Lecture: The Federal Reserve & Monetary Policy
Lecture script · about 15–20 minutes spoken · Week 10
Opening
Here's a question worth asking the next time you sign for a loan. Who decides the interest rate on it? Not the bank on the corner by itself, and not the lawmakers who write the budget. Much of that decision traces back to one institution, the Federal Reserve.
You'll meet it in more places than you'd expect. A first-time car buyer compares two loan offers and wonders why the rates differ. A small-business owner decides whether to borrow for new equipment now or wait. A finance major will one day trade the very bonds the central bank buys and sells. All three are watching monetary policy.
Here's where we are. In Week 3, Measuring Inflation & Unemployment, you learned to compute the unemployment rate and the inflation rate. In Week 5, Aggregate Demand & Aggregate Supply, you learned to tell a movement along a curve from a shift of the whole curve. And in Week 9, Money & the Banking System, you saw banks build a large money supply on a small monetary base. In this lecture we meet the institution that controls that base.
Here's the plan. I'll introduce the Fed and its goals. Then we'll go through its tools, one at a time, asking which way each one pushes the money supply. Finally we'll build the money market, a small model that turns the amount of money into an interest rate. All the numbers in this lecture are illustrative, built for this course, and measured in dollars.
1. Meet the Federal Reserve
Most countries with their own currency have a bank that the banks use. It holds their reserves, it can lend to them, and it decides how much money the whole system should have.
Here's the term. A central bank is a country's official bank for the banking system and the government, which holds banks' reserves and runs the nation's monetary policy. In the United States, that's the Federal Reserve, the central bank of the United States, often called the Fed. And monetary policy is a central bank's use of its tools to change the money supply and interest rates in order to influence the whole economy; it is set by the central bank, not by the legislature.
By the Fed's own description, it has three main parts. The Board of Governors is the governing board that leads the system as a whole. The Reserve Banks are the regional banks, each serving its own part of the country. And the Federal Open Market Committee, the FOMC, is the policy-making committee that decides the stance of monetary policy and directs the buying and selling of bonds.
The FOMC's main dial is a rate you've likely seen in headlines. The federal funds rate is the interest rate banks charge one another to borrow reserves overnight. The FOMC sets a target for it as its chief way of adjusting policy.
Now keep one line very sharp. In Week 7, fiscal policy was the legislature's spending and taxes. Monetary policy is the central bank's tools. They're different levers held by different hands.
Pause and try this. A headline says, "Lawmakers approve a new highway program." Is that fiscal policy or monetary policy?
Ask yourself who actually acted.
Here's the answer. It's fiscal policy. Lawmakers set spending, and the Fed has no say over the budget, so a highway program belongs to the legislature.
2. The dual mandate
Picture a city bus system whose manager gets two goals from the city council. Keep as many buses running as possible, and keep fares steady. Some days the goals pull together; some days they pull apart.
The Fed has a similar pair of goals, written into law. The law directs it to promote maximum employment, stable prices, and moderate long-term interest rates. The first two travel together so often that they have a name. The dual mandate is the two goals the law gives the Federal Reserve that are named together: maximum employment and stable prices.
Here's the good news. You already know how to measure both. Maximum employment is read with the unemployment rate. Stable prices are read with the inflation rate.
Let's use Week 3's illustrative numbers. The labor market had 6 unemployed people out of a labor force of 120, both counted in the same units. Divide 6 by 120 and multiply by 100, and the unemployment rate is 5 percent. The market basket's price index rose from 100 in the base year to 108 in year 2. Take 108 minus 100, divide by 100, and multiply by 100, and the inflation rate is 8 percent.
So the 5 percent is the reading for the employment goal, and the 8 percent is the reading for the price goal. A word of honesty here. How much weight each goal deserves when they pull apart is a value judgment, and people disagree. This lecture states the goals; it doesn't settle that argument.
Pause and try this. Someone says the price index of 108 means prices rose 108 percent. What's the slip?
Think level versus rate.
Here's the answer. The 108 is a level measured against the base year's 100. The inflation rate is the percentage change between two periods, which here is 8 percent.
3. Open-market operations
Now the tools. Picture a regional bank with government bonds in its vault. A bond is a written promise by a borrower, such as the government, to repay a sum of money with interest over a set period, and it can be bought and sold before it's repaid.
Here's the main tool. Open-market operations are the central bank's buying and selling of government bonds; buying adds reserves to banks and raises the money supply, and selling drains reserves and lowers it.
How does the Fed pay for a bond? It credits the selling bank's account at the Fed with new reserves. The bank hands over a bond and gets reserves it can lend. Reserves are part of the monetary base, so the base grows, and the money multiplier from Week 9 does the rest.
Let's run the numbers. The required reserve ratio is 0.10, so the money multiplier is 10. The monetary base starts at 105 dollars, so the money supply is 10 times 105, or 1,050 dollars. The Fed buys bonds, and the base rises from 105 to 110. Now the money supply is 10 times 110, or 1,100 dollars. Run it the other way: the Fed sells bonds, reserves drain out, and the base falls to 100. The money supply becomes 10 times 100, or 1,000 dollars.
Two traps live here. First, buying bonds is not government spending. The Fed isn't buying a road; it's trading reserves for a bond, so this is monetary policy. Second, the multiplier must be the right one. Week 7's spending multiplier of 5 on the new base would give 550 dollars instead of 1,100. Reserves turning into money is a banking question, and banking uses 1 divided by the reserve ratio.
Pause and try this. The Fed buys bonds from banks. Does the money supply rise or fall, and is the Fed loosening or tightening?
Follow the reserves.
Here's the answer. The money supply rises, and the Fed is loosening. Buying a bond puts new reserves into the banks, and the multiplier builds more money on them.
4. The other three tools
The Fed has three more tools, and in this course you only need their direction. Picture yourself in a bank manager's chair and ask one question: does this make me lend more or less?
The discount rate is the interest rate the central bank charges banks when it lends them reserves. If it falls, borrowing reserves gets cheaper, you lend more, and the money supply tends to rise.
The reserve requirement is the rule, used as a policy tool, that sets how large a share of deposits banks must hold as reserves. If it rises, you must keep more of each deposit and lend less. In the illustrative numbers, raising the ratio from 0.10 to 0.20 cuts the multiplier from 10 to 5, and the base of 105 then supports at most 525 dollars.
Interest on reserve balances is the interest rate the Federal Reserve pays banks on the reserves they keep at the Fed. If it rises, parking reserves at the Fed looks better than lending them out, so lending slows and interest rates are pushed up.
Here's an honesty note about the real Fed. Required reserve ratios in the United States have been zero since March 2020. The Fed now runs an ample-reserves system, with banks holding plenty of reserves, and it steers its federal funds rate target in part through interest on reserve balances. The classroom tools still teach the mechanism, but that rate is a key lever in practice.
Pause and try this. The Fed raises the reserve requirement. A classmate says that gives banks more reserves, so they'll lend more. What happens instead?
Sit in the manager's chair again.
Here's the answer. Banks lend less, and the money supply falls. A higher requirement means each bank must keep more of every deposit, so the money multiplier shrinks.
5. Building the money market
Let's switch from the Fed to you. An illustrative student has 300 dollars that won't be needed for a year. Keep it in checking, where it's easy to spend but earns nothing, or put it in a savings bond that pays interest? If the bond pays 6 percent, keeping the cash in checking gives up 18 dollars of interest over the year.
That gives-up amount is the whole idea. Holding money has an opportunity cost: the interest you skip by not holding a bond. When rates are high, money is expensive to hold, so people hold less. When rates are low, they hold more.
Here are the terms. Money demand is the amount of money people want to hold at each interest rate; it slopes down because a higher interest rate raises the interest given up by holding money instead of bonds. The money market is the model in which the demand for money meets the supply of money. And the equilibrium interest rate is the rate at which the amount of money people want to hold equals the money supply.
Let me describe the picture in words. The quantity of money runs along the bottom. The interest rate runs up the side. Money demand slopes down from upper left to lower right. Money supply stands straight up, a vertical line, because the Fed's tools set the amount of money whatever the rate is. The crossing point is the equilibrium interest rate.
In the illustrative money market, money demand is 1,200 minus 25 times the interest rate, and money supply is 1,050. Set them equal. 1,200 minus 1,050 is 150, so 25 times the rate is 150, and the rate is 6 percent.
Pause and try this. Check it. At a rate of 6 percent, how much money do people want to hold?
Use money demand: 1,200 minus 25 times 6.
Here's the answer. They want to hold 1,050 dollars, because 25 times 6 is 150 and 1,200 minus 150 is 1,050. That matches money supply exactly, which is why 6 percent is the equilibrium.
6. Shifting money supply
Now let the Fed act. When it buys bonds, the money supply grows, and the vertical line slides right. At the old rate of 6 percent, people are holding more money than they want. So they try to buy bonds with it, and that pushes rates down until people are content to hold the bigger amount.
With the purchase, money supply is 1,100. Take 1,200 minus 1,100, which is 100, and divide by 25. The new rate is 4 percent, down from 6. With a sale instead, money supply is 1,000. Take 1,200 minus 1,000, which is 200, and divide by 25. The new rate is 8 percent, up from 6.
So here's the rule you can say without a graph. More money, lower rate. Less money, higher rate. That's the kind of change you'd eventually notice on a savings account or a car loan.
One more trap. People often say the Fed sets the interest rate by decree, like a price tag. In this model the Fed moves the quantity of money, and the rate lands where money demand crosses the new money supply. Even the federal funds target is reached by steering reserves and the rate the Fed pays on them.
Pause and try this. The Fed sells bonds. Which line moves, which way, and where does the rate land?
Name the line before you name the number.
Here's the answer. The money supply line shifts left to 1,000, and the rate rises from 6 to 8 percent. Selling bonds drains reserves, so there's less money and holding it gets pricier.
7. Movement along versus shift
Here's where your Week 5 habit pays off. When the rate fell from 6 to 4 percent, did money demand change? No. People slid down the same money demand line to a new point. The rate is on this graph's own axis, so a change in the rate is a movement along money demand.
What does shift money demand? Something other than the rate. Picture a busy holiday season in an illustrative city. Incomes rise and people make more purchases, so they want more money on hand at every interest rate. Or picture prices rising across the board, so the same shopping trip takes more dollars. Either way, money demand shifts right. Lower income or a lower price level shifts it left.
And the Fed's tools? They shift money supply only. So before you move a line, ask what changed. If it was the Fed's tools, move money supply. If it was income or prices, move money demand.
Pause and try this. Incomes rise while the Fed holds the money supply at 1,050. Which line moves, which way, and what happens to the rate?
Ask what changed: the Fed, or income?
Here's the answer. Money demand shifts right, and the interest rate rises above 6 percent. Income changed, not the Fed's tools, so the demand line moves while the vertical supply line stays put.
Closing
Let's pull it together. The Federal Reserve is the U.S. central bank, and monetary policy is its job, not the legislature's. The dual mandate is maximum employment and stable prices, read with the unemployment rate and the inflation rate. Buying bonds adds reserves and raises the money supply; selling drains them. A lower discount rate raises the money supply, while a higher reserve requirement or higher interest on reserves lowers it. Money demand slopes down because holding money skips interest, and the crossing with the vertical money supply sets the rate. More money, lower rate. And a rate change is a movement along money demand; only income or prices shift it.
Next in this module, you'll find the slide deck, the Readings & Resources page, the lecture tutorial, the practice set, and the quiz. Then Week 11, Monetary Policy, Interest Rates & Aggregate Demand, follows this new interest rate into investment and the AD–AS diagram.
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