In addition to fiscal policy, a government affects the economy through its monetary policy, which controls the amount of money, or currency, in the economy. Money is like any other commodity: When there is more of it, the price of money—that is, interest rates—goes down; when there is less money in the economy, its price goes up. Controlling the amount of money in the economy allows the government to directly influence the economy.
Most governments have a central bank that controls monetary policy. In the United States, the central bank is called the Federal Reserve Bank (also known simply as the Fed). The powers that central banks have vary from state to state.
Example: The European Central Bank (ECB) was formed as part of the creation of the European Union. It consists of the main bank plus the central banks of the twenty-five member states of the EU. The bank attempts to control inflation throughout the EU through monetary policy, specifically by monitoring the euro.
The Federal Reserve Bank
The Federal Reserve System was created as part of Franklin Roosevelt’s New Deal to reform the American banking system after the Great Depression. The Federal Reserve System consists of twelve branches of the Federal Reserve Bank that are located throughout the country. The system is governed by the Federal Reserve Board, a group of people appointed by the president of the United States and the Senate to determine the national banking policies, including setting interest rates. The Fed is responsible for a number of functions, including:
- Adjusting the supply of money and credit to help the economy
- Ensuring that banks do not overextend themselves
- Facilitating the exchange of cash, checks, and credit
- Setting interest rates
Central Bank Independence
Central banks have varying degrees of independence from the other branches of government. Many scholars think that the central bank should be completely independent from the rest of the government. They reason that the central bank can only make sound economic decisions through independence. Political pressure from the government could hurt the bank’s ability to make good policy by demanding short-term fixes that will hurt in the long run. Others argue that the central bank should be under the control of elected officials because the bank, like the rest of the government, needs to respond to the will of the people.
Example: The selection of members of the Federal Reserve Board in the United States is one way of trying to resolve the dilemma of how independent the Fed should be. The president nominates and the Senate approves members of the board. However, once someone has been confirmed, he or she serves for a set period and cannot be fired. This job security encourages Federal Reserve Board members to make sound economic policy choices without regard to short-term politics.
Although monetary policy affects the economy, it does not directly control the economy. Instead, monetary policy encourages certain kinds of behavior. The actions of central banks often lower unemployment and reduce inflation. Lowered interest rates, for example, encourage people to borrow. More borrowing often leads to business investment, which, in turn, creates jobs. But low interest rates do not guarantee that people will borrow. Higher interest rates, in contrast, discourage people from borrowing, which lowers the amount of money being spent and thus reduces inflation. In the long term, monetary policy can be very effective, but in the short term, it may do little. And ultimately, monetary policy cannot force people to borrow money or spend it in ways that help the economy.