Monetary Policy

The Money Market Model

As for monetary policy, the Federal Reserve has several ways to get money from banks into businesses and factories.

The Money Market Model is a graph of supply and demand, but instead of a good, it looks at the cost of having money versus investing it. The vertical part of the graph shows the nominal interest rate and the horizontal part shows how much money there is. The money supply (MS) is almost vertical because the Federal Reserve decides how much money exists and that amount doesn't change just because interest rates go up or down. Money demand (MD) goes down as you move to the right; high interest rates make it costly to have cash sitting around (you're missing out on bond returns!) so people keep less on hand. Low interest rates mean holding cash is cheap and people hold onto more. The point where MS and MD meet is the equilibrium interest rate.

If the actual market rate is above equilibrium, people are holding onto too much money for that high of an opportunity cost. They'll buy bonds, which raises bond prices and causes yields to fall back to equilibrium. If the rate is below equilibrium, the opposite happens and rates go up. A dramatic example happened in September 2019. The overnight repo rate, usually around the Fed's 2% target, jumped to 10% in a single morning because the amount of money available and the need for it were unbalanced. The New York Fed had to quickly put $75 billion into the system, and then promised another $100 billion in daily repo operations. This lasted about two weeks and really showed how the money market model works in reality.

The Fed's Tools

The Federal Reserve has three main tools to manage bank reserves - all aiming at them from slightly different directions. These tools have changed since the Fed was founded in 1913, but the basic idea is the same.

Open Market Operations (OMOs) are the most frequently used. The Fed buys government bonds from banks and adds the money to the bank's reserve account (newly created money). Banks then have extra reserves and will lend them out. Because of the money multiplier, a single bond purchase leads to a much bigger increase in the total amount of money. Selling bonds does the opposite - it takes reserves out of the system and reduces the amount of money available. In Spring 2020 the Fed was purchasing over $80 billion of Treasury bonds and $40 billion of mortgage-backed securities each month, putting a huge amount of money into the economy, far more than in 2008-2009 during Quantitative Easing.

The discount rate is the interest the Fed charges banks for very short-term emergency loans from the 'discount window'. Lowering it means banks can borrow reserves more cheaply and so are encouraged to lend. Raising it makes borrowing expensive. In reality banks only use the discount window as a final option because borrowing from it is seen as a sign to regulators and other banks that they're in trouble.

The reserve requirement used to determine what percentage of customer deposits banks had to keep as a backup and not lend out. Lowering it meant more deposits could be lent and the money multiplier increased. Increasing it meant more reserves were locked up and less could be lent. In March 2020 the Fed reduced the reserve requirement to zero for the first time, and it's stayed there. It has fundamentally changed how the Fed controls the reserve system.

The Federal Funds Rate

Every six weeks, the world's financial markets are completely focused on one figure: the federal funds rate. This is the interest rate at which banks lend spare funds to each other overnight, and it's the Federal Reserve's main goal for their policies.

A lot of people wrongly think the FOMC simply decides this rate, but it doesn't happen like that. Instead, the committee sets a target range, and then the New York Fed's trading desk adjusts the money available through what are called open market operations. They do this until the actual overnight rate between banks matches the target. For example, on March 15, 2020, when the FOMC made an emergency cut bringing the rate to almost zero, the trading desk immediately began buying huge amounts of Treasury bonds and mortgage-backed securities. This injected reserves into the system and pushed the actual rate down.

That single overnight rate for bank-to-bank loans might seem a complicated detail, but it's the foundation for all credit costs. When the fed funds rate changes, banks change their prime rate, and this affects mortgage rates, car loan rates, business loans, and credit card interest. A decision from the Federal Reserve building in Washington D.C. impacts a first-time home buyer in the suburbs of Ohio within a few weeks. It is the movement from overnight lending between banks to what individuals pay to borrow that allows monetary policy to influence the economy.

Expansionary Monetary Policy

By the end of March 2020, the US economy had fallen into a classic recession. GDP was falling at over 30% when calculated for a year, millions of unemployment applications were flooding state offices, and actual production was far below what was possible. The Fed responded with expansionary policy, or "easy money", which aims to make borrowing cheaper and encourage people to spend.

Here's how it works. The Fed buys bonds, lowers the discount rate, or decreases the reserve requirement. This increases bank reserves, the money supply grows, and the money supply curve on a money market graph moves to the right. The point at which supply and demand meet (equilibrium) and thus the interest rate, falls. Lower rates make it cheaper for businesses to invest in factories, machinery and people. People are more likely to get mortgages, car loans and make other purchases that depend on interest rates. Both investment and spending go up, the overall demand curve shifts right and either closes or reduces the gap between actual and potential output.

On the money market graph, the money supply moves right and the interest rate goes down. This lower rate is the link between the Fed's activity in the financial markets and real-world activity in businesses, workplaces and stores. If increasing the money supply didn't lower the interest rate, the real economy wouldn't be affected. In this model, the interest rate is the key to everything.

Contractionary Monetary Policy

June 2022. The Bureau of Labor Statistics said the Consumer Price Index had increased by 9.1% over the previous year, the largest increase since November 1981. The economy's production was going above its potential, companies were desperately looking for employees, and the price of food, gas and rent went up every month. This was a clear sign of an inflationary gap. Jerome Powell and the FOMC switched to contractionary policy, or "tight money", and the transmission process worked in reverse.

The Fed sells bonds, raises the discount rate, or increases the reserve requirement. Bank reserves are reduced, the money supply gets smaller, and the money supply curve shifts left. The equilibrium interest rate increases. Borrowing becomes more expensive for companies deciding whether to invest in equipment and for individuals considering significant purchases. Investment and spending that is sensitive to interest rates fall, overall demand shifts left, and the upward push on prices eases.

From March 2022 to July 2023, the FOMC raised the federal funds rate from nearly zero to a target of 5.25% to 5.50% - the quickest increase in rates in forty years. Mortgage rates went over 7%, car loan rates went past 8%, and it became much more expensive for businesses to borrow money. The process unfolded exactly as the model predicted it would. To reduce demand, credit is made more expensive.

The Transmission Mechanism

But how does the Federal Reserve's buying of bonds in New York actually affect a family getting a mortgage in Phoenix, or a factory beginning construction in Tennessee? The "transmission mechanism" details all of these connections. It's a complete series: the Fed's actions change the amount of money available, this alters interest rates, investment is impacted, which then changes overall demand, and ultimately, GDP and prices are affected. Each step requires the last one, and if any one of them fails, the policy won't affect the real economy.

There are weak points in this process and they are important. If people don't really change their spending habits when the amount of money increases (what we call 'money demand' is very flexible), then even a large increase in the money supply won't move interest rates very much. And if companies are really worried about the future and don't think demand will go up, even very low interest rates won't get them to borrow money and expand. This is what happened for much of 2009 and 2010; banks had lots of extra money but nobody wanted to borrow.

This unevenness is significant: monetary policy is typically better at slowing down an economy that's growing too fast, than at getting a struggling economy going again. Paul Volcker showed how to slow things down in 1980-1982 by increasing the federal funds rate to over 20%, and accepting a serious recession as the consequence, and he did manage to get double-digit inflation under control. The Fed's difficulty getting the economy to recover after the 2008 financial crisis illustrates the other side of this.

The complete picture is shown in two graphs. The money market graph explains the first three steps, from what the Fed does to the change in the interest rate. The Aggregate Demand/Aggregate Supply (AD/AS) model then covers the rest, from how investment reacts to the change in GDP and prices. On the AP exam's free-response questions, you're often asked to go through each of these graphs, step by step.

Monetary Policy and the Phillips Curve

The Phillips Curve shows the trade off between inflation and unemployment, and it's the flip side of everything the Fed does. When the Fed increases the money supply, buys bonds, and lowers rates, overall demand increases, production goes up, unemployment goes down, and inflation rises. On the short-run Phillips Curve, the economy moves up and to the left; lower unemployment is achieved at the cost of higher inflation.

Volcker's interest rate increases in the early 1980s followed the opposite path. Demand decreased, unemployment went above 10% by the end of 1982, and inflation fell from double-digits to below 4% by 1983. This is a downward and to the right movement on the Phillips Curve. However, this came at the price of a very bad recession, destroying manufacturing jobs in the Midwest.

Jerome Powell's increases to interest rates from 2022-2023 followed the same pattern. The federal funds rate went from almost zero to over 5%, and the Phillips Curve indicated what would happen next. Inflation went down from a high of 9.1% to around 3%, and unemployment initially stayed surprisingly low, before slowly beginning to fall in areas like technology and commercial real estate.

The long-run Phillips Curve is a vertical line at the "natural rate" of unemployment, which is similar to the vertical Long-Run Aggregate Supply (LRAS) curve at full employment output. Monetary policy can move the economy along the short-run curve, but it can't permanently lower unemployment below the natural rate. If you try, the short-run Phillips Curve itself will move upwards because people and companies will start expecting higher inflation when setting wages and prices. Unemployment will return to the natural rate, but inflation will settle at a permanently higher level.

To get a good score on an AP free-response question, you need to connect the monetary policy chain to the Phillips Curve. For example, the Fed buys bonds, rates fall, demand increases, and the Phillips Curve shows lower unemployment and higher inflation. The ability to explain this entire sequence across the money market, AD/AS and Phillips Curve graphs is how you earn the most points on the exam.

Worked Example

Let's work through an example: The Fed buys $100 million in government bonds and the reserve requirement is 10%. How does this all work?

The money multiplier: with a 10% reserve requirement, the multiplier is 1 / 0.10 = 10. This means that the initial $100 million increase in bank reserves could support a $1 billion increase in the money supply as banks loan out their excess reserves, those loans are deposited in other banks, and this lending and depositing continues until all the reserves are being used.

Money Market Graph: The money supply (MS) shifts to the right by $1 billion. Money demand has not yet changed because income and the price level haven't been adjusted. The equilibrium interest rate goes down. How much it falls depends on how responsive money demand is (its slope); a steeper demand means a larger interest rate change, a flatter one a smaller change.

The Real Economy: Lower interest rates make it cheaper for companies and people to borrow. Investment projects that weren't profitable at the higher rates now are. AD shifts to the right, GDP rises, and the price level goes up along the short-run Aggregate Supply (SRAS) curve. The gap where the economy is below its potential shrinks.

So, to recap: the Fed buys bonds → bank reserves increase → the money supply expands by the multiplied amount → interest rates fall → investment increases → AD shifts to the right → GDP rises. The AP exam might ask about any of these steps, so practice going through this chain in both directions (expansionary and contractionary) until it's second nature.