Monetary Policy

Monetary policy refers to actions taken by the Federal Reserve (the Fed) that influence bank reserves, the money stock, and interest rates. An expansionary monetary policy lowers short-term interest rates by increasing the availability of money and credit. Lower interest rates encourage spending, particularly on investment projects. If the economy is operating well below capacity, increased spending is likely to lead to increased output. Once the economy is at or near capacity, however, rapid monetary expansion leads to inflation (a sustained increase in prices) rather than output growth. Conversely, tight monetary policy reduces the growth rate of the money stock, increases short-term interest rates, and eventually lowers inflation. In the short run, the Fed can use monetary policy to increase the availability of credit and to lower interest rates. In the long run, an excessively expansionary monetary policy leads to inflation and higher nominal interest rates. Although interest rates, monetary aggregates, and other indicators help the Fed assess the effects of its actions, no set of indicators provides a reliable forecast of the future consequences of current monetary policy choices.

The goal of using monetary policy to increase output without increasing inflation is inherently difficult to achieve. When the Fed increases or decreases bank reserves, the path from reserve changes to interest rates to output and prices is often unpredictable. In recent years, a number of factors have further complicated the task of setting monetary policy. The weakening in the relation among the money supply, interest rates, and nominal GDP has decreased the reliability of monetary aggregates as indicators of policy. Transitory problems in financial markets and structural changes in the global economy have also altered the response of the U.S. economy to Fed policy. As such, the use of monetary policy to fine-tune the U.S. economy has become increasingly problematic.

fiscal policy

Spending and taxing policies of the government automatic stabilizers

Buffers designed to smooth the pace of economic activity discretionary policy

Unrestricted changes in spending and taxes

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