🏦 Monetary Policy

Definition: The actions of a central bank (e.g., the Federal Reserve in the US) to manage the money supply and interest rates in order to achieve macroeconomic goals: price stability, maximum employment, and moderate long-term interest rates.

Key courses: Wharton MGEC 612, HBS BGIE, Booth Macroeconomics

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🔑 Central Bank Objectives (The Fed’s “Dual Mandate”)

The US Federal Reserve has two legally-mandated goals:

1. Price stability: Target ~2% inflation (PCE measure)
2. Maximum employment: As close to full employment as possible without generating inflation

Other central banks (ECB, Bank of England) have slightly different mandates — often just price stability.

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🛠️ Tools of Monetary Policy

1. Federal Funds Rate (The Main Tool)

The interest rate at which banks lend to each other overnight — set by the Fed.

Transmission mechanism:

Fed lowers rates
        ↓
Banks borrow cheaper from each other
        ↓
Banks lower lending rates to businesses and consumers
        ↓
More borrowing, more investment, more spending
        ↓
GDP growth ↑, employment ↑, (eventually) inflation ↑

Reverse (raising rates): Cools economy, reduces inflation.

2. Open Market Operations (OMO)

• Fed buys/sells US Treasury bonds in the open market
• Buying bonds: Injects money into banking system → expansionary
• Selling bonds: Removes money from system → contractionary
• Primary tool for adjusting the federal funds rate

3. Reserve Requirements

• The % of deposits banks must hold in reserve (not lend out)
• Lowering reserve requirements → banks can lend more → money supply expands
• Currently set to 0% in the US (rarely used as a tool)

4. Discount Rate

• Rate the Fed charges banks that borrow directly from it (discount window)
• Typically above the fed funds rate (borrowing directly = lender of last resort)

5. Quantitative Easing (QE)

Used when conventional policy is exhausted (rates at zero):

• Fed purchases large quantities of longer-term assets (Treasury bonds, MBS)
• Pushes down long-term rates, inflates asset prices
• Used in: 2008–2014, 2020 (COVID), reversed via QT (Quantitative Tightening) 2022+

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📊 Monetary Policy Stances

Stance	Action	Used When
Expansionary (Dovish)	Lower rates, buy assets, increase money supply	Recession, high unemployment
Contractionary (Hawkish)	Raise rates, sell assets, reduce money supply	High inflation, overheating economy
Neutral	Neither stimulating nor restricting	Economy near equilibrium

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🔄 The Taylor Rule (Framework for Rate Setting)

A guideline for what the Fed funds rate should be:

$r=r^{\ast }+\pi +0.5(\pi -{\pi }^{\ast })+0.5(y-y^{\ast })$

Where:

• r* = neutral real interest rate (~2%)
• π = current inflation rate
• π* = inflation target (2%)
• y − y* = output gap (GDP vs. potential GDP)

Intuition: Raise rates if inflation is above target or GDP is above potential; lower if below.

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🌍 Key Macroeconomic Relationships

The Phillips Curve

Historical tradeoff between unemployment and inflation:

• Low unemployment → wage pressure → higher inflation
• High unemployment → weak demand → lower inflation

Modern view: Relationship has weakened; not a reliable short-term tradeoff.

Quantity Theory of Money

$MV=PQ$

• M = money supply, V = velocity, P = price level, Q = real output
• If M increases faster than Q, inflation (P) rises (assumes V constant)
• Used by monetarists (Friedman) to explain inflation

Yield Curve

The relationship between bond yields and maturities:

• Normal: Long rates > short rates (growth expected)
• Inverted: Short rates > long rates → recession predictor (has preceded every US recession)
• Flat: Short ≈ long rates → transition period

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💼 Business Implications

Fed Action	Business Impact
Rate hike	Higher borrowing costs → less investment, lower valuations
Rate cut	Cheaper debt → more M&A, capex, hiring
QE	Asset price inflation → higher equity multiples
QT	Asset price compression → valuation multiples compress

The “Fed Put”: Market belief that Fed will cut rates if stock market falls too much → creates moral hazard.

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🔗 Connected Concepts

• Inflation and Interest Rates — The core tension monetary policy manages
• WACC — Interest rates directly affect discount rates and valuations
• Capital Structure — Debt costs change with Fed policy
• DCF Valuation — Risk-free rate input changes with monetary policy
• Behavioral Economics Overview — Fed credibility is partly psychological

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← 📈 Economics MOC | Related: Inflation and Interest Rates · WACC · DCF Valuation