How Monetary Policy Affects the Economy
The initial link in the chain between
monetary policy and the economy is the market for balances held at the Federal
Reserve Banks. Depository institutions have accounts at their Reserve Banks, and
they actively trade balances held in these accounts in the federal funds market
at an interest rate known as the federal funds rate. The Federal Reserve
exercises considerable control over the federal funds rate through its
influence over the supply of and demand for balances at the Reserve Banks.
The FOMC sets the federal funds rate at a
level it believes will foster financial and monetary conditions consistent with
achieving its monetary policy objectives, and it adjusts that target in line
with evolving economic developments. A change in the federal funds rate, or even
a change in expectations about the future level of the federal funds rate, can
set off a chain of events that will affect other short term interest rates,
longer term interest rates, the foreign exchange value of the dollar, and stock
prices. In turn, changes in these variables will affect households’ and
businesses’ spending decisions, thereby affecting growth in aggregate demand and
the economy.
Short term interest rates, such as those on
Treasury bills and commercial paper, are affected not only by the current level
of the federal funds rate but also by expectations about the overnight federal
funds rate over the duration of the short-term contract. As a result, short term
interest rates could decline if the Federal Reserve surprised market
participants with a reduction in the federal funds rate, or if unfolding events
convinced participants that the Federal Reserve was going to be holding the
federal funds rate lower than had been anticipated.
Interest rates would increase if the Federal
Reserve surprised market participants by announcing an increase in the federal
funds rate, or if some event prompted market participants to believe that the
Federal Reserve was going to be holding the federal funds rate at higher levels
than had been anticipated.
It is for these reasons that market participants closely follow data releases and statements by Federal Reserve officials, watching for clues that the economy and prices are on a different trajectory than had been thought, which would have implications for the stance of monetary policy.
Changes in short term interest rates will
influence long term interest rates, such as those on Treasury notes, corporate
bonds, fixed rate mortgages, and auto and other consumer loans. Long term rates
are affected not only by changes in current short term rates but also by
expectations about short term rates over the rest of the life of the long term
contract. Generally, economic news or statements by officials will have a
greater impact on short term interest rates than on longer rates because they
typically have a bearing on the course of the economy and monetary policy over
a shorter period; however, the impact on long rates can also be considerable
because the news has clear implications for the expected course of short term
rates over a long period.
Changes in long-term interest rates also
affect stock prices, which can have a pronounced effect on household wealth.
Investors try to keep their investment returns on stocks in line with the return
on bonds, after allowing for the greater riskiness of stocks. For example, if
long term interest rates decline, then, all else being equal, returns on stocks
will exceed returns on bonds and encourage investors to purchase stocks and bid
up stock prices to the point at which expected risk adjusted returns on stocks
are once again aligned with returns on bonds. Moreover, lower interest rates may
convince investors that the economy will be stronger and profits higher in the
near future, which should further lift equity prices.
Furthermore, changes in monetary policy
affect the exchange value of the dollar on currency markets. For example, if
interest rates rise in the
Changes in the value of financial assets, whether the result of an actual or expected change in monetary policy, will affect a wide range of spending decisions.
Lower interest
rates in the
If the economy slows and employment softens, policy makers will be inclined to ease monetary policy to stimulate aggregate demand.
The dollar and higher stock prices will
stimulate various types of spending. Investment projects that businesses
believed would be only marginally profitable will become more attractive with
lower financing costs. Lower consumer loan rates will elicit greater demand for
consumer goods, especially bigger ticket items such as motor vehicles. Lower
mortgage rates will make housing more affordable and lead to more home
purchases. They will also encourage mortgage refinancing, which will reduce
ongoing housing costs and enable households to purchase other goods. When
refinancing, some homeowners may withdraw a portion of their home equity to pay
for other things, such as a motor vehicle, other consumer goods, or a
long desired vacation trip. Higher stock prices can also add to household wealth
and to the ability to make purchases that had previously seemed beyond reach.
The reduction in the value of the dollar associated with a drop in interest
rates will tend to boost
If the economy slows and employment softens,
policy makers will be inclined to ease monetary policy to stimulate aggregate
demand. When growth in aggregate demand is boosted above growth in the economy’s
potential to produce, slack in the economy will be absorbed and employment will
return to a more sustainable path. In contrast, if the economy is showing signs
of overheating and inflation pressures are building, the Federal Reserve will be
inclined to counter these pressures by tightening monetary policy to bring
growth in aggregate demand below that of the economy’s potential to produce for
as long as necessary to defuse the inflationary pressures and put the economy on
a path to sustainable expansion.
While these policy choices seem reasonably
straightforward, monetary policy makers routinely face certain notable
uncertainties. First, the actual position of the economy and growth in aggregate
demand at any point in time are only partially known, as key information on
spending, production, and prices becomes available only with a lag. Therefore,
policy makers must rely on estimates of these economic variables when assessing
the appropriate course of policy, aware that they could act on the basis of
misleading information. Second, exactly how a given adjustment in the federal
funds rate will affect growth in aggregate demand (in terms of both the overall
magnitude and the timing of its impact) is never certain. Economic models can
provide rules of thumb for how the economy will respond, but these rules of
thumb are subject to statistical error. Third, the growth in aggregate supply,
often called the growth in potential output, cannot be measured with certainty.
Key here is the growth of the labor force and associated labor input, as well as
underlying growth in labor productivity. Growth in labor input typically can be
measured with more accuracy than underlying productivity; for some time, growth
in labor input has tended to be around the growth in the overall population of 1
percentage point per year. However, underlying productivity growth has varied
considerably over recent decades, from approximately 1 percent or so per year to
somewhere in the neighborhood of 3 percent or even higher, getting a major boost
during the mid- and late 1990s from applications of information technology and
advanced management systems. If, for example, productivity growth is 2 percent
per year, then growth in aggregate supply would be the sum of this amount and
labor input growth of 1 percent or 3 percent per year. In which case, growth in
aggregate demand in excess of 3 percent per year would result in a pickup in
growth in employment in excess of that of the labor force and a reduction in
unemployment. In contrast, growth in aggregate demand below 3 percent would
result in a softening of the labor market and, in time, a reduction in
inflationary pressures.