How does the Federal Reserve affect inflation and employment?
As the Federal Reserve conducts monetary policy, it influences employment and inflation primarily through using its policy tools to influence the availability and cost of credit in the economy.
The primary tool the Federal Reserve uses to conduct monetary policy is the federal funds rate—the rate that banks pay for overnight borrowing in the federal funds market. Changes in the federal funds rate influence other interest rates that in turn influence borrowing costs for households and businesses as well as broader financial conditions.
For example, when interest rates go down, it becomes cheaper to borrow, so households are more willing to buy goods and services, and businesses are in a better position to purchase items to expand their businesses, such as property and equipment. Businesses can also hire more workers, influencing employment. And the stronger demand for goods and services may push wages and other costs higher, influencing inflation.
During economic downturns, the Fed may lower the federal funds rate to its lower bound near zero. In such times, if additional support is desired, the Fed can use other tools to influence financial conditions in support of its goals.
However, there are many factors that affect inflation and employment. And while the linkages from monetary policy to both inflation and employment are not direct or immediate, monetary policy is an important factor.
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Last Update: August 27, 2020
