Monetary Policy

With great power comes great responsibility. Yup, I'm talking about the Federal Reserve, the United States' central bank. Through its influence on the U.S. money supply, the Fed has more power to affect the economy than any other institution. In fact, the chairperson of the Federal Reserve is arguably the second most powerful person in the United States after the president. The U.S. Federal Reserve has the power to create money, to buy trillions in government bonds, and to act as a lender of last resort. And yet, despite these awesome powers, the Fed also has limitations and weaknesses.

Monetary policy, which describes the Fed's actions to control the supply of money and influence the economy -- it can only affect real growth in the short run. How come? Well, let's go back to the quantity theory of money, which states that: M x V = P x Y. If M goes up, then in the long run prices go up, and why? Real GDP, it doesn't change. Real GDP is determined by the fundamental factors of growth that we talked about in earlier videos -- human and physical capital, and good institutions.

But things are different in the short run. Sticky prices slow the adjustment of P to changes in M, so in the short run, the Fed can have a dramatic effect on aggregate demand and on real output. But even the Fed's ability to affect aggregate demand in the short run -- it can be tenuous because of incomplete data, lagged results, and a lack of direct control. And because of these difficulties the Fed has, at times, made the economy worse rather than better.

One of the difficulties is that defining what money is isn't so easy. What counts as money? Is it just paper money and coins? What about checking accounts? What about gift cards? Defining money -- that's the topic we're going to dive into next.