How Does Monetary Policy Work? (Pt. 1)

PART 1: Introduction

In my foundational macroeconomics course, the answer was simple: Monetary policy is when the Federal Reserve sets the short-term interest rate. The expectation of short-term interest rates over time comprises longer-term interest rates. Thus, the Federal Reserve determines short-term and long-term interest rates. 

Why do interest rates matter? Well, rates influence the amount of borrowing and spending in an economy. If rates are high, they are said to be ‘restrictive’ in that they limit excess borrowing and spending as the cost of borrowing is high. If rates are low, they are ‘stimulative’ as they incentivize more borrowing and spending. 

Great! Here’s a question, though: Why don’t we keep rates low? That is, why doesn’t the Federal Reserve keep rates at 0? Or, even better, why don’t they set rates at negative levels? That way, it’s super attractive to borrow money, so we’ll have a lot of borrowing and spending which is good for the economy! Well, one consistent theme in life is that too much of a good thing is a bad thing. There are healthy levels of spending, and there are unhealthy levels of spending. If an economy borrows and spends without a commensurate increase in the production of goods and services, a phenomenon called ‘inflation’ occurs. And, if borrowing and spending vastly outpace production, we’ll see something called hyperinflation, where money is so devalued it essentially becomes worthless. Some examples of hyperinflation include Germany after World War I, Zimbabwe in 2008, and Hungary in 1946. Fun fact: Hungary experienced 13,600,000,000,000,000% inflation in a month! Makes 5% annual inflation seem pretty tame, right? (Be sure to search “Zimbabwe hyperinflation” for a visual depiction of what this looks like!)

In sum, the Federal Reserve, or any central bank for that matter, uses interest rates to balance spending and inflation. In fact, the Federal Reserve has a ‘mandate’ to “pursue maximum employment and price stability”. In other words, they seek to keep inflation manageable while supporting borrowing and spending such that firms are healthy enough to hire people looking for jobs. This is great! Now, at a broad level, we understand what the Federal Reserve does. It plays an important role in managing inflation and keeping the labor market healthy. 

But, how exactly does the Fed do this? How do they set the interest rate? What about different kinds of interest rates? Mortgage rates are different from credit card rates which are different from government bond yields. Why? How exactly do interest rates affect the economy? Sure, they make borrowing more or less expensive, but do they do anything else? How do banks play into all of this? The Fed is also a lender of last resort. What does that mean? These questions and more are what I’ll attempt to answer with this series of blog posts. Let’s start with the mechanics.