Monetary Policy and the Fed, when do we raise and lower rates and why?
April 22, 2008 1:38 PM Subscribe
Economics Filter: Monetary Policy and the Fed, when do we raise and lower rates and why?
What are some possible reasons the Fed would raise or lower rates and why would they do so?
What are some possible reasons the Fed would raise or lower rates and why would they do so?
lower rates are like NO2 for the domestic economic engine. They encourage "borrow & spend" activity (essentially pulling consumption from the future to the present) and punish savers by lowering interest rates across the board. These lower interest rates encourage capital outflight and concomitant currency depreciation against currencies with higher central bank rates.
posted by tachikaze at 1:50 PM on April 22, 2008
posted by tachikaze at 1:50 PM on April 22, 2008
punish savers by lowering interest rates across the board.
Savers and investors are two sides of the same coin. It doesn't "punish" savers so much as it encourages businesses to invest (which requires capital from investors in the form of debt and equity). When you lower the interest rate, theoretically you lower the cost of capital, which makes projects that have a lower rate of return more appetizing to businesses.
This question is exactly why Wikipedia exists. Just look up the Fed, and look up monetary policy. Do have a more specific question?
posted by SeizeTheDay at 2:48 PM on April 22, 2008
Savers and investors are two sides of the same coin. It doesn't "punish" savers so much as it encourages businesses to invest (which requires capital from investors in the form of debt and equity). When you lower the interest rate, theoretically you lower the cost of capital, which makes projects that have a lower rate of return more appetizing to businesses.
This question is exactly why Wikipedia exists. Just look up the Fed, and look up monetary policy. Do have a more specific question?
posted by SeizeTheDay at 2:48 PM on April 22, 2008
What are some possible reasons the Fed would raise or lower rates and why would they do so?
You can read the statement from each meeting of the Federal Open Market Committee (FOMC) on the Fed website.
posted by mullacc at 3:17 PM on April 22, 2008
You can read the statement from each meeting of the Federal Open Market Committee (FOMC) on the Fed website.
posted by mullacc at 3:17 PM on April 22, 2008
More technically, the Fed's job is to make sure the money supply is "right". If there is too much money, inflation. Not enough, deflation. They control this by the rate at which they skim money off.
As others have noted, read here http://en.wikipedia.org/wiki/Federal_funds_rate
posted by gjc at 3:19 PM on April 22, 2008
As others have noted, read here http://en.wikipedia.org/wiki/Federal_funds_rate
posted by gjc at 3:19 PM on April 22, 2008
If you really want to dive into monetary policy, here's an in-depth article on the money supply and how it effects the economy. Theoretical in part, but pretty awesome.
posted by BirdD0g at 3:24 PM on April 22, 2008 [2 favorites]
posted by BirdD0g at 3:24 PM on April 22, 2008 [2 favorites]
Best answer: So here's the basics:
The economy can only grow so fast in the long run. But in the short run, it grows at a varying speed, due to "the business cycle", the series of booms and busts that countries have. The goal of monetary policy is to make sure that the business cycle is as mild as possible.
If there's lots of money around, people will be willing to spend it on more things: buying consumer goods, investing in businesses, and so forth. And if there's less money around, people won't be willing to spend it on as much. Too much money makes the economy overheat: the economy grows faster than its "natural" rate, which produces inflation and many other negative consequences in the end. Too little money and the economy grows slower than its natural rate, leading to unemployment.
What does this have to do with the "federal funds rate"? This rate is the amount that banks are willing to take in exchange for lending money to other banks. The more money there is, the lower this rate will be, as there will be an increase in the supply of money available to lend. The less money there is, conversely, the higher this rate will be.
The Fed uses the federal funds rate as a gauge of how much money there is in the economy. When the Fed changes its federal funds rate target, this means that they will increase or decrease the money supply until the federal funds rate has moved to a new place.
Note that during the current "credit crunch", the Fed is doing things for entirely different reasons. In addition to setting monetary policy, the Fed must ensure the stability of the financial system; right now, this means that the fed may buy and sell securities for reasons other than the direct impact those operations have on the money supply.
posted by goingonit at 3:47 PM on April 22, 2008 [1 favorite]
The economy can only grow so fast in the long run. But in the short run, it grows at a varying speed, due to "the business cycle", the series of booms and busts that countries have. The goal of monetary policy is to make sure that the business cycle is as mild as possible.
If there's lots of money around, people will be willing to spend it on more things: buying consumer goods, investing in businesses, and so forth. And if there's less money around, people won't be willing to spend it on as much. Too much money makes the economy overheat: the economy grows faster than its "natural" rate, which produces inflation and many other negative consequences in the end. Too little money and the economy grows slower than its natural rate, leading to unemployment.
What does this have to do with the "federal funds rate"? This rate is the amount that banks are willing to take in exchange for lending money to other banks. The more money there is, the lower this rate will be, as there will be an increase in the supply of money available to lend. The less money there is, conversely, the higher this rate will be.
The Fed uses the federal funds rate as a gauge of how much money there is in the economy. When the Fed changes its federal funds rate target, this means that they will increase or decrease the money supply until the federal funds rate has moved to a new place.
Note that during the current "credit crunch", the Fed is doing things for entirely different reasons. In addition to setting monetary policy, the Fed must ensure the stability of the financial system; right now, this means that the fed may buy and sell securities for reasons other than the direct impact those operations have on the money supply.
posted by goingonit at 3:47 PM on April 22, 2008 [1 favorite]
Best answer: Changing rates is what we all see the Fed do in public, but their actions are actually all about regulating the quantity of money in circulation, as gjc notes. The details of monetary policy can be brain-splittingly complicated, but it's all based on a bunch of simple, intuitive principles. Bear with me here -- it'll take a minute to get to interest rates.
First, there's the "quantity theory of money," which simply says "all things equal, the more money in circulation in an economy, the higher prices will be." That's pretty intuitive. Since money is a good just like coconuts or car tires or whatever, ramping up supply makes it lose value. When cash is worth less, prices are higher.
From the QTM comes a simple but super-important equation underlying monetary theory, called the equation of exchange:
MV = PQ
Where M is the money supply, V is the "velocity of money," or the frequency with which a particular bill changes hands, P is the price level, and Q is the quantity of output, basically the value of all goods and services in an economy. So, as long as transaction frequency and output don't change, increasing the money supply should directly increase the price level.
Economic policymakers can't directly control the quantity of output (Q) or the velocity of money (V). They'd like to muck around with the price level (P) -- in order to manage inflation, but they don't have control over that either. What they can control -- and what institutions like the Fed and central banks manage -- is the money supply (M). So, by controlling M, central banks indirectly exert some control over P.
But, it gets more complicated when theory gets put into practice. How can the Fed change the money supply? The classic high-school-econ example is stuffing a helicopter with dollar bills and dropping them from the sky. People would pick them up, the money supply would expand. To contract the money supply, Fed bureaucrats could pass the hat around the office and light a bonfire of bills. Neither method would be a particularly effective policy tool.
So instead, the Fed uses other tricks to manage the quantity of money. One of those is changing interest rates. When the Fed "changes" the federal funds rate, they don't simply mandate a new rate. Instead, they issue a target, and buy or sell government bonds until it gets there. Buying bonds (you give the Fed your bonds in exchange for money) increases the money supply. Selling bonds (You get a bond, the Fed gets your money) contracts it. Similarly, cutting rates is expansionary, and raising 'em contractionary. So, targeting interest rates is actually a proxy for targeting the money supply which is a proxy for targeting the price level -- and the number of jumps involved is why monetary policy changes can take a long time to have any effect.
posted by ecmendenhall at 7:24 PM on April 22, 2008
First, there's the "quantity theory of money," which simply says "all things equal, the more money in circulation in an economy, the higher prices will be." That's pretty intuitive. Since money is a good just like coconuts or car tires or whatever, ramping up supply makes it lose value. When cash is worth less, prices are higher.
From the QTM comes a simple but super-important equation underlying monetary theory, called the equation of exchange:
MV = PQ
Where M is the money supply, V is the "velocity of money," or the frequency with which a particular bill changes hands, P is the price level, and Q is the quantity of output, basically the value of all goods and services in an economy. So, as long as transaction frequency and output don't change, increasing the money supply should directly increase the price level.
Economic policymakers can't directly control the quantity of output (Q) or the velocity of money (V). They'd like to muck around with the price level (P) -- in order to manage inflation, but they don't have control over that either. What they can control -- and what institutions like the Fed and central banks manage -- is the money supply (M). So, by controlling M, central banks indirectly exert some control over P.
But, it gets more complicated when theory gets put into practice. How can the Fed change the money supply? The classic high-school-econ example is stuffing a helicopter with dollar bills and dropping them from the sky. People would pick them up, the money supply would expand. To contract the money supply, Fed bureaucrats could pass the hat around the office and light a bonfire of bills. Neither method would be a particularly effective policy tool.
So instead, the Fed uses other tricks to manage the quantity of money. One of those is changing interest rates. When the Fed "changes" the federal funds rate, they don't simply mandate a new rate. Instead, they issue a target, and buy or sell government bonds until it gets there. Buying bonds (you give the Fed your bonds in exchange for money) increases the money supply. Selling bonds (You get a bond, the Fed gets your money) contracts it. Similarly, cutting rates is expansionary, and raising 'em contractionary. So, targeting interest rates is actually a proxy for targeting the money supply which is a proxy for targeting the price level -- and the number of jumps involved is why monetary policy changes can take a long time to have any effect.
posted by ecmendenhall at 7:24 PM on April 22, 2008
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The fed has a dual mandate of sustainable growth and price stability. That means they have to balance inflation and growth.
posted by OldReliable at 1:49 PM on April 22, 2008