A Dry Primer on Monetary Policy

To understand why interest rates were declining in the years leading up to the credit crisis we need to take a step back and look at some broader concepts in economics. The U.S. Federal Reserve has the difficult task of trying to promote general economic prosperity. In broad terms, economic prosperity can be thought of as low unemployment, low and stable inflation, and high Gross Domestic Product (GDP). The concept of GDP, although it sounds complex, is quite simple. GDP is the sum of all labor and services performed in a country. It is the sum of the output of every member’s contribution: the value of all cars produced by Ford, all of the computer chips manufactured by Intel, the value of all of the services offered by McKinsey Consulting, etc. Higher employment almost always leads to higher GDP – more people are working and contributing to the total output of society.

So how does the Federal Reserve control employment, GDP, and inflation? The primary tool the Fed uses is interest rate management. By controlling interest rates, the Fed can help generate new jobs (raise employment. If interest rates are low, people are more willing to borrower and they spend more money. Businesses too are more likely to borrower, expand, and hire more workers. In the economic sphere, we call this expansionary economic policy: lower interest rates expand the economy. Sounds great but there is a downside – inflation.

The mechanism by which the Fed sets the interest rate is by controlling the amount of money printed. The Fed cannot just announce interest rates and then magically a new interest rate is set. What the Fed literally does is print more money. Just like other rare items (think gold, silver, Michael Jordan rookie cards), the more abundant the item is, the less valuable. The Fed can print as much money as it wants, but the more it prints, the less valuable we consider it.

So why was the Fed lowering interest rates in the years leading up to the credit crisis? After the attacks of September 11^th, 2001 and the collapse of the dot-com bubble, there were legitimate fears that the economy might contract, people would loose their jobs, spend less money and a recession might ensue. To combat the recessionary fears, the Fed stepped in and sharply reduced interest rates.