- Monetary policy is the means by which the Federal Reserve uses the supply of money and the cost of borrowing money to regulate the economy. The cost of borrowing money is better known as interest rate. While the interest rates set by the Federal Reserve are not the same as the interest rates people pay on their credit cards and home mortgages, they are related.
- Expansionist monetary policy is aimed at expanding credit and the money supply. It is a common tool for combating recessions, but it has been broadly the standing monetary policy of the United States since the mid-1980s, when the economic malaise known as "stagflation" was tamed. The Federal Reserve has three mechanisms for expanding the money supply. First, it can can increase the actual, real money supply. This is done not by printing money (a function of the Treasury), but by buying up bonds. Buying bonds dumps hard currency into the open market. A second tool is to reduce the reserve requirements of banks. This is the amount of capital a bank is required to keep on hand, so lowering it means they can loan out more of its capital. The third tool is to lower the discount and Federal funds rate, which is the interest charged on the short-term loans made by the Federal Reserve or between banks to meet reserve requirements.
- Contractionary monetary policy means contracting the availability of credit and/or the money supply. The Federal Reserve does this using the same tools, only in reverse: raising reserve requirements, raising interest rates and selling off bonds to soak cash out of circulation. The classical target of a contractionary policy is to fight inflation, which was the standing policy of the Federal Reserve under Paul Volcker in the late 1970s to the mid-1980s.
- Paul Volcker's contractionary policy is widely credited with taming the 1970s demon of stagnant economic growth and high inflation known as "stagflation." Inflation hit a 1981 high of 13.5 percent, but had dropped to 3.5 percent by 1983, and was below 2 percent for much of the 1990s. Volcker raised the interest rates under his control to above 20 percent, which caused a severe recession, practically strangling both the construction and agricultural sectors. However, the results tamed inflation and set the stage for the more prosperous economic conditions enjoyed over the next 20 years.
His successor, Alan Greenspan, pursued a mixed expansionary-contractionary policy. While broadly speaking, the period between the mid-1980s and the early years of the 21st century were expansionary in nature, with easy credit being encouraged, Greenspan had a tight policy in the late 1980s to act as a counterweight to the Federal deficit, and raised interest rates several times in 2000 with an eye on keeping a lid on inflation and deflating the speculative bubble in the stock market, particularly the tech sector.
Greenspan responded to the 2001 recession with a markedly expansionist monetary policy, which was continued by his successor Ben Bernake. This very loose, expansionist policy has been blamed for the reckless lending that characterized the credit crisis and global recession of 2007 to 2009. - A different set of interest rates that effect the economy is the interest rates offered by the U.S. Treasury on bonds and other debt instruments. These interest rates must be sufficient to attract investors and their money, or the government will be unable to raise the cash to cover budget deficits. The more money the government needs to borrow, the higher the interest offered on government bonds needs to be, and therefore the more expensive that debt becomes. Expensive debt limits future government spending options, with a direct impact on the U.S. economy. Also, the interest offered on government debt has an indirect effect on trade relations, as foreign governments often buy up public debt to get negotiating leverage on the U.S. government. This was the practice of the Japanese in the 1980s, and the Chinese in the early part of the 21st century. By buying up cheap debt, those governments were able to force trade settlements that were advantageous to them, lest the government lose an important creditor and be forced to raise interest rates to compensate. That has a direct impact on American jobs.
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