Why does monetary policy affect interest rates

First, economic conditions change rapidly, and in practice monetary policy can be more nimble than fiscal policy. The Fed meets every six weeks to consider changes in interest rates and can call an unscheduled meeting any time. Large changes to fiscal policy typically occur once a year at most. Once a decision to alter fiscal policy has been made, the proposal must travel through a long and arduous legislative process that can last months before it can become law, whereas monetary policy changes are made instantly.

Both monetary and fiscal policy measures are thought to take more than a year to achieve their full impact on the economy due to pipeline effects. In the case of monetary policy, interest rates throughout the economy may change rapidly, but it takes longer for economic actors to change their spending patterns in response. For example, in response to a lower interest rate, a business must put together a loan proposal, apply for a loan, receive approval for the loan, and then put the funds to use.

In the case of fiscal policy, once legislation has been enacted, it may take some time for authorized spending to be outlaid. An agency must approve projects and select and negotiate with contractors before funds can be released.

In the case of transfers or tax cuts, recipients must receive the funds and then alter their private spending patterns before the economy-wide effects are felt. For both monetary and fiscal policy, further rounds of private and public decisionmaking must occur before multiplier or ripple effects are fully felt. Second, monetary policy is determined based only on the Fed's mandate, whereas fiscal policy is determined based on competing political goals.

Fiscal policy changes have macroeconomic implications regardless of whether that was policymakers' primary intent. Political constraints have prevented increases in budget deficits from being fully reversed during expansions. Over the course of the business cycle, aggregate spending in the economy can be expected to be too high as often as it is too low.

This means that stabilization policy should be tightened as often as it is loosened, yet increasing the budget deficit has proven to be much more popular than implementing the spending cuts or tax increases necessary to reduce it.

As a result, the budget has been in deficit in all but five years since , which has led to an accumulation of federal debt that gives policymakers less leeway to potentially undertake a robust expansionary fiscal policy, if needed, in the future. By contrast, the Fed is more insulated from political pressures, as discussed in the previous section, and experience shows that it is willing to raise or lower interest rates. Third, the long-run consequences of fiscal and monetary policy differ.

Expansionary fiscal policy creates federal debt that must be serviced by future generations. Some of this debt will be "owed to ourselves," but some presently, about half will be owed to foreigners. To the extent that expansionary fiscal policy crowds out private investment, it leaves future national income lower than it otherwise would have been. Furthermore, the government faces a budget constraint that limits the scope of expansionary fiscal policy—it can only issue debt as long as investors believe the debt will be honored, even if economic conditions require larger deficits to restore equilibrium.

Fourth, openness of an economy to highly mobile capital flows changes the relative effectiveness of fiscal and monetary policy. Expansionary fiscal policy would be expected to lead to higher interest rates, all else equal, which would attract foreign capital looking for a higher rate of return, causing the value of the dollar to rise. Thus, higher foreign capital inflows lead to higher imports, which reduce spending on domestically produced substitutes and lower spending on exports.

The increase in the trade deficit would cancel out the expansionary effects of the increase in the budget deficit to some extent in theory, entirely if capital is perfectly mobile. Expansionary monetary policy would have the opposite effect—lower interest rates would cause capital to flow abroad in search of higher rates of return elsewhere, causing the value of the dollar to fall.

Foreign capital outflows would reduce the trade deficit through an increase in spending on exports and domestically produced import substitutes. Thus, foreign capital flows would tend to magnify the expansionary effects of monetary policy. Fifth, fiscal policy can be targeted to specific recipients.

In the case of normal open market operations, monetary policy cannot. This difference could be considered an advantage or a disadvantage. On the one hand, policymakers could target stimulus to aid the sectors of the economy most in need or most likely to respond positively to stimulus.

On the other hand, stimulus could be allocated on the basis of political or other noneconomic factors that reduce the macroeconomic effectiveness of the stimulus. As a result, both fiscal and monetary policy have distributional implications, but the latter's are largely incidental whereas the former's can be explicitly chosen.

In cases in which economic activity is extremely depressed, monetary policy may lose some of its effectiveness. When interest rates become extremely low, interest-sensitive spending may no longer be very responsive to further rate cuts.

Furthermore, interest rates cannot be lowered below zero so traditional monetary policy is limited by this "zero lower bound. As is discussed in the next section, some argue that the U. Of course, using monetary and fiscal policy to stabilize the economy are not mutually exclusive policy options. But because of the Fed's independence from Congress and the Administration, the two policy options are not always coordinated.

If Congress and the Fed were to choose compatible fiscal and monetary policies, respectively, then the economic effects would be more powerful than if either policy were implemented in isolation. For example, if stimulative monetary and fiscal policies were implemented, the resulting economic stimulus would be larger than if one policy were stimulative and the other were neutral. Alternatively, if Congress and the Fed were to select incompatible policies, these policies could partially negate each other.

For example, a stimulative fiscal policy and contractionary monetary policy may end up having little net effect on aggregate demand although there may be considerable distributional effects. Thus, when fiscal and monetary policymakers disagree in the current system, they can potentially choose policies with the intent of offsetting each other's actions.

If one actor chooses inappropriate policies, then the lack of coordination allows the other actor to try to negate its effects. The financial crisis was the worst crisis since the Great Depression, freezing virtually all parts of the financial system. To restore liquidity and stability to financial markets, the Fed responded by taking a series of unprecedented actions that can be divided into three categories. The first category involved actions related to the federal funds rate.

The Fed reduced interest rates from 5. Its other actions attempted to provide stimulus through other channels. For example, the Fed subsequently made a series of pledges, called forward guidance , to keep future interest rates low.

Because long-term rates today depend on market views of future short-term rates, a credible promise by the Fed to keep short-term rates low in the future could potentially lower long-term rates today. The second category involved actions that provided direct assistance to the financial sector in the Fed's capacity as the lender of last resort. Traditionally, the Fed acted as lender of last resort by making short-term collateralized loans to banks at the discount window. The Fed made discount window loans during the crisis, but it also created a series of emergency facilities that were unlike anything the Fed had done before in its year history.

The first facility was introduced in December , and several more were added after the worsening of the crisis in September Through these facilities, the Fed provided liquidity to nonbank firms for the first time since the Great Depression. In a handful of cases, the Fed also provided assistance to prevent the failure of a specific firm such as AIG or facilitate the takeover of a failing firm such as Bear Stearns , which have been popularly called bailouts.

These firms were viewed as too big to fail , meaning that their failure could have exacerbated the overall crisis. The Fed's lender of last resort actions were taken under both the Fed's traditional authority e. The amount of assistance provided during the crisis was an order of magnitude larger than in normal times, as shown in Figure 1.

Once financial stability was restored, most of these programs were wound down relatively quickly. The last loan from the crisis was repaid on October 29, Figure 1. Direct Fed Assistance to the Financial Sector. The third category of actions involved large-scale asset purchases. Over three rounds of what was popularly referred to as quantitative easing QE between and , the Fed purchased Treasury securities.

Given the role of mortgages at the heart of the financial crisis and its limited statutory authority , it also purchased mortgage-backed securities and debt issued by the government-sponsored enterprises Fannie Mae and Freddie Mac and the Federal Home Loan Banks and government agencies Ginnie Mae.

Table 2 summarizes the change in the Fed's securities holdings during the QE programs. In this program, it replaced short-term securities on its balance sheet with long-term securities. The goal of these actions was to reduce long-term interest rates to provide further stimulus at the zero lower bound. Long-term interest rates were very low over this period, and many studies have tried to tease out the extent to which that should be attributed to QE.

Table 2. The "QE1" and "total" rows include agency securities and mortgage-backed securities MBS that the Fed began purchasing in September and January , respectively. The final column does not equal the sum of the first three columns because of changes in other items not shown on the Fed's balance sheet. The final row does not equal the sum of the first three rows because it includes changes in holdings between the three rounds of QE.

The figures in the table are based on actual data, not announced amounts at the onset of the program. The two can differ because of timing and the maturity of prior holdings, which decrease the amounts shown in the table. The size of actions in the second and third categories can be seen in data on the Fed's balance sheet. Loans and securities are assets on the Fed's balance sheet, so the Fed's balance sheet grew when it made loans and provided other financial assistance during the financial crisis and bought securities under QE.

The effect this had on the Fed's profits is discussed in the text box below. The increase in the Fed's assets was matched by an equal increase in its liabilities. The two largest liabilities on the Fed's balance sheet are currency Federal Reserve notes and bank reserves that banks deposit in their reserve account at the Fed. The increase in the Fed's balance sheet had the potential to be inflationary because bank reserves are a component of the portion of the money supply controlled by the Fed called the monetary base , which grew at an unprecedented pace.

The growth in the monetary base did not translate into higher inflation because it did not lead to a commensurate increase in lending or asset purchases by banks. The Fed earns interest on its securities holdings, and it uses this interest to fund its operations. It receives no appropriations from Congress.

The Fed's income exceeds its expenses, and it remits most of its net income to the Treasury, which uses it to reduce the budget deficit. Although the increases in, first, direct lending and, later, holdings of mortgage-related securities increased the potential riskiness of the Fed's balance sheet, it had the ex post facto effect of more than doubling the Fed's net income and remittances to Treasury.

Although some analysts have raised concerns that the Fed could have negative net income as a result of normalization, the New York Fed is not currently projecting that will occur under various interest-rate and balance-sheet scenarios.

Instead, it projects that remittances will decline from the higher levels that have prevailed since the crisis to closer to precrisis levels. On October 29, , the Fed announced that it would stop making large-scale asset purchases at the end of the month. One option to return to normal monetary policy would be to remove the bulk of those excess reserves by shrinking the balance sheet through asset sales. The Fed did not sell any securities during normalization, however.

In September , it gradually reduced the balance sheet by ceasing to roll over some securities as they mature. The Fed's goal was to reduce the balance sheet until it held "no more securities than necessary to implement monetary policy efficiently and effectively. In part, that is because other liabilities on the Fed's balance sheet are larger—there is more currency in circulation now than there was before the crisis, and the Treasury has kept larger balances on average in its account at the Fed.

But the balance sheet is also significantly larger because the Fed decided in January to continue using its new method of targeting the federal funds rate even after normalization is completed. By contrast, if it had gone back to the pre-crisis method of targeting the federal funds rate, only minimal excess reserve balances would be necessary but perhaps more than before the crisis , so its balance sheet could have been much smaller.

The Fed ended the balance sheet wind-down in August , but resumed balance sheet growth in September in response to repo market turmoil see the section below entitled " The Federal Reserve's Response to Repo Market Turmoil in September ". In order to raise the federal funds rate in the presence of large reserves, the Fed has raised the two market interest rates that are close substitutes—it has directly raised the rate it pays banks on reserves held at the Fed and used large-scale reverse repurchase agreements repos to alter repo rates.

In , Congress granted the Fed the authority to pay interest on reserves. Reverse repos are another tool for draining liquidity from the system and influencing short-term market rates. They drain liquidity from the financial system because cash is transferred from market participants to the Fed. As a result, interest rates in the repo market, one of the largest short-term lending markets, rise. The Fed has long conducted open market operations through the repo market, but since it has engaged in a much larger volume of reverse repos with a broader range of nonbank counterparties, including the government-sponsored enterprises such as Fannie Mae and Freddie Mac and certain money market funds, through a new Overnight Reverse Repurchase Operations Facility.

The Fed is currently not capping the amount of overnight reverse repos offered through this facility. There has been some concern about the potential ramifications of the Fed becoming a dominant participant in this market and expanding its counterparties.

For example, will counterparties only be willing to transact with the Fed in a panic, and will the Fed be exposed to counterparty risk with nonbanks that it does not regulate? Repo rates suddenly spiked on September 17, Nevertheless, the average effective federal funds rate that day rose 0. There is no indication that the recent spike in repo rates was caused by a panic—the markets were not experiencing wider financial disruption and no problems with particular participants were seen.

Instead, it was caused by a temporary increase in demand for cash and decrease in supply of bank reserves that have been attributed to three factors. First, federal tax payments were due on September When taxes are paid, money is initially transferred out of the reserve account of the taxpayer's bank into the Treasury's general account at the Fed.

Second, relatively large Treasury debt issuance at that time similarly transferred money out of the reserve accounts of banks who purchased the securities for themselves or customers and into the Treasury general account.

Finally, financial reporting requirements at the end of the third quarter made banks temporarily less willing to lend in the repo market.

Instead, it reflects the difficulty in forecasting the demand for reserves given the changes in regulations.

Since September , the Fed has responded in two ways to avoid further repo market turmoil. First, since the turmoil began, it has engaged in daily repos, and has pledged to continue to do so at least through April Both achieve the same aim—they increase market liquidity and the supply of bank reserves.

Repo rates and the federal funds rate have been stable since the Fed began these operations. A focus on the Fed's repos only presents one side of the Fed's influence on repo market liquidity and bank reserves, however.

The Fed intervenes on both sides of the repo market—that is, it simultaneously injects liquidity into markets by entering into repos and it withdraws liquidity by entering into reverse repos. While the Fed had not used repos from to September , it had regularly used reverse repos during that period. Since the financial crisis, the Fed has been withdrawing liquidity from repo markets on net because its reverse repos have exceeded its repos.

That is still true—despite the liquidity shortfall—even since the Fed's intervention beginning in September The reason the Fed's repo activity is still withdrawing liquidity on net is mainly because of the Fed's foreign repo pool, which invests foreign central banks' and international institutions' excess balances held at the Fed in reverse repos with the Fed.

It also impacts business expansion, net exports, employment, the cost of debt, and the relative cost of consumption versus saving—all of which directly or indirectly impact aggregate demand. In order to understand how monetary and policy affect aggregate demand, it's important to know how AD is calculated, which is with the same formula for measuring an economy's gross domestic product GDP :. Fiscal policy determines government spending and tax rates. Expansionary fiscal policy , usually enacted in response to recessions or employment shocks, increases government spending in areas such as infrastructure, education, and unemployment benefits.

According to Keynesian economics , these programs can prevent a negative shift in aggregate demand by stabilizing employment among government employees and people involved with stimulated industries. The theory is that extended unemployment benefits help to stabilize the consumption and investment of individuals who become unemployed during a recession.

Similarly, the theory says that contractionary fiscal policy can be used to reduce government spending and sovereign debt or to correct out-of-control growth fueled by rapid inflation and asset bubbles. In relation to the formula for aggregate demand, the fiscal policy directly influences the government expenditure element and indirectly impacts the consumption and investment elements. Monetary policy is enacted by central banks by manipulating the money supply in an economy.

The money supply influences interest rates and inflation, both of which are major determinants of employment, cost of debt, and consumption levels. Expansionary monetary policy involves a central bank buying Treasury notes, decreasing interest rates on loans to banks, or reducing the reserve requirement.

All of these actions increase the money supply and lead to lower interest rates. This creates incentives for banks to loan and businesses to borrow. Debt-funded business expansion can positively affect consumer spending and investment through employment, thereby increasing aggregate demand.

Expansionary monetary policy also typically makes consumption more attractive relative to savings. Exporters benefit from inflation as their products become relatively cheaper for consumers in other economies. Contractionary monetary policy is enacted to halt exceptionally high inflation rates or normalize the effects of expansionary policy. Tightening the money supply discourages business expansion and consumer spending and negatively impacts exporters, which can reduce aggregate demand.

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Given the linkage between various financial markets, there is a decline in not only financial institutions' lending rates but also interest rates at which firms borrow directly from the market, such as in the form of corporate bond issuance.

In this situation, firms find it easier to procure working capital funds needed for the payment of salaries and input costs and fixed investment funds funds needed for construction of factories, stores, etc. As a result, firms' and households' economic activity picks up, and this stimulates the economy.

Upward pressure on prices is also generated in turn. On the other hand, when interest rates rise, financial institutions must procure funds at higher interest rates, and raise their lending rates on loans to firms and households. Firms and households find it difficult to borrow funds, which makes their economic activity sluggish.

This, in turn, contains overheating of the economy and exerts downward pressure on prices.