How does monetary policy affect the U.S. economy?
The point of implementing policy through raising or lowering
interest rates is to affect people's and firms' demand for goods and
This section discusses how policy actions affect real interest rates,
which in turn affect demand and ultimately output, employment, and
What are real interest rates and why do they matter?
For the most part, the demand for goods and services is not
related to the market interest rates quoted in the financial pages of
known as nominal rates. Instead, it is related to real interest rates—that
is, nominal interest rates minus the expected rate of inflation.
example, a borrower is likely to feel a lot happier about a car loan
at 8% when the inflation rate is close to 10% (as it was in the
1970s) than when the inflation rate is close to 2% (as it was in
the late 1990s). In the first case, the real (or inflation-adjusted)
of the money that the borrower would pay back would actually be lower
than the real value of the money when it was borrowed. Borrowers,
of course, would love this situation, while lenders would be disinclined
to make any loans.
So why doesn't the Fed just set the real interest
rate on loans?
Remember, the Fed operates only in the market for bank reserves.
Because it is the sole supplier of reserves, it can set the nominal
The Fed can't set real interest rates directly because it can't
set inflation expectations directly, even though expected inflation
to what the Fed is expected to do in the future. Also, in general,
the Fed has stayed out of the business of setting nominal rates
instruments and instead allows financial markets to determine longer-term
How can the Fed influence long-term rates then?
Long-term interest rates reflect, in part, what people in financial
markets expect the Fed to do in the future. For instance, if
they think the Fed
isn't focused on containing inflation, they'll be concerned that
inflation might move up over the next few years. So they'll add
a risk premium
to long-term rates, which will make them higher. In other words,
the markets' expectations about monetary policy tomorrow have
a substantial impact on long-term interest rates today. Researchers
out that the Fed could inform markets about future values of
in a number of ways. For example, the Fed could follow a policy
of moving gradually once it starts changing interest rates. Or,
Fed could issue
statements about what kinds of developments the FOMC is likely
to focus on in the foreseeable future; the Fed even could make
statements about the future stance of policy.
How do these policy-induced
changes in real interest rates affect the economy?
Changes in real interest rates affect the public's demand for
goods and services mainly by altering borrowing costs, the
availability of bank
loans, the wealth of households, and foreign exchange rates.
example, a decrease in real interest rates lowers the cost of borrowing;
that leads businesses to increase investment
spending, and it leads
households to buy durable goods, such as autos and new homes.
In addition, lower real rates and a healthy economy may increase banks'
willingness to lend to businesses and households.
This may increase
spending, especially by smaller borrowers who have few
sources of credit other
Lower real rates also make common stocks and
other such investments more attractive than bonds and other debt instruments;
a result, common
stock prices tend to rise. Households with stocks in
their portfolios find that the value of their holdings is higher,
and this increase
in wealth makes them willing to spend more. Higher stock
prices also make
it more attractive for businesses to invest in plant
and equipment by issuing stock.
In the short run, lower real interest
rates in the U.S. also tend to reduce the foreign exchange value of
the dollar, which lowers
of the U.S.-produced goods we sell abroad and raises
the prices we pay for foreign-produced goods. This
goods and services produced in the U.S.
in aggregate demand for the economy's output through these different
channels leads firms
employment, which in turn increases business spending
on capital goods even
making greater demands on existing factory capacity.
It also boosts consumption further because of the
of economic output.
How does monetary policy affect
Wages and prices will begin to rise at faster rates
if monetary policy stimulates aggregate demand
push labor and
beyond their long-run capacities. In fact, a monetary
policy that persistently attempts to keep short-term
low will lead
higher inflation and higher nominal interest rates,
with no permanent increases
in the growth of output or decreases in unemployment.
As noted earlier, in the long run, output and employment
policy. In other words, while there is a trade-off
between higher inflation
and lower unemployment in the short run, the trade-off
disappears in the
Policy also affects inflation directly
through people's expectations about future inflation. For
suppose the Fed eases
monetary policy. If consumers and businesspeople
figure that will mean
in the future, they'll ask for bigger increases
in wages and prices. That in itself will raise
Doesn't U.S. inflation depend on
worldwide capacity, not just U.S. capacity?
In this era of intense global competition, it
might seem parochial to focus on U.S. capacity
as a determinant
of U.S. inflation,
on world capacity. For example, some argue
that even if unemployment in the U.S. drops to very
be able to push for higher wages because they're
competing for jobs
workers abroad, who are willing to accept much
lower wages. The implication is
that inflation is unlikely to rise even if
the Fed adopts
an easier monetary policy.
This reasoning doesn't
hold up too well, however, for a couple of reasons. First, a large
proportion of what
in the U.S.
very much by foreign trade. One example is
health care, which isn't traded internationally
15% of U.S.
More important, perhaps, is the fact
that such arguments ignore the role of flexible
rates. If the
Fed were to adopt
it would tend to increase the supply of
U.S. dollars in the market. Ultimately, this would
tend to drive
of the dollar
relative to other
countries, as U.S. consumers and firms
used some of this increased money supply to buy
got rid of
the additional U.S. currency they did not
want. Thus, the price of
in terms of U.S. dollars would go up—even
though they would not in terms
of the foreign currency. The higher prices
of imported goods would, in
turn, tend to raise the prices of U.S.
How long does it take a policy action to
affect the economy and inflation?
It can take a fairly long time for a
monetary policy action to affect the
the lags can vary
example, the major effects on output
can take anywhere from three months to
two years. And the effects on inflation
tend to involve even longer lags,
perhaps one to three years, or more.
are the lags so hard to predict?
So far, we've described a complex chain
of events that links a change in
the funds rate
Developments anywhere along this
chain can alter how much a policy action
the economy and when.
one link in the chain is long-term interest rates, and
to a policy
market's expectations about future
Fed policy. If markets expect a
funds rate to be the beginning
of a series of moves in the same direction,
rates will react by more than if
had expected the Fed to take no
further action. In contrast, if
markets had anticipated the policy action,
long-term rates may not move much
at all because
would have factored it into the
rates already. As a
same policy move
different effects on financial
markets and, through them, on output and
Similarly, the effect
of a policy action on the economy
Fed action means for inflation
in the future. If people believe
of policy means the Fed is determined
to keep inflation under control,
expect low inflation
future, so they're
likely to ask for smaller wage
and price increases,
and this will help achieve
low inflation. But if people
aren't convinced that the Fed is going
to contain inflation,
they're likely to
bigger wage and
and that means that inflation
is likely to rise. In this case, the
there are significant losses
in employment and
What problems do lags
The Fed's job would be much
easier if monetary policy had
and sure effects.
policy, see its effects,
the settings until they eliminated
any discrepancy between economic
developments and the goals.
with the long lags associated with monetary policy actions, the Fed
must try to anticipate
of its policy
future. To see why, suppose
the Fed waits to shift its
stance until it actually
that inflationary momentum
already had developed, so
the task of
reducing inflation would
be that much harder
more costly in terms of job
losses. Not surprisingly,
is a difficult