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Why can the Fed attempt to target either changes in the money supply or changes in...

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armyof32000 | (Level 1) Salutatorian

Posted July 29, 2013 at 5:46 PM via web

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Why can the Fed attempt to target either changes in the money supply or changes in interest rates, but not both?

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jraineharrison | College Teacher | (Level 1) Assistant Educator

Posted July 30, 2013 at 6:02 PM (Answer #1)

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The Federal Reserve monetary policy sets the money supply and interest rates in the United States.  The money supply is the amount of money circulating in the United States economy and is measured by the monetary base; the M1; and the M2 measures.  Interest rates determine the amount of money, or interest, banks or other lenders can charge on loans.  

Increasing the money supply too rapidly can lead to increasing levels of price inflation.  Thus, the Federal Reserve attempts to maintain the money supply or to increase it only gradually. 

A similar concept exists with interest rates.  Interest rates are lowered or increased to either encourage or discourage lending. Increases in lending increases the money supply by increasing the M1 amount of money flowing throughout the United States economy (M1 = currency held + depository accounts).

Therefore, economists avoid targeting both money supply and the interest rate because it could have a detrimental effect on inflation since the size of the impact of any single monetary policy action cannot be precisely predicted; this is due in part to the delay in reaction time to monetary policy changes.

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