In this chapter, you will learn about:
- The Federal Reserve Banking System and Central Banks
- Bank Regulation
- How a Central Bank Executes Monetary Policy
- Monetary Policy and Economic Outcomes
- Pitfalls for Monetary Policy
The Problem of the Zero Percent Interest Rate Lower Bound
Most economists believe that monetary policy (the manipulation of interest rates and credit conditions by a nation’s central bank) has a powerful influence on a nation’s economy. Monetary policy works when the central bank reduces interest rates and makes credit more available. As a result, business investment and other types of spending increase, causing GDP and employment to grow.
However, what if the interest rates banks pay are close to zero already? They cannot be made negative, can they? That would mean that lenders pay borrowers for the privilege of taking their money. Yet, this was the situation the U.S. Federal Reserve found itself in both at the end of the 2008–2009 recession and during the COVID-19 recession of 2020. The federal funds rate, which is the interest rate for banks that the Federal Reserve targets with its monetary policy, was slightly above 5% in 2007. By 2009, it had fallen to 0.16%. It then fell again from over 2% to 0.05% in March 2020.
During the Great Recession, the Federal Reserve’s situation was further complicated because fiscal policy, the other major tool for managing the economy, was constrained by fears that the federal budget deficit and the public debt were already too high. What were the Federal Reserve’s options? How could the Federal Reserve use monetary policy to stimulate the economy? And while fiscal policy was more aggressive in 2020, the economic situation has in some cases been more severe and additional financial support was necessary. The solution to the problem of the lower bound in both recessions, as we will see in this chapter, was to change the rules of the game.
Money, loans, and banks are all interconnected. Money is deposited in bank accounts, which is then loaned to businesses, individuals, and other banks. When the interlocking system of money, loans, and banks works well, economic transactions smoothly occur in goods and labor markets and savers are connected with borrowers. If the money and banking system does not operate smoothly, the economy can either fall into recession or suffer prolonged inflation.
The government of every country has public policies that support the system of money, loans, and banking. However, these policies do not always work perfectly. This chapter discusses how monetary policy works and what may prevent it from working perfectly.