Question

For more than 20 years, the Fed has used the federal funds rate as its monetary policy target. Why doesn't the Fed target the money supply at the same time?

Short answer

The Fed targets the federal funds rate instead of the money supply because it allows them to more directly and precisely influence short-term interest rates, which are crucial for overall economic activity. While controlling the money supply impacts inflation directly, it's less effective for addressing short-term economic changes and more challenging to implement accurately due to the complexity of global financial markets.

Step-by-step solution

Understand Federal Reserve’s monetary policies

The Federal Reserve (Fed) has two main monetary policies: adjusting the money supply and manipulating the federal funds rate. Adjusting the money supply – the total amount of money in circulation in a country – is directly linked to inflation. The Fed can increase the money supply to stimulate the economy or decrease it to curb inflation. On the other hand, the federal funds rate is the interest rate banks charge each other for overnight loans. The Fed can influence this rate to stimulate financial activity or slow it down.

Relate the monetary policies to the Fed’s goals

The Fed has two main goals: maintaining price stability and promoting maximum employment. Both adjusting the money supply and manipulating the federal funds rate can help achieve these goals but in different ways. Money supply manipulation affects inflation directly, while federal funds rate manipulation affects the lending and borrowing between banks, thereby indirectly influencing economic activity and inflation.

Explain why the Fed targets the federal funds rate

The federal funds rate provides a more direct mechanism for influencing short-term interest rates, which are crucial for the overall economic activity. By targeting the federal funds rate, the Fed can fine-tune economic conditions with more precision.

Explain why the Fed does not target the money supply

While the control of money supply directly impacts inflation, it is less effective in regulating short-term Economic changes due to lags in policy implementation and the time it takes for money supply changes to affect the economy. Moreover, given the complexity and global nature of financial markets, it is difficult for the Fed to accurately control the money supply. Hence the Fed focuses on the federal funds rate as its primary monetary policy target.

Key concepts

federal funds rate

The federal funds rate is a critical monetary policy tool used by the Federal Reserve. It represents the interest rate at which banks lend funds to each other overnight. This rate is crucial because it influences a wide range of other interest rates in the economy, including those for mortgages, loans, and savings.

By adjusting this rate, the Federal Reserve attempts to either stimulate economic growth or slow it down. For example, lowering the federal funds rate makes borrowing cheaper, encouraging banks to lend more and businesses and consumers to spend more. Conversely, raising the rate can help cool an over-heating economy and control inflation.

• Impact on financial activity: Changes in the federal funds rate can affect everything from consumer spending to business investments.
• Short-term control: The Fed finds it more effective to influence short-term interest rates directly through the federal funds rate than attempting to control the broader monetary aggregates.

Consequently, the federal funds rate serves as a swift and responsive way to adjust economic conditions.

money supply

The money supply includes all the money available in an economy at any given time. This consists of cash, coins, and balances held in bank accounts. Adjusting the money supply is one of the fundamental tools of the Federal Reserve’s monetary policies. An increase in the money supply generally aims to boost economic activity by making more funds available for spending and investment. However, managing the money supply can be challenging due to several factors:

• Lag effect: Changes in the money supply can take a substantial amount of time to affect economic activity, making it difficult to target short-term objectives.
• Global complexities: The interconnectedness of global markets adds layers of complexity, making precise control over the money supply increasingly challenging.
• Inflation control: Although changes in the money supply have a direct relationship with inflation, other factors can offset these efforts.

In summary, while critical, direct control over the money supply is not the primary focus of the Fed's current policy approach.

price stability

Price stability is one of the principal objectives of the Federal Reserve's monetary policy. It involves maintaining the general price level in the economy at a stable rate, avoiding significant inflation or deflation. Ensuring price stability is crucial as it directly impacts purchasing power, savings, and investment decisions.

Here’s how the Federal Reserve works towards achieving price stability:

• Controlling inflation: The Fed uses interest rate tools like the federal funds rate to curb excessive inflation by making borrowing more expensive, which, in turn, reduces spending.
• Avoiding deflation: Similarly, the Fed can lower interest rates to encourage spending and investment, stimulating demand and preventing deflation, which can stall economic activity.
• Long-term economic growth: Stability in prices provides a predictable economic environment, encouraging consumer and business confidence.

By focusing on price stability, the Federal Reserve seeks to create a solid foundation for economic growth and maximum employment.

maximum employment

Maximum employment represents another key goal of the Federal Reserve's monetary policy. This objective refers to the highest level of employment that the economy can sustain while maintaining a stable inflation rate. Attaining maximum employment involves creating conditions that foster job growth and retain job security for workers.

The Federal Reserve tackles this through several approaches:

• Encouraging investment and consumption: By adjusting the federal funds rate, the Fed influences the amount of money that businesses and consumers wish to spend or invest, impacting employment levels.
• Supporting economic activity: Low-interest rates encourage borrowing and spending, which can lead to business expansions and more employment opportunities.
• Balancing inflation: The balance between promoting job growth and keeping inflation in check is delicate; too much focus on one can negatively impact the other.

Ultimately, achieving maximum employment involves not just reducing unemployment but ensuring that the conditions necessary for optimal job creation are in place.