How Monetary Policy Affects the Economy

How Monetary Policy Affects the Economy

Monetary policy is conducted in the United States by the Federal Reserve System (the Fed), which is the U.S. central bank. A central bank is an institution that oversees the banking system and regulates the quantity of money in an economy. The Fed influences the economy by changing the money supply and interest rates to either increase or decrease aggregate demand (AD), which is overall spending on newly produced goods and services. When the Federal Reserve conducts monetary policy, it may increase or decrease the money supply depending on the condition of the economy.

Expansionary monetary policy occurs when the Federal Reserve System induces commercial banks to increase the amount of money they create through loans. Thus, expansionary monetary policy increases the money supply. If the economy needs stimulation (e.g., to fight unemployment), then the Fed usually conducts expansionary monetary policy to increase the money supply, reduce interest rates, and encourage more consumption and investment spending. Low interest rates encourage households and businesses to borrow money. If they use this borrowed money to increase spending on consumer products (C) and investment (I) in capital equipment, inventories, and structures, then aggregate demand increases. Aggregate demand is composed of consumption spending (C), investment spending (I), government purchases (G), and net exports (X-M).


AD = C + I + G + X - M


Contractionary monetary policy occurs when the Federal Reserve System induces commercial banks to decrease the amount of money they create through loans. Thus, contractionary monetary policy decreases the money supply. If the economy needs dampening (e.g., to fight inflation), then the Fed usually conducts contractionary monetary policy to decrease the money supply, increase interest rates, and discourage consumption and investment spending. High interest rates discourage households and businesses from borrowing money. If higher interest costs reduce spending on consumer products (C) and investment (I) in capital equipment, inventories, and structures, then aggregate demand decreases.