Have you ever wondered who decides how much money the government prints? That role belongs to the Federal Reserve Board (FRB). The Fed (as it’s commonly called) sets monetary policy, which influences how much currency is in the financial system.
The money supply is used as a tool to influence two things:
Some economists describe the Fed’s responsibilities as a “dual mandate.” Supporting economic growth and employment - especially during a recession - can require enormous amounts of money to make a noticeable impact. Controlling inflation also requires a careful strategy and can involve large-scale changes to the money supply.
The challenge is that these two goals often pull in opposite directions:
Assume we’re in the middle of a recession. Thousands of jobs are being cut each week, and stock market values are dropping rapidly. One of the Fed’s goals is to stimulate economic growth, so it will try to revive economic activity.
To do that, the Fed increases the money supply, which tends to lower interest rates. With more money available to lend, banks and other financial institutions can charge less to borrow it.
Interest rate changes can reshape the economy because borrowing is central to the financial system. The government borrows money, businesses borrow money, and individuals borrow money. When the Fed increases the money supply, banks generally lend at lower interest rates. Lower borrowing costs can make it easier for businesses to invest and earn profits, which can lead to more job openings, more hiring, and more consumer spending. In that way, falling interest rates can create a “positive” domino effect.
Putting more money into the system loosens (expands) the money supply. Interest rates fall, which encourages businesses and consumers to buy more goods and services because borrowing is cheaper.
The health of the economy is often measured by Gross Domestic Product (GDP), which is the value of all domestic goods and services produced. When more goods and services are purchased and produced, GDP tends to rise.
This sounds appealing - so why wouldn’t the Fed keep interest rates low forever? The answer is inflation. In a world with limited resources, adding more money to the system can eventually push prices higher.
Let’s do a quick exercise to see why. The world has a limited supply of oil. If every person in the world magically received $1 billion, oil prices would likely surge. Even though everyone would have more money, the amount of oil in the ground wouldn’t change.
The Fed watches inflation closely for this reason. When inflation rises more than usual, the dual mandate pushes the Fed to shift attention away from stimulating growth and toward reducing inflation.
What exactly is inflation? Simply put, it’s when general prices rise, as discussed in depth in the equity securities unit. Inflation is generally considered acceptable when it’s around 2% annually. When prices rise rapidly and unpredictably, it can create major economic problems.
When the Fed sees inflation rising more than usual, it may act to reduce it. To manage inflation, the Fed does the opposite of loosening: it removes significant amounts of money from the financial system. With less money available, banks have less to lend, and interest rates tend to rise. This is known as tightening (contracting) the money supply.
Higher borrowing costs usually reduce spending on goods and services. That can slow economic growth (and often does), but it can also bring inflation down over time. When demand falls, prices tend to rise more slowly - and may even drop - especially when people have more incentive to save rather than spend.
The Fed continually faces this trade-off:
Billions (if not trillions) of dollars can be involved when the Fed carries out its policies. Because its actions operate at such a large scale, the Fed can significantly influence the economy. Some economists even describe it as one of the most powerful organizations in the world.
Although many factors affect economic conditions, those who subscribe to Monetarist theory argue that the Fed’s actions are the primary driver of the economy.
The Fed pursues its goals of economic growth and manageable inflation through monetary policy. In the next chapter, you’ll look at the specific tools the Fed uses to carry out that policy.
Sign up for free to take 6 quiz questions on this topic