Goals of Monetary Policy - Online Tutor, Practice Problems & Exam Prep

Monetary policy, managed by the Federal Reserve, aims to control the money supply to achieve key goals: price stability, high employment, financial market stability, and economic growth. Price stability helps maintain the value of money, while high employment ensures resources are utilized effectively, boosting GDP. The Fed acts as a lender of last resort to stabilize financial markets and manages interest rates to influence investment levels, crucial for economic growth. Understanding these dynamics is essential for grasping macroeconomic principles and the role of central banks in the economy.

Goals of Monetary Policy

Go a little deeper into monetary policy. So let's go ahead and start by defining what the goals of monetary policy are. Monetary policy is the management of the money supply. Okay? So, we're thinking about the supply of money. Remember M₁ and M₂, we define those as the money supply. So we're going to get into a little more detail about that now. And the money supply is managed by the Fed, right? The Federal Reserve, which is the central bank in the United States.

Well, what is the goal of monetary policy? Why are they going to be managing this money supply? The first two are the most important goals here, and then the other two have been goals more recently as well. So price stability. We're basically managing inflation. Okay? We want to keep inflation under control, and it allows money to hold its value. Right? We don't want inflation to grow and grow and whatever money you have to lose its value. Remember when we learned the definition of money and the function of it, it must be able to act as a medium of exchange and a store of value, right? It has to be able to store the value that when you go to work and you get paid in money, you want that money to hold its value for when you use it, right? So that's one of the goals of monetary policy.

The other one is high employment. Right? Because underused resources reduce our GDP below its potential level. So, by managing our money supply, it basically keeps the level of investment in the economy at a high level and keeps employment high. So these go hand in hand, managing inflation and managing employment. Okay?

So, these other two are, I don't want to say less important, but they are other goals of monetary policy. The stability of financial markets. So basically ensuring that the markets do not fail, right? So the Fed acts as the lender of last resort. When things start to go bad, we depend on the Fed to bail us out of problems. And hey, you know, things are going wrong. Do something. Right? So they want to keep stability in the financial markets. And when the Fed was created in 1913, that stability was mainly concerned with commercial banks. And this is where you keep a checking account or something like that. But in the most recent recession of 2008, the Fed also was working with investment banks. And we get into more details about that crisis in 2008, in other videos as well.

So the final goal here is economic growth. Right? We want economic growth in our society. So they want to allow for this economic growth by managing the interest rate in the financial markets. Okay? So, remember that interest rate, I'll put IR for interest rate, determines the amount of investment by firms, right? Higher interest rate means loans cost more. Right? There's more interest on a loan. Let me get out of the way. Loans cost more, so less investment. Right? So as the interest rate goes up, well, then there's going to be less investment because it's costlier to make an investment. And firm investment is a key element of economic growth, so they want to manage the level of investment by managing the interest rate. Okay? So let's go into a little more detail about monetary policy and what the Fed actually does to reach these goals. Cool? Alright. Let's do that.

Here’s what students ask on this topic:

What are the primary goals of monetary policy?

The primary goals of monetary policy are price stability, high employment, financial market stability, and economic growth. Price stability aims to control inflation, ensuring that money retains its value over time. High employment focuses on utilizing resources effectively to maximize GDP. Financial market stability involves the Federal Reserve acting as a lender of last resort to prevent market failures. Lastly, economic growth is promoted by managing interest rates to influence investment levels, which are crucial for long-term economic development.

How does the Federal Reserve manage the money supply to achieve its goals?

The Federal Reserve manages the money supply through various tools such as open market operations, the discount rate, and reserve requirements. Open market operations involve buying or selling government securities to influence the amount of money in the banking system. The discount rate is the interest rate charged to commercial banks for borrowing funds from the Fed, affecting the cost of loans. Reserve requirements dictate the amount of funds banks must hold in reserve, impacting their ability to lend. These tools help the Fed control inflation, employment, and economic growth.

Why is price stability important in monetary policy?

Price stability is crucial because it helps maintain the value of money, ensuring that it can effectively serve as a medium of exchange and a store of value. When inflation is controlled, the purchasing power of money remains stable, which is essential for economic planning and investment. Uncontrolled inflation can erode savings and reduce consumer and business confidence, leading to economic instability. Therefore, maintaining price stability is a key objective of monetary policy to foster a healthy economic environment.

What role does the Federal Reserve play in ensuring financial market stability?

The Federal Reserve plays a critical role in ensuring financial market stability by acting as the lender of last resort. This means that during times of financial distress, the Fed provides liquidity to banks and other financial institutions to prevent market failures. By doing so, the Fed helps maintain confidence in the financial system, ensuring that markets function smoothly. This role was particularly evident during the 2008 financial crisis when the Fed took measures to stabilize both commercial and investment banks.

How does managing interest rates influence economic growth?

Managing interest rates is a key tool for influencing economic growth. When the Federal Reserve lowers interest rates, borrowing costs decrease, making loans more affordable for businesses and consumers. This encourages investment and spending, which can stimulate economic growth. Conversely, higher interest rates increase borrowing costs, which can reduce investment and spending, slowing down economic growth. By adjusting interest rates, the Fed can influence the level of economic activity and help achieve its goal of sustainable economic growth.