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Informing the public about the Federal Reserve

How does monetary policy influence inflation and employment?

In the short run, monetary policy influences inflation and the economy-wide demand for goods and services--and, therefore, the demand for the employees who produce those goods and services--primarily through its influence on the financial conditions facing households and firms. During normal times, the Federal Reserve has primarily influenced overall financial conditions by adjusting the federal funds rate--the rate that banks charge each other for short-term loans. Movements in the federal funds rate are passed on to other short-term interest rates that influence borrowing costs for firms and households. Movements in short-term interest rates also influence long-term interest rates--such as corporate bond rates and residential mortgage rates--because those rates reflect, among other factors, the current and expected future values of short-term rates. In addition, shifts in long-term interest rates affect other asset prices, most notably equity prices and the foreign exchange value of the dollar. For example, all else being equal, lower interest rates tend to raise equity prices as investors discount the future cash flows associated with equity investments at a lower rate.

In turn, these changes in financial conditions affect economic activity. For example, when short- and long-term interest rates go down, it becomes cheaper to borrow, so households are more willing to buy goods and services and firms are in a better position to purchase items to expand their businesses, such as property and equipment. Firms respond to these increases in total (household and business) spending by hiring more workers and boosting production. As a result of these factors, household wealth increases, which spurs even more spending. These linkages from monetary policy to production and employment don't show up immediately and are influenced by a range of factors, which makes it difficult to gauge precisely the effect of monetary policy on the economy.

Monetary policy also has an important influence on inflation. When the federal funds rate is reduced, the resulting stronger demand for goods and services tends to push wages and other costs higher, reflecting the greater demand for workers and materials that are necessary for production. In addition, policy actions can influence expectations about how the economy will perform in the future, including expectations for prices and wages, and those expectations can themselves directly influence current inflation.

Since 2008, with short-term interest rates essentially at zero and thus unable to fall much further, the Federal Reserve has undertaken nontraditional monetary policy measures to provide additional support to the economy. The Federal Reserve has purchased longer-term mortgage-backed securities and notes issued by certain government-sponsored enterprises, as well as longer-term Treasury bonds and notes. The primary purpose of these purchases is to try to lower the level of longer-term interest rates, thereby improving financial conditions. Thus, this nontraditional monetary policy operates through the same broad channels as traditional policy, despite the differences in implementation of the policy.

 

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Last update: May 13, 2014