Monetary policy

Have you ever wondered who decides how much money the government prints? That’s the job of the Federal Reserve Board (FRB). The Fed (as it’s loosely referred to) controls monetary policy, which dictates how much currency is in our financial system. The size of the money supply is used as a tool to influence two things:

• Economic growth (low unemployment)
• Inflation levels

Some economists call the Fed’s responsibilities a “dual mandate.” Keeping our economy going and Americans employed, especially during a recession, is challenging and requires billions of dollars to make an impact. Managing inflation levels also requires an intelligent strategy and involves enormous amounts of money. The two tasks are virtually impossible to do at the same time. Encouraging economic growth can create inflation, while managing inflation can reduce economic growth.

Assume we’re in the middle of a recession. Thousands of jobs are being cut weekly, and stock market values are dropping rapidly. One of the Fed’s jobs is stimulating economic growth, so it will try to bring the economy back to life. To do so, the Fed increases the money supply, which lowers interest rates. There’s more money to lend out, so banks and financial institutions charge less to borrow it.

Interest rate changes can significantly transform the economy. Borrowing money is a staple of our financial system. Our government borrows money, large and small businesses borrow money, and everyday people borrow money. When the Federal Reserve puts more money in the system, banks lend money at lower interest rates, which makes it easier to make a profit, which leads to more job openings, which leads to more people being hired, which leads to more people spending their income, and so on. Declining interest rates can have a “positive” domino effect on the economy.

Putting more money into the system “loosens” (expands) the money supply. Interest rates fall, incentivizing businesses and people to buy more goods and services because money is “cheap.” The health of our economy is measured through Gross Domestic Product (GDP), which is the measure of all domestic goods and services produced. When more goods and services are bought, GDP rises along with the health of our economy.

This sounds great, right? Why wouldn’t the Fed keep interest rates low forever? The answer is inflation. In a world of limited resources, putting more money into the system will eventually create higher prices.

Let’s do a quick exercise to prove this point. As you know, there is a limited oil supply in the world. If every person in the world magically received $1 billion, oil prices would drastically increase. Just because everyone is now a billionaire doesn’t change the fact that there’s a fixed amount of oil in the ground.

The Fed is well aware of this problem, so it pays close attention to inflation levels. When inflation rises more than usual, their dual mandate requires them to shift their focus from the economy to reducing inflation. What exactly is inflation? Simply put, it’s when general prices rise as we discussed in depth in the preferred stock unit. Inflation is considered acceptable if it hovers around 2% annually. When prices rise rapidly and are out of control, it creates a massive economic problem.

When the Fed sees inflation rising more than usual, it will move to reduce it. To manage inflation levels, the Fed does the opposite of “loosening” (expanding) and removes significant amounts of money from the financial system. With less money in the system, banks have less money to lend out, and interest rates begin to rise. This is known as “tightening” (contracting) the money supply. With a higher cost of borrowing, fewer goods and services are purchased. This might seem bad for economic growth (which it is), but it eventually brings inflation levels down. Prices tend to drop when there’s a lack of demand for goods and a bigger incentive for people to save their money.

The Fed continually deals with a double-edged sword. It is given two tasks, both of which provide opposite outcomes. When the Fed encourages economic growth by putting more money into the system, inflation can become a problem. When the Fed tries to reduce inflation levels, it takes money out of the system, which reduces economic activity.

Billions (if not trillions) of dollars are involved when the Fed pursues its policies. Due to the sheer size of its actions, this organization significantly influences the economy. In fact, some economists refer to the Fed as the most powerful organization in the world. Although many factors change economic dynamics, those who subscribe to Monetarist theory believe the Fed’s actions are the primary “driver” of the economy.

The Fed pursues its economic growth and manageable inflation goals through monetary policy. In the next chapter, we’ll discuss the specific tools the Fed utilizes to pursue its goals.