The Federal Reserve uses monetary policy to influence interest rates and the money supply in order to achieve its policy goals of price stability, maximum employment, and moderate long-term growth. It targets the federal funds rate through open market operations and adjusts the money supply through bond purchases and sales. Raising interest rates and reducing the money supply are used to fight inflation, while lowering rates and increasing the supply are used to stimulate the economy during recessions. The Fed aims to keep recessions short and mild through timely countercyclical monetary policy actions.

1. Monetary Policy
The Basics

2. What is Monetary Policy?
• The actions the Federal Reserve takes to
manage the money supply and interest rates
to pursue macroeconomic policy goals.
– Goals of Monetary Policy
• Price stability
• High employment
• Stability of financial markets and institutions
• Economic growth

3. Price Stability
• Rising prices erode the value of money as a
medium of exchange and a store of value.
• Increase in inflation rate results in a rise in
prices.
• Decrease in inflation rate results in a decrease
in prices.
• Keeping the inflation rate stable helps keep
prices stable.

4. High Employment
• Unemployed workers contribute to reducing
GDP below its potential level.
• Unemployment causes financial distress and
decreases self-esteem of workers who lack
jobs.
– Lack of job results in less spending/more saving
which decreases demand and causes inflation and
prices to rise.

5. Stability of Financial Markets and
Institutions
• The Fed promotes this so that an efficient
flow of funds from savers to borrowers will
occur.
– Resources are lost when they are not efficient in
matching savers and borrowers.
– Firms with the potential to produce valuable
goods and services cannot obtain the financing
they need.
– Savers waste resources looking for satisfactory
investments.

6. Economic Growth
• Stable growth allows households and firms to
plan accurately and encourages the long-run
investment needed to sustain growth.
– Provide incentives for saving for larger pool of
investment funds
– Provide direct incentives for business investment

7. Monetary Policy Targets
• The Fed cannot effect unemployment and
inflation rates directly.
• The Fed uses variables that it can affect
directly and that affect variables like real GDP,
employment, and price level.
• Two main targets:
– Money supply
– Interest rate

8. Money Supply and Interest Rate
Lower interest rates lead to increased spending!

9. Choosing a Monetary Policy Target
• The fed can either choose money supply or
interest rate.
– Typically focus on interest rate
• There are many kinds of interest rates.
– The Fed targets federal funds rate.
• The interest rate banks charge each other for loans.
– Determined by the supply of reserves relative to the demand
for them.
• The Fed can increase/decrease supply of bank reserves
through open market operations and set a target for
the federal funds rate.

10. • Expansionary Monetary Policy
– The Federal Reserve’s increasing the money
supply and decreasing interest rates to increase
real GDP.
– Used during a recession when unemployment is a
problem.
– To increase the money supply, the Federal Reserve
can:
• buy government bonds (an open market purchase)
• lower the discount rate
• lower the reserve requirement

11. Too Low for Zero?
• If the Fed must reduce the federal funds rate to
nearly zero then Quantitative Easing is tried.
– The buying financial assets from commercial
banks and other private institutions with newly
created money in order to inject a pre-
determined quantity of money into the economy.
– Although more money is floating around, there is still
a fixed amount of goods for sale. This will eventually
lead to higher prices or inflation.

13. • Contractionary Monetary Policy
– The Federal Reserve’s adjusting the money supply
to increase the interest rates to reduce inflation.
– Used when inflation is the problem.
– To decrease the money supply, the Federal
Reserve can:
• sell government bonds (an open market sale)
• raise the discount rate
• raise the reserve requirement

15. Inflation Targeting
• Conducting monetary policy so as to commit
the central bank to achieving a publicly
announced level of inflation.

16. Can the Fed Eliminate Recessions?
• The best the Fed can do is to keep recessions
shorter and milder then they would be
otherwise.
– Offsetting the effects of the business cycle
– Timing is essential
• If the Fed too early or late in recognizing a recession
and implementing a policy then it could destabilize the
economy.