US Monetary Policy - Essay Example

Lowering interest rates is an approach taken when the economy goes into a period of recession. Lower rates may induce banks to lend to businesses and households. This will increase spending and stimulate productive output. It should be noted that the change in interest rates has only a short-term effect of returning inflation or employment to its long-term objectives (Federal Reserve Board). By setting interest rates, the FOMC is able to indirectly control the money supply. Lower interest rates alter the total amount of loans, bonds, and shares issued.

According to the quantity theory of money, as the money supply increases the inflation rate rises ("The Quantity Theory of Money"). Setting the interest rate becomes a task of stimulating economic output while keeping inflation under control. The effects of interest rate changes may take from three months to two tears to show an effect. Chart 1 in appendix A illustrates the relationship between the interest rates, set by the FOMC, on unemployment, inflation, and GDP. At the beginning of 2001, the FOMC began reducing interest rates on Federal Funds (Federal Funds).

This stimulated the economy from a -7.5% growth rate to a positive rate by 2003 and a 2.4% growth rate by 2006 (Historical GDP). The interest rates that fell from 2001-2003 also began to reduce unemployment by 2004 (Current Population). The rise in interest rates beginning in 2004 was a reaction to the gradually rising inflation rate and it has also slowed the rising growth rate that was experienced in 2001-2003 (Inflation). As has been seen, monetary policy is a slow and deliberate method of controlling the important aspects of our economy.

Setting the Federal Fund interest rate is a balancing act designed to stimulate the economy while not expanding the money supply to the point that it would produce high inflation. Because these changes may take years to show their effect, it demands that the policymakers continually monitor our economy and correct it for its eventual long-term changes.