The Federal Reserve affects aggregate demand by controlling the money supply and the rate of interest charged on loans to banks.
Monetary policy is intervention in an economy through central bank actions, such as adjustments to interest rates, reserve requirements, and open-market operations, that affect the money supply and interest rates. Each country has one or more institutions with the authority to establish and enforce the nation's monetary policy. The goal of these institutions is to maintain stability in the economy and reduce the impact of fluctuations. The stability of an economy is affected by aggregate demand (AD), the total demand for final goods and services at a given time. The equation for aggregate demand shows that it depends on consumption (C), investment (I), government spending (G), and the difference in exports (X) and imports (M):
Various factors can affect aggregate demand, such as differing levels of consumer spending and business investment. Because aggregate demand fluctuations caused by these and other factors can have a number of undesirable effects on the economy, such as high unemployment, monetary policy often responds to changes in aggregate demand.
In the United States, Congress is responsible for the nation's monetary policy. Although Congress oversees and passes legislation that affects monetary policy, it delegates the primary responsibility of monetary policy to the central bank and lender of last resort in the United States, the Federal Reserve, also known as the Fed. Three goals of the Fed are to ensure maximum employment in the United States, to maintain price stability, and to set moderate interest rates for the long run in order to promote economic growth. Addressing these goals is a constant challenge for the Fed in order to prevent both inflation and high unemployment caused by increases and decreases in aggregate demand, respectively. The Fed uses monetary policy to stimulate investment, which is a component of aggregate demand. This stimulation of investment is done via interest rates.
Goals of Monetary Policy
The federal government can act directly to stimulate or slow the economy by increasing or decreasing government spending. This government intervention in the economy through spending and tax policies is known as its fiscal policy. Monetary policy involves controlling the supply of money and the interest rate of federal funds. Managing the money supply and interest rate are indirect methods of affecting aggregate demand as compared with more direct fiscal policy tools. Fed policy can thus be described as actions taken in order to establish a favorable economic environment.
The Fed affects aggregate demand through various means. The concept underpinning the Fed's actions is the theory of liquidity preference, first proposed by British economist John Maynard Keynes in 1936. The theory of liquidity preference suggests that interest rates are determined by the supply and demand of money. According to this theory, high demand for money leads to higher interest rates. Borrowing money becomes more expensive, and the money supply decreases. Low demand for money leads to lower interest rates. Borrowing money becomes less expensive, and the money supply increases. Because money supply and interest rates are linked, it does not matter whether policy is described in terms of money supply or interest rate. A change in one will produce a change in the other. As prices rise, demand for money also increases. The increase in prices also increases the interest rate, which can be described as the cost of borrowing. Because of the relationship between money supply and interest rates, the Fed can impact aggregate demand through monetary policy. If the Fed wishes to increase aggregate demand, it can reduce the interest rate, which increases the money supply. The result is increased business investment in physical capital, since it is more appealing to borrow funds. This shifts the aggregate demand curve to the right. If the Fed wishes to decrease aggregate demand, it can increase the interest rate, reducing the money supply. Higher interest rates will reduce business investment because it is less enticing to borrow money. In this case, the demand curve shifts to the left.
The Fed's interventions in the economy are conducted through policy tools. One type of intervention involves a Treasury bill (also known as a T-bill), which is a security issued by the U.S. Treasury Department representing a short-term debt obligation with a relatively low interest rate and a maturity period of less than a year. The process through which the Federal Reserve buys Treasury bills to expand the money supply or sells Treasury bills to contract the money supply is known as an open-market operation. The Fed may also change the discount rate (the interest rate on loans the Federal Reserve makes directly to banks to meet temporary shortages of reserves) and change reserve requirements (increasing or decreasing the percentage of deposits required to be held in reserve by banks and not lent out or invested). In addition, the Fed also sets targets for the federal funds rate, the rate charged for loans of excess reserves between banks to meet reserve requirements.