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.

Strategies for Controlling Inflation

Strategies for Controlling Inflation

1. Break the cycle of expectations. This helps to control cost-push inflation.
2. Reduce the costs of production. This helps reduce cost-push inflation.
3. Reduce aggregate demand. This helps to control demand-pull inflation.

AD = C + I + G + X – M
where:
AD = aggregate demand
C = consumption
I = investment
G = government purchases
X – M = exports – imports = net exports = NE


Objective to help achieve low inflation
Fiscal policy
to achieve this objective
Monetary policy
to achieve this objective
Break the cycle of inflationary expectations.
Anything that convinces the public that the government is committed to reducing inflation.
Anything that convinces the public that the Federal Reserve System is committed to reducing inflation.
Decrease the costs of production.
Anything that reduces costs of production. Increasing the world supply of oil, for example, would reduce production costs for many industries.

Reduce aggregate demand.
Decrease government purchases or increase taxes. Since government purchases are a component of aggregate demand (and GDP), reduced government spending will reduce aggregate demand directly. Higher taxes leave workers and businesses with less disposable income. This leads to a reduction in consumption and investment spending, which are two of the components of aggregate demand.
Decrease the money supply to increase interest rates. Higher interest rates discourage borrowing. This causes a decrease in consumption and investment spending, which are two of the components of aggregate demand
Table 3. Using fiscal and monetary policies to achieve low inflation.

GDP data: C + I + G + X - M

Gross domestic product is the total value of final goods and services produces in the economy in a given time period (usually a year).

Gross Domestic Product = Consumption + Investment + Government Purchases + Exports - Imports

GDP = C + I + G + X - M

The Economic Report of the President provides U.S GDP data since 1959.

Table B-1 (Gross domestic product) provides nominal GDP data. They are not adjusted for inflation.
Table B-2 (Real gross domestic product) provides GDP data adjusted for inflation.

In both tables, consumption (C) and investment (I) data appear on the first page of the Excel spreadsheet. The data for government purchases (G), exports (X), and imports (M) are provided on page 2 of each spreadsheet.