28.4 Monetary Policy and Economic Outcomes

Monetary policy is the Federal Reserve's powerful tool to steer the economy. By adjusting interest rates and money supply, the Fed can stimulate growth or cool down an overheating economy. It's like a thermostat for the nation's financial system.

The Fed's decisions have far-reaching effects. Lower rates can boost spending and investment, while higher rates can slow inflation. Over the past 40 years, the Fed has faced challenges from high inflation to financial crises, adapting its approach to keep the economy on track.

Monetary Policy

Expansionary vs Contractionary Policies

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• Expansionary monetary policy
  • Stimulates economic growth and increases aggregate demand by increasing money supply and lowering interest rates
  • Federal Reserve tools:
    • Open market operations: Buying government securities injects money into the economy
    • Lowering discount rate makes borrowing from the Fed cheaper for banks
    • Lowering reserve requirement allows banks to lend more money
• Contractionary monetary policy
  • Slows economic growth and decreases aggregate demand by decreasing money supply and raising interest rates
  • Federal Reserve tools:
    • Open market operations: Selling government securities removes money from the economy
    • Raising discount rate makes borrowing from the Fed more expensive for banks
    • Raising reserve requirement restricts banks' ability to lend money

Interest Rates and Aggregate Demand

• Interest rates
  • Expansionary policy lowers interest rates
    • Encourages borrowing and spending (loans, mortgages)
    • Discourages saving (lower returns on savings accounts, CDs)
  • Contractionary policy raises interest rates
    • Discourages borrowing and spending (higher costs for loans, credit cards)
    • Encourages saving (higher returns on savings accounts, bonds)
• Aggregate demand (AD)
  • Lower interest rates stimulate AD
    • Increases consumption (C) as financing costs decrease (auto loans, credit cards)
    • Increases investment (I) as borrowing costs for businesses decrease (equipment, factories)
    • May increase net exports (NX) if currency depreciates making exports cheaper and imports more expensive
  • Higher interest rates decrease AD
    • Decreases consumption (C) as financing costs increase
    • Decreases investment (I) as borrowing costs for businesses increase
    • May decrease net exports (NX) if currency appreciates making exports more expensive and imports cheaper
• Transmission mechanism
  • $M \uparrow \rightarrow i \downarrow \rightarrow I \uparrow , C \uparrow \rightarrow AD \uparrow$
  • $M \downarrow \rightarrow i \uparrow \rightarrow I \downarrow , C \downarrow \rightarrow AD \downarrow$

Federal Reserve's Policy Decisions

Policy Decisions Over Four Decades

• 1980s: Volcker era
  • Combated high inflation with contractionary policy
    • Significantly raised interest rates (federal funds rate peaked at 20% in 1981)
    • Reduced money supply growth
  • Successfully reduced inflation (from 14% in 1980 to 4% by 1983) but caused a recession (1981-1982)
• 1990s: Greenspan era
  • Maintained low, stable inflation (around 3%)
  • Responded to crises by lowering interest rates
    • Asian financial crisis (1997)
    • Long-Term Capital Management collapse (1998)
  • Criticized for potentially contributing to dot-com bubble (1995-2000) by keeping interest rates too low for too long
• 2000s: Greenspan and Bernanke era
  • Early 2000s: Lowered rates after dot-com crash (2000) and 9/11 attacks (2001)
  • Housing bubble and financial crisis (2007-2008)
    • Implemented expansionary policy to combat recession
    • Lowered federal funds rate to 0-0.25% range
    • Introduced quantitative easing (QE) programs to buy mortgage-backed securities and Treasury bonds
• 2010s: Bernanke, Yellen, and Powell era
  • Continued expansionary policies to support recovery
  • Gradually raised rates as economy improved (2015-2018)
  • Began unwinding QE and reducing Fed's balance sheet (2017)
  • COVID-19 pandemic challenges
    • Lowered rates back to 0-0.25% range
    • Reintroduced QE programs to support economy (buying Treasury bonds and mortgage-backed securities)