Overview

Who controls the value of money? The Central Bank (The Fed). They have a magic dial called “Interest Rates.” If they turn it up, the economy slows down. If they turn it down, the economy speeds up. Monetary Policy is the art of turning that dial without crashing the car.

Core Idea

The core idea is The Cost of Money.

  • Low Rates: Money is cheap. Businesses borrow to build factories. People borrow to buy houses. The economy grows. (Risk: Inflation).
  • High Rates: Money is expensive. Borrowing stops. Spending stops. The economy cools. (Risk: Recession).

Formal Definition

The actions of a central bank that determine the size and rate of growth of the money supply. Dual Mandate (USA): Maximum Employment and Stable Prices (2% Inflation).

Intuition

  • The Party: The economy is a party. The Fed is the Chaperone.
    • If the party is too quiet (Recession), the Fed spikes the punch bowl (Low Rates) to get people dancing.
    • If the party gets too wild (Inflation), the Fed takes the punch bowl away (High Rates) before things get broken.

Examples

  • Volcker Shock (1980): Inflation was 14%. Paul Volcker (Fed Chair) raised rates to 20%. It caused a massive recession, but it killed inflation.
  • QE (Quantitative Easing): After 2008, rates were already 0%. The Fed couldn’t go lower. So they started printing money to buy bonds directly. It was an emergency measure.

Common Misconceptions

  • The President controls the economy: The Fed Chair is more powerful than the President when it comes to the economy. And the Fed is independent (politicians can’t fire them easily).
  • Fiat Money: Money that has value because the government says so. It allows the Fed to control the supply.
  • Gold Standard: The old system. The supply of money was tied to gold. It prevented inflation, but it made recessions worse because the Fed couldn’t print money to help.

Applications

  • Mortgages: When the Fed raises rates, your mortgage gets more expensive. House prices usually fall.

Criticism / Limitations

  • Liquidity Trap: When rates are 0% and people still won’t spend money. The Fed pushes on a string.

Further Reading

  • Bernanke, Ben. The Courage to Act.
  • Lowenstein, Roger. America’s Bank.