19.1 Chapter Introduction


Monetary Policy



The chairmanship of the Federal Reserve, currently held by Janet Yellen, is arguably the most powerful position in the U.S. government.

What You Will Learn in This Chapter

  • What the money demand curve is

  • Why the liquidity preference model determines the interest rate in the short run

  • How the Federal Reserve implements monetary policy, moving the interest rate to affect aggregate output

  • Why monetary policy is the main tool for stabilizing the economy

  • How the behavior of the Federal Reserve compares to that of other central banks

  • Why economists believe in monetary neutrality—that monetary policy affects only the price level, not aggregate output, in the long run

image | interactive activity

IN 2014 NICHOLAS LEMANN, A reporter for the New Yorker, visited the trading floor of the Federal Reserve Bank of New York. He found it oddly unimpressive—writing that the people at the desks “look like graduate students” and “dress business casual.” Off the main floor were two small rooms. In one room five “serious-looking people” were buying “long-term U.S. government bonds amounting to thirty billion dollars every month.” In the other, seven people were buying a slightly smaller amount of mortgage-backed securities—bonds backed by government-sponsored home loans. Lemann was bewildered by the lack of drama, asking “Can a spectacle so lacking in the indicia of importance—no pageantry, no emotions, not even any speaking—really be the beating heart of capitalism?”

The answer, basically, is yes. Lemann visited the New York Fed as he worked on a profile of Janet Yellen, chairwoman of the Fed’s Board of Governors. And that’s a very important position indeed. As Lemann wrote, “There is an old saw that the Fed chair is the most powerful person in government. In the aftermath of the financial crisis, that may actually be an understatement.”

People sometimes say that the head of the Fed decides how much money to print. That’s not quite true: for one thing, the Fed doesn’t literally print money, and beyond that, monetary decisions are made by a committee rather than by one person. But as we learned in Chapter 18, the Federal Reserve can use open-market operations and other actions, such as changes in reserve requirements, to alter the money supply—and Janet Yellen has more influence over these actions than anyone else in America.

And these actions matter a lot. Roughly half of the recessions the United States has experienced since World War II can be attributed, at least in part, to the decisions of the Federal Reserve to tighten money to fight inflation. In a number of other cases, the Fed played a key role in fighting slumps and promoting recovery. The financial crisis of 2008 put the Fed at center stage. Its aggressive response to the crisis inspired both praise and condemnation.

The power of the Fed chair comes from the ability of the Board of Governors to direct the actions of people like those working in those two small rooms in New York. For what the Fed does, mainly, is set monetary policy. Monetary policy in action isn’t much to look at, but it’s crucially important—for job creation, for price stability, and more—that it be done right.

In this chapter we’ll learn how monetary policy works—how actions by the Federal Reserve can have a powerful effect on the economy. We’ll start by looking at the demand for money from households and firms. Then we’ll see how the Fed’s ability to change the supply of money allows it to move interest rates in the short run and thereby affect real GDP. We’ll look at U.S. monetary policy in practice and compare it to the monetary policy of other central banks. We’ll conclude by examining monetary policy’s long-run effects.