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Goals of Monetary Policy

Goals of Monetary Policy

Author: Kate Eskra

Determine how monetary policy relates to inflation and deflation.

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Hi. Welcome to macroeconomics. This is Kate. This tutorial is on the goals of monetary policy. As always, my key terms are in red and my examples are in green.

So in this tutorial we'll discuss the goals of the Federal Reserve. We'll talk about the problems that both inflation and deflation can cause in an economy. And you'll understand why price stability then is so important and therefore a major goal of monetary policy.

So why is it that the Fed is necessary? Well, initially, back in 1913, it was formed to reduce the frequency and likelihood of bank runs and panics that were going on. It was really meant to bring stability to the banking system. And that certainly still does provide stability in our banking system.

But over time it's role in managing our nation's money supply and overseeing our banking system has evolved. Its main goals today are to promote full employment in our economy and price stability. So what the Fed does is they manage our money supply.

And we divide our money supply according to liquidity into M0, M1, and M2. M0 is the most liquid way of defining what money is. It is the money that we can use right now. So it's physical cash in circulation.

Whereas M1 includes M0, but now it also includes checking accounts. This is still liquid. You can write a check. You can swipe your debit card. And it will come right out of your checking account.

M2 is the broadest definition of money. And it's the least liquid. So it includes M1, but it also includes now time deposits. Time deposits are things like savings accounts and money market mutual funds. So here are your key terms, the official terms for you.

M0, the narrowest definition of money. Like we said, only the physical currency in circulation. M1 are including your demand or checking account deposits. And M2 now are going to include time deposits. OK.

So let's talk about the first goal of the Fed, and that's to promote full employment. When the economy is slowing, or when we're in some kind of recession, that is what's going on because we're at less than full employment.

The Fed is different than the federal government. The Fed's way of helping out this situation is to try to increase the money supply. And these are the three big, broad categories of things they can do. Each of these is a topic of another tutorial.

But as a reminder, they could lower the reserve requirement. They could lower the discount rate or Fed funds target rate. Or they can buy Treasury securities. Any of these tools are going to help banks to make loans, which is also going to help get money into people's hands, circulating out there, and hopefully lowering our unemployment rate, getting us more towards full employment again.

So when the economy, though, is growing too quickly-- that's actually possible. The economy can be in the short-term beyond full employment. It's almost like an overheated situation.

And the major concern is not necessarily that the unemployment rate is too low. But when the unemployment rate is actually too low, like way under 5%, inflation can become a major concern. So the Fed can cool things down by decreasing the money supply.

And the things they could do would be to raise the reserve requirement, raise the discount rate or Fed funds target rate, or sell treasury securities. All of those tools are going to work to encourage banks to make fewer loans and actually keep money in the banks, tying it up there. And that should slow things down enough to bring our economy back to full employment. OK.

The topic, though, of the rest of this tutorial is really about price stability, their second goal other than encouraging full employment in an economy. So we know that it's normal for an economy to experience a slow overall increase in prices over time. That's fine. That's normal.

Obviously, today things are more expensive than the day I was born. Most economists say that about 2% annual inflation rates are normal and just fine. But what if prices were really unpredictable? Think about how that would change things.

If you had no idea what the price of things were going to be a year from now, a month from now, a week from now, even a couple hours from now, how would that change your decisions? Unstable prices can really change people's ability to purchase with a currency. They can also change our banks ability and willingness to make loans.

So let's talk about an inflationary risk. And I'm using Weimar, Germany as an example here. So if you ever learned anything about history, you might recall that after World War I, Germany had huge cost and huge reparations to pay after the war.

What they did was they chose to borrow the money in order to pay for these things. We'll talk about in other tutorials how as you borrow and borrow and borrow money, you're exchange rate in your economy begins to fall and that really devalues your currency. In order to make up for the devalued currency, they started printing more money, which actually, in honesty, makes your currency even weaker. And hyperinflation became the result.

At the beginning of the war, just to give you an idea, it was about four Marks to buy one dollar. At one point, it got so bad that it would've taken over four trillion Marks just to purchase $1. This is not normal inflation. This is hyperinflation that resulted from the massive borrowing and massive printing of money.

So what is the result, though, of this hyperinflation? Well, prices were actually rising so quickly that people had to be paid by the hour. They would then go to try and spend that money as quickly as possible before it lost even more value.

They had to shop with wheelbarrows full of money. You might have seen pictures of that somewhere in history class. Restaurants couldn't even print menu prices, because the prices were changing so quickly and money was changing its value so quickly.

The key idea here is that when there is hyperinflation in an economy, eventually people tend to resort to barter or actually going back to using a commodity, like gold, since the currency becomes essentially worthless. What ended up being the result also is that the rich-- not good for them-- but they were able to survive. Most of the rich owned land. And they could grow their own food or had connections or something.

But it was really the poor and the middle class suffering. People in the middle class who had savings, their hard earned savings completely vanished almost overnight. And they had end up selling what they could just to survive. Some of them sold old family heirlooms and such. It was pretty sad. And then we know in history that a lot of these people ended up turning to Hitler to fix the situation.

So certainly there can be some pretty negative consequences of hyperinflation. That's why it's such a concern. Deflation is the opposite of inflation. It means that prices are falling over a period of time.

And how could that be a problem? It sounds good, right? Our money can actually buy more. This actually also has risks. So we'll think about this.

During a period of significant deflation, people actually tend to hoard money. They don't tend to spend it. You're putting off your purchases until prices fall even further. If you know that prices are going to continue to fall, you say, why would I buy that now? I'll wait until it's even cheaper.

Businesses will do the same thing. They'll put off investment. So with both consumption and investment spending down, those are both components of aggregate demand, if you recall, that continues to fall along with overall economic activity. And this is really easy for a downward spiral to begin and to enter into a recession and then make it worse and worse and worse.

So as an example for you in current times, in the early 2000s, prices of homes in certain parts of our country were rising rapidly. So that's not the example of deflation. But what ended up happening was many people borrowed money to invest in housing in areas they felt they could quickly flip the house. And flipping a house means you're not buying it to live there, you're buying it to sell it for more than you ended up purchasing it for.

Well, unfortunately, this continual increase in the housing prices did not last forever. It was a bubble. And it burst. And home values absolutely plummeted in some of these areas.

So just an example for you, let's say I purchased a house out in California for $1 million. I'm thinking that a year from now, if I can fix it up and make it great, I can sell it for maybe $2 million. All of a sudden, though, now that the housing bubble burst, my house is only apparently worth, let's say, $400,000. But the problem is I still own almost $1 million on it. So I owe way more than the worth of my home.

The same or a very similar series of events happened leading up to the Great Depression, where many people were actually borrowing money to invest in companies that were rising, rising, rising, rising in value. People thought the stock market was never going to fall in value again. But then it did. And when it burst, not only did they lose money on those investments, they still owed money.

So the impact of deflation on M0 and M1 can be-- like even though the Fed was taking action to increase the money supply and pump money into M0, since people were hoarding cash, holding onto it, taking it out of the bank, and putting off purchases, the size of our M1 was actually decreasing.

So price stability is really important for a healthy economy, because predictability helps us to keep the economy going through our purchases and investments. And it also helps our banks to continue to make loans available to both consumers and businesses. So it's a major goal of the Fed.

So here's what we talked about in this tutorial. Thanks so much for listening. Have a great day.

Terms to Know

The narrowest definition of money; includes only the stock of physical currency.


Includes demand deposits (checking account balances) + M0 (stock of physical currency).


Time deposits + M1 (demand deposits + stock of physical currency).