Monetary Policy and Its Effects on the Economy
Fiscal policy, the tax and spending policies of the federal government, are decisions voted and enacted by the Congress and the Administration; the Federal Reserve (Fed), or central bank, plays no role in the creation or implementation of fiscal policy. The Fed does, however, enact and implement monetary policy, which refers to policy goals of the central bank to achieve its macroeconomic policy mandates set forth by the Congress. These stated goals look to control/regulate the overall money supply and promote sustained economic growth.
These goals, known as the Fed’s dual mandate, are price stability and maximum employment.
To achieve its dual mandate, the Fed enacts three strategies in conducting monetary policy – reserve requirements, interest rates (federal funds rate), and open market operations. The Board of Governors of the Federal Reserve System is responsible for the federal funds rate and reserve requirements, while the Federal Open Market Committee (FOMC) is tasked with open market operations. The Board of Governors can adjust the reserve requirements at banks, which sets the minimum amount of deposits they must keep on hand, to ensure they are able to meet their liabilities (i.e., to avoid a bank run, as seen with Silicon Valley Bank).
Another tool of the Fed is the federal funds rate, which is the rate commercial banks borrow and lend their excess reserves for overnight loans to satisfy reserve requirements. This rate, a key short-term interest rate, has great influence on the general level of short-term market interest rates. It is set as a range with an upper and lower limit - the fed funds rate range currently sits at 5.00% - 5.25%. By adjusting short-term interest rates in response to changes in the macroeconomic landscape, the Fed can influence long-term interest rates and key asset prices. These changes in financial conditions can have an impact on the spending decisions of individual households, business, and/or the greater economy.
Lastly, the FOMC sells or purchases government bonds in the open market to affect the money supply, known as open market operations. When selling bonds, the FOMC decreases the amount of money in the economy while increasing the number of available bonds. Alternatively, when purchasing government bonds, the FOMC infuses money into the economy (expanding the money supply), while decreasing the number of bonds available.
Fed policy can be aimed at either expanding or contracting the economy, depending on the macroeconomic environment. As such, monetary policy can be labeled as either expansionary or contractionary. During times of economic slowdown (i.e., recession), expansionary monetary policy supports economic growth by increasing the money supply and lowering interest rates to encourage consumer spending and borrowing. Conversely, contractionary monetary policy, consists of strategies to limit the money supply, lower inflation, and slow economic growth. The latter, which is the current policy of the Fed, has been ongoing since March of 2022 to combat decades-high inflation. As we have seen over the past year, increasing interest rates can have negative effects on the economy, especially producer and consumer prices, mortgage interest rates, and reduced business expansion.