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Money and Financial Markets, Effect of Monetary Policies on the U.S. Economy

long periods of unemployment, world economies, fixed incomes, Federal Reserve System, financial experts

The monetary policies adopted by the Federal Reserve System can have dramatic effects on the national economy and, in particular, on financial markets. Most directly, of course, when the Federal Reserve System increases the money supply and expands the availability of credit, then the interest rate, which determines the amount of money that borrowers pay for loans, is likely to decrease. Lower interest rates, in turn, will encourage businesses to borrow more money to invest in capital goods, and will stimulate households to borrow more money to purchase housing, automobiles, and other goods.

But the Federal Reserve System can go too far in expanding the money supply. If the supply of money and credit grows much faster than the production of goods and services in the economy, then prices will increase, and the rate of inflation will rise. Inflation is a serious problem for those who live on fixed incomes, since the income of those individuals remains constant while the amount of goods and services they can purchase with their income decreases. Inflation may also hurt banks and other financial institutions that lend money, as well as savers. In a period of unanticipated inflation, as the value of money decreases in terms of what it will purchase, loans are repaid with dollars that are worth less. The funds that people have saved are worth less, too.

When banks and savers anticipate higher inflation, they will try to protect themselves by demanding higher interest rates on loans and savings accounts. This will be especially true on long-term loans and savings deposits, if the higher inflation is considered likely to continue for many years. But higher interest rates create problems for borrowers and those who want to invest in capital goods.

If the supply of money and credit grows too slowly, however, then interest rates are again likely to rise, leading to decreased spending for capital investments and consumer durable goods (products designed for long-term use, such as television sets, refrigerators, and personal computers). Such decreased spending will hurt many businesses and may lead to a recession, an economic slowdown in which the national output of goods and services falls. When that happens, wages and salaries paid to individual workers will fall or grow more slowly, and some workers will be laid off, facing possibly long periods of unemployment.

For all of these reasons, bankers and other financial experts watch the Federal Reserve’s actions with monetary policy very closely. There are regular reports in the media about policy changes made by the Federal Reserve System, and even about statements made by Federal Reserve officials that may indicate that the Federal Reserve is going to change the supply of money and interest rates. The chairman of the Federal Reserve System is widely considered to be one of the most influential people in the world because what the Federal Reserve does so dramatically affects the U.S. and world economies, especially financial markets.

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