI for all Urban Consumers, https://data.bls.gov/pdq/SurveyOutputServlet
- Federal Reserve, Federal Reserve Issues FOMC Statement, https://www.federalreserve.gov/newsevents/pressreleases/monetary20220615a.htm
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