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Monetary Policy - The Economic Lowdown Podcast Series, Episode 20
When it comes to the U.S. economy, the Federal Reserve has a very important role to play. Whether you realize it or not, its decisions affect you. In this episode of The Economic Lowdown podcast series, you’ll learn about how the Federal Reserve uses monetary policy to influence the economy.
Below is a full transcript of this audio presentation. It has not been edited or reviewed for accuracy or readability.
The Federal Reserve Bank of St. Louis presents The Economic Lowdown. Episode 20—Monetary Policy.
The Federal Reserve System, often simply called “the Fed,” is the central bank of the United States.
What do you know about the Federal Reserve? If you’re like most people, probably not much. Janet Yellen is the current chair of the Federal Reserve Board of Governors. Most people don’t know that either. A 2014 Pew Research poll found that only 24 percent of those surveyed correctly picked her from a list of four names as the current chair. If people simply guessed, the outcome would be about the same. Yet, in that same year, according to Forbes magazine, Janet Yellen was the most powerful women in the United States.1
When it comes to the U.S. economy, the Federal Reserve has a very important role to play. Whether you realize it or not, its decisions affect you. In this Economic Lowdown podcast, you’ll learn about how the Federal Reserve uses monetary policy to influence the economy.
Monetary policy refers to the actions the Federal Reserve takes to promote a strong economy. Specifically, Congress has given the Federal Reserve two objectives: maximum employment and price stability. These two objectives are often referred to as the dual mandate, and here’s how those objectives promote a strong economy:
Price stability means that the economy’s inflation rate remains low and stable over time. The Fed’s goal for the inflation rate is 2 percent over the longer run. So, while the inflation rate might be a bit higher or lower at times, it should tend to fluctuate around 2 percent. How does price stability help build a strong economy?
When inflation is low and stable, consumers and businesses can go about their business without letting inflation worries affect their planning.
The Federal Reserve has decided the 2 percent target provides good balance, because it provides a “buffer” against deflation without reducing the purchasing power of money very much.
The other part of the dual mandate is maximum employment. The Fed doesn’t have a numerical goal for maximum employment.
While the unemployment rate never goes to zero, economists generally think that there is a full employment level, and that employment will move to that level when the economy is functioning well.
You can also think of full employment as the economy reaching its potential. Just as students don’t always work up to their full potential, the economy doesn’t always work up to its full potential. And, when the economy grows at a slower rate than it could, or contracts, it’s not likely to create enough jobs to reach full employment.
The Fed, then, tries to move the economy back toward its full potential.
The “dual” part of the mandate means that the Fed is to strive to meet both goals at the same time. While that’s not always easy, many economists believe that an economy with price stability is more likely to reach its potential, which makes it easier to achieve maximum employment.
So, how does the Fed influence the economy to meet its dual mandate?
It uses monetary policy to influence the demand for goods and service in the economy. Let’s take a look at two specific economic conditions and what the Fed is likely to do.
First, imagine the economy is in recession, which means that the economy is contracting, or getting smaller—it’s producing fewer goods and services than it did in the past period. When this happens, the unemployment rate is usually on the rise and inflation might be falling below the Fed’s 2 percent objective. In other words, the economy is moving away from its potential. In such a case, the Fed might use monetary policy to lower interest rates. Here’s why.
Lower interest rates decrease the cost of borrowing money, which encourages households to spend on goods and services and firms to invest in new equipment and technology.
The increase in consumption spending by households and investment spending by firms increases the overall demand for goods and services in the economy.
Businesses respond to this increase in spending by increasing their production of goods and services.
With increased production, businesses are likely to hire additional employees and spend more on other resources.
As employment increases and more people earn more income, they will likely increase their spending on goods and services.
As this increase in spending ripples through the economy, the unemployment rate decreases; moving back toward full employment.
If inflation has fallen below the Fed’s target, the increase in spending will help move the inflation rate back toward 2 percent.
As the economy returns to a healthy state, the Federal Reserve would use monetary policy to move interest rates back to a more neutral level.
However, at some point, spending by households and firms might exceed the economy’s ability to produce goods and services. At this point, inflation might start to rise above the Fed’s 2 percent objective. How can the Fed reduce the inflation rate?
Economists are fond of saying that rising inflation is caused by “too much money chasing too few goods.” In short, this means inflation is caused when there is too much spending in the economy. Or, when spending exceeds the economy’s ability to produce goods and services.
Again, the Fed can influence the spending decisions of households and firms through interest rates. In this case, it is likely to raise interest rates.
Higher interest rates increase borrowing costs, which makes households less willing to buy goods and services and businesses less willing to expand and invest.
The decrease in spending caused by higher interest rates ripples through the economy, reducing overall spending and reducing the inflation rate.
Again, once the inflation rate moves back toward its 2 percent target, the Federal Reserve would move interest rates back to more neutral levels.
Now do you see now how the Federal Reserve’s decisions can affect you? The Fed uses monetary policy to satisfy its dual mandate set by Congress—price stability and maximum employment. During a recession, when the unemployment rate rises or inflation falls below its target, the Fed uses monetary policy to decrease interest rates to encourage consumers and businesses to spend. The increased spending encourages businesses to produce more and hire more employees. When inflation rises too far above the 2 percent target, the Fed uses monetary policy to increase interest rates to discourage consumers and businesses spending, which reduces inflationary pressures.
So, the next time you hear on the news that interest rates are going up or down, you’ll have a good idea why.