How Monetary Policy Affects the Economy Photo of the US Capitol Building

You've probably heard endless discussion of monetary policy on the news—but how does it affect your life?

Here's an example. Imagine that you are interested in buying a new house. Let's say that mortgage rates are only 3 percent but you expect them to rise to 5 percent next year. Most likely, you and thousands of others would want to take advantage of the current low interest rates by buying a home now. This demand would lead to increased demand for lumber, cabinets, carpet, tile, construction workers, etc., which in turn would have a ripple effect on the entire economy, spurring production. Increased sales would lead to higher earnings and growth potential for companies, thus boosting the stock market. As you can see, interest rates have a tremendous effect directly or indirectly on the economy. Because the Federal Reserve largely controls interest rates through its monetary policy, the Fed has a tremendous impact on the overall economy.

The Fed influences the economy in two major ways: by changing the interest rates it charges banks for loans, and by buying and selling government securities.

Interest rates. The Fed will often raise or lower the rate which it charges banks for short-term loans, called the discount rate. Banks will then raise or lower their interest rates in response to the Fed's action.Open market operations. This is the Federal Reserve's practice of buying or selling US government securities such as Treasury bills (T-bills). When they sell these securities, the money received from the sale is taken out of circulation, thus reducing the money supply. When the Fed buys these securities, the money returns to the market, increasing the money supply.

Increasing or decreasing the money supply through open market operations also affects interest rates. If the Fed decreases the money supply, money becomes scarcer. Therefore, banks are able to charge higher interest rates. If the money supply increases, money is relatively more abundant, and interest rates will decline as a result.

By setting the basis for interest rates throughout the economy, and regulating the amount of money in circulation, the Fed's monetary policy has a profound effect on every consumer and investor.