The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates. Aggregate demand is a measure of the total consumption of goods and services over any time period. Aggregate demand is the most important ingredient that can be targeted by the government through fiscal or monetary policy.
Fiscal Vs. Monetary Policy
Fiscal policy is a much more direct way to affect aggregate demand as it can put money directly in the hands of consumers, especially those who have the greatest marginal propensity to spend. This increased spending leads to positive spillover effects such as businesses hiring more workers.
Some typical ways fiscal policy is used to increase aggregate demand include tax cuts, military spending, job programs and government rebates. In contrast, monetary policy uses interest rates as its mechanism to reach its goals. Ostensibly, the Federal Reserve’s mandate is to balance competing goals of employment and price levels.
Targeting Aggregate Demand
However, aggregate demand is an important component in both of these measures. Therefore, the Federal Reserve is deeply concerned with it. When resources are constrained and there is an increase in aggregate demand, inflationary risks increase. If total consumption of goods and services in the economy decreases, then businesses have to let go of workers in response to the declining revenue.
The Federal Reserve’s direct effect on aggregate demand is mild. When it lowers interest rates, asset prices climb. Higher asset prices for assets such as homes and stocks boost confidence among consumers, leading to purchases of larger items and greater overall spending levels. Higher stock prices lead to companies being able to raise more money at cheaper rates.
Financial Conditions
The Federal Reserve’s largest effect in boosting aggregate demand is to create supportive financial conditions. It lacks the tools to generate aggregate demand in the way of fiscal policy, but it can create an environment in which low interest rates lead to lower borrowing costs and higher asset prices, which is supportive of increased spending and investing.
Adverse Effects
Bond markets, stock markets and commodities hit all-time highs within five years of the bottom in asset prices of March 2009. Economic conditions slowly improved, but many people were left out of the recovery. This divergence highlights the limitations of monetary policy in such circumstances.
Gridlock in Congress led to a complete halt in any sort of discussion of fiscal policy. The Federal Reserve started buying billions of dollars worth of bonds to improve liquidity and financial conditions. Given the lackluster recovery, it failed to generate aggregate demand.
Critics of the Federal Reserve highlight this as evidence its policie…