Money, Banking, and Monetary Policy

Monetary Policy

By the end of this lesson, you will be able to describe how the Federal Reserve controls the money supply, explain the transmission mechanism from interest rates to the economy, and evaluate unconventional monetary policy tools.

The Federal Reserve's Dual Mandate

The Fed has two equally weighted goals:

1. Maximum employment — minimize cyclical unemployment
2. Stable prices — keep inflation near 2%

These goals sometimes conflict: fighting inflation requires raising rates, which slows growth and increases unemployment.

The Policy Rate: The Fed Funds Rate

The federal funds rate is the interest rate banks charge each other for overnight loans of reserves. The Fed sets a target range for this rate.

When the Fed LOWERS the fed funds rate:

• Borrowing becomes cheaper for banks → banks lend more
• Business investment increases (cheaper credit)
• Consumer spending on big-ticket items (mortgages, cars) increases
• The dollar may weaken (lower returns attract less foreign capital)
• Economic activity expands
• Use: fighting recessions

When the Fed RAISES the fed funds rate:

• Borrowing becomes more expensive
• Investment and consumption fall
• The dollar may strengthen
• Economic activity slows
• Inflation falls
• Use: fighting inflation

How the Fed Implements Policy

Open market operations (OMO): the primary tool.

To LOWER the fed funds rate:

• The Fed BUYS Treasury securities from banks
• Banks receive cash (reserves increase)
• More reserves → banks can lend more at lower rates → fed funds rate falls

To RAISE the fed funds rate:

• The Fed SELLS Treasury securities
• Banks pay cash (reserves decrease)
• Fewer reserves → banks compete to borrow, driving the rate up

The Transmission Mechanism

Rate changes affect the economy through multiple channels:

1. Credit channel: lower rates → cheaper loans → more investment
2. Asset price channel: lower rates → higher stock prices (future earnings discounted at lower rate) → wealthier consumers spend more (wealth effect)