Monetary policy refers to the actions that a nation’s central bank engages in to influence the amount of money and credit in its economy. Such policies directly affect the interest rate, which indirectly affects spending, investment, production, employment, and inflation. Ideally, central banks are an independent government entity. While their operations are accountable to citizens and the government, other branches of government cannot directly control the central bank.
In the United States, the central bank is the Federal Reserve. Monetary policy consists of the Federal Reserve’s strategies to promote price stability, moderate long-term interest rates, and maximum employment. The Fed works towards these goals through three primary instruments: open market operations, the discount rate, and reserve requirements. The Federal Open Market Committee (FOMC) is the Fed’s main monetary policymaking body.
Contractionary and expansionary monetary policy are the two primary avenues of monetary policy. Contractionary monetary policy decreases the supply of money while expansionary monetary policy increases the supply of money in an economy. When GDP is high and the inflation rate is climbing, the Fed engages in contractionary monetary policy. Conversely, during periods of low GDP and high unemployment, the Fed utilizes expansionary monetary policy.
During periods of high unemployment, individuals’ disposable income declines from a lack of stable income. This causes the demand for goods and services to decline. Businesses tend to suffer from this decline in consumption, which is often accompanied by a drop in GDP. The Federal Reserve responds to rising unemployment by boosting aggregate demand, the sum of spending by households, businesses, and the government in an economy. Heightening the demand for goods and services— expanding the economy— increases production of such goods and services; businesses then begin to employ additional workers to meet the supply of goods demanded by consumers.
The Federal Reserve increases aggregate demand through the federal funds rate. Set by the Fed, the federal funds rate is “the rate that banks pay for overnight borrowing in the federal funds market.” Changes to the federal funds rate triggers changes to other interest rates in the economy. Thus, the Fed can indirectly decrease interest rates. Households and businesses are encouraged to borrow and spend, which promotes overall economic activity and growth. Specifically, the economic position of businesses improves, affording them the opportunity to hire additional workers.
For example, in 2020 the unemployment rate more than tripled and GDP sharply declined. The U.S. economy depressed, entering a period of recession in the business cycle. Accordingly, the federal funds rate greatly declined in 2020 to increase the money supply and encourage household investment and spending. A similar phenomenon occurred during the recession of 2007-2009. The federal funds rate dips as the unemployment rate increases. Conversely, the federal funds rate remains relatively constant and increases only slightly when unemployment rates are declining.
While the Fed aims to reduce unemployment by increasing the demand for goods and services, a growth in aggregate demand also causes wages and the cost of goods and services to increase. This increase in the price level results in inflation. Thus, there exists a short-run tradeoff between reducing unemployment and experiencing inflation. This tradeoff is called the Phillips curve.
The inflation rate is determined by three factors: cyclical unemployment (the deviation of unemployment from the natural rate), expected inflation, and supply shocks. The addition of the latter two factors to the curve occurred following the stagflation of the 1970s. The oil crisis of 1973 highlighted the effect of supply shocks and stagflation on the long-run aggregate supply curve. Experts also realized that once inflation is already occurring, the tradeoff between unemployment and inflation disappears.
This process can be seen during Fed Chairman Paul Volcker’s disinflation throughout the 1980s. In early 1980, inflation reached a peak of 11%. The Fed brought down the inflation rate to 4% by the end of 1983. Engineering this reduction in inflation required a loss of twenty percentage points of GDP; the U.S. experienced two recessions, one of which was the largest cumulative business cycle decline of employment and output in the post-World War II period. Disinflation is often not painless. However, the costliness of new policies to reduce inflation are often influenced by their credibility. Forecasting the results of new policies requires predicting how the public will view such policies, which is often difficult.
Most economists believe that the Phillips curve operates in the short run: fluctuations in aggregate demand only affect unemployment and output in the short run. Over the long-run, unemployment returns to its natural level. However, some experts argue that changing the real interest rate influences not only the actual unemployment rate but also the natural rate of unemployment. The Phillips curve represents a traditional understanding of unemployment and inflation. It continues to guide the Fed’s forecasts and policy decisions. In recent decades, the relationship between the two variables has weakened, flattening the curve. Experts have expressed concerns about the reliability of the curve as an effective tool to direct monetary policy.
Engaging in expansionary monetary policy for an extended period of time may allow for greater systemic risk in the system, leading to the emergence of an asset bubble. Asset bubbles occur when assets increase over a short period of time, unsupported by the value of the asset. During these periods of instability, some Fed’s decisions may increase economic vulnerability. Such was the case in the 2000s, when the Fed cut interest rates to historically low levels during the recession of 2001. While low interest rates helped the economy recover, they also played a role in easing the process of getting a mortgage and buying a home. Housing demand and home prices drove up, creating the housing bubble which ultimately burst.
Critics claim there needs to be stronger regulatory responses by the Fed to combat instability caused by monetary policy decisions. However, the effectiveness of monetary decisions on economic stability are hindered by the presence of lags on policy. Implementation lags are short term, influenced by the open-market operations required by policy changes to be put into immediate effect. Impact lags are more long term and are influenced by multiple factors, such as the deposit expansion process delaying, firms and businesses needing time to adjust to interest rates, and delaying effects of changes to exchange rates and net exports.
Another long-term concern of expansionary monetary policy is that countries are increasingly susceptible to falling into the liquidity trap. This trap occurs when low interest rates align with low investment spending. To combat the possibility of a liquidity trap, the Fed utilizes expansionary monetary policies.
Other economists believe that central banks can further expand the economy when the interest rate hits the lower bound of zero. Lowering longer-term interest rates, for example, through forward guidance and quantitative easing can stimulate the economy.
Some experts argue that monetary policy affects not only the actual rate of unemployment but also the natural rate of unemployment. A clear instance of this phenomenon can be seen during recessions, which may also leave permanent scars on the economy. For example, the job search may become permanently inhibited as skills or motivation to find employment diminishes; thus, the amount of frictional unemployment increases. Moreover, real wages may be pushed above equilibrium level, leading to an increase in the amount of structural unemployment.
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