The Traditional Explanation for How Monetary Policy Affects the Economy

Cars for sale are seen on display in Boulder, Colorado, on September 24, 2015.

This series lays out some of the key insights of recent economic research, but the traditional understanding of how monetary policy affects the real economy provides an important foundation for deeper discussions. The Federal Reserve uses interest rates to manage the economy—lowering rates when it struggles and raising them to cool down an overheating economy. This column walks through the three channels that dominated economists’ understanding of how the Fed’s actions could filter down to affect the U.S. economy throughout the 20th century.

Investment-based channels

Monetary policy can have a major effect on the cost of investments in capital, such as houses or factories, for both businesses and households. Economists typically believe that changes in the user cost of capital—a more technical and complete definition of the cost of making a capital investment at any point—are a major driver of decisions to invest in capital goods—including new machines, buildings, or software—especially for corporations. For example, when rates are 5 percent, people taking out a typical 30-year mortgage to buy a house will pay back about twice as much as they borrow due to interest costs. But at 3 percent, these costs are only half the size of the loan.

When inflation is predictable, the Fed can encourage households and businesses to delay some investments by raising rates, which can reduce inflation or even pop speculative bubbles. As investment slows, so does economic growth and inflationary pressure, along with demand for investment goods. And as demand for investment opportunities falls, the value of these assets fall, too. Both physical assets, such as factory equipment or existing buildings, and financial assets, such as shares of a company, appreciate more slowly or even fall in value as demand for investment goods falls. The effect of relatively small changes in asset prices can be large because these assets are a potential source of financing or collateral for additional borrowing that can be used for more investment. This argument works both ways in normal times: Lowering interest rates can encourage firms and households to make investments they plan on making down the line more immediately, both raising the demand and prices for assets and raising the value of assets used as loan collateral for new and existing loans.

Moreover, when a publicly traded firm’s stock price, which represents the market value of its capital, exceeds the replacement cost, or the book value, of its existing capital, it is a signal that markets think additional investment in this firm will be profitable. When a firm is worth less that its capital, markets are saying additional investment does not make sense. There is some evidence that the investment decisions of public companies can be explained by looking at these values—which nerds call a Q ratio. In theory, low rates cause stock prices to go up, encouraging companies to raise money for new investments by selling more stock.

Consumption-based channels

Monetary policy affects consumption most directly by changing the timing of household spending. A car buyer targeting a monthly payment can buy a car with a lower down payment when interest rates are lower, so that she can save enough to make the purchase in fewer paychecks. This is true across the economy—lower rates mean lower returns to saving and lower costs of borrowing, giving consumers an incentive to pull consumption forward. That consumption creates additional economic activity sooner, sparking faster economic growth. The same process can work in reverse; higher rates can make it more rewarding to spend less and save more. Across the economy, this delaying of consumption into the future slows economic growth in the present.

For households with assets, lower interest rates also make their assets worth more, creating a windfall of greater wealth. Households spend a much smaller fraction of wealth gains than of income gains. But across an entire economy, if households experience similar wealth gains and spend similar shares of their gains, when monetary policy raises asset prices, it can raise consumer spending and economic growth.

International trade-based channels

When the Fed cuts interest rates, it is effectively cutting the return to holding assets in the U.S. This means U.S. asset prices fall, investors move some money to other countries, and the value of the dollar falls. But a weaker dollar can be a very good thing—it makes U.S. exports cheaper and imports more expensive. Gross domestic product goes up because both because the United States sells more exports and because Americans buy more domestically made products instead of pricey imports.

Conclusion

There is a lot going on in a few simple points here, but there is also a lot of nuance missing. More recently, economists have focused on how debt-based financing for business investment, wealth inequality, and the multiple players in the international economy affect the traditional story. These issues are covered in the next installment of this series.

Michael Madowitz is an Economist at the Center for American Progress.