Monetary Policy and Government Intervention

Arend Pryor
Jan 2, 2022
7 min read

Updated: Jan 17, 2022

Author: Arend Pryor | Created: 06/10/2021

Details: Sharing content created as part of pursuing my MBA degree

Assignment Details: This assignment is comprised of the following two sections.

Federal Reserve

Analyze how changes in the Federal Reserve’s monetary policy affect at least 2 of the 4 components of GDP (e.g., consumption, investment, government spending, net exports). Justify your answer to the following question: Have the Federal Reserve’s countercyclical monetary policies been effective in moderating business cycle swings?

Government Intervention

Government interventions into markets can sometimes succeed, but sometimes they make the situation worse. Explore 2 examples of government intervention that did not work. Explain why the intervention made things worse and what could have been done differently to improve the situation. Support your analysis by including:

What was the situation?
What did the intervention look to solve?
What happened?
What might have been done differently?

Ronald Regan once said, “The most terrifying words in the English language are: I'm from the government and I'm here to help” (Zaharov, 2020). This quote aligns quote well with the topics for this post, which have to do with the government stepping in to help in different scenarios. The first of which has to do with the Fed applying monetary policies during times they deem necessary and the impact these policies have on Gross Domestic Product (GDP). Taking this a step further, we will also look at countercyclical monetary policies and the role they play in controlling swings in the business cycle or markets. Lastly, two examples of government intervention will be presented along with an analysis of how this involvement played out and make suggestions as to what could have been done differently.

Aggregate demand, also commonly known as gross domestic product (GDP), is a total measure of goods and services produced by a country within a specific period of time and is calculated based on the sum of consumer consumption, investments, government spending and net exports minus imports. These factors represent an important set of values to calculate and monitor, as this value can be an indicator of a country’s economic health and potential for growth (Hall, 2021).

As one might imagine, any changes made as a result of monetary policies such as expansionary or contractionary changes would have an impact on GDP. For example, during times of unemployment and recession, the Fed will typically take steps to implement expansionary policy measures with a goal of increasing the supply of money and decreasing interest rates, which should encourage consumption of goods and services by consumers as well as decrease interest rates leading to more lending via investments (McConnell et al., 2018).

Specifically, this happens as a result of open market operations where the Federal Reserve buys government bonds from banks, leaving them with more cash which in turn opens the doors to offering more loans at lower interest rates. Conversely, during times of increased inflation, the situation will often reach a point where the Fed looks to intervene and take a contractionary approach via monetary policy in order to slow the growth of aggregate demand. In this situation, the Federal Reserve will make changes that result in higher interest rates and a decrease in the money supply. Consequently, most businesses will not invest in physical capital and consumer spending will decrease, both of which are due to the higher interest rates.

Countercyclical monetary policies utilized by the Fed are typically put into action as a result of conditions seen in the marketplace that are either adverse or on their way to being so. As mentioned in the previous section, these actions can include attempts to boost GDP and employment by increasing the money supply and decreasing interest rates or they can be more restrictive by taking the opposite approach in order to prevent inflation from increasing (Mathai, 2020).

To aid in answering the question of whether the Federal Reserve’s countercyclical monetary policies have been effective in moderating business cycle swings, we will reference the chart in figure 1 below. This chart, identifies several instances, also referred to as episodes, where the Fed implemented countercyclical monetary policies that changed the federal funds interest rate and shows the outcome on the values for inflation and unemployment (Texas Education Agency, 2021).

Figure 1: Episodes (Texas Education Agency, 2021)

Based on an analysis of data from the chart above, it appears that over time, these policies have for the most part been effective, however, some events have required additional intervention steps. This can be seen in the way the inflation rate has directly responded to changes made by the Fed to the Federal funds interest rate during episodes 1, 2, 3, 6 and 9.

The same can be said, to some extent for the unemployment rate, which has also responded during times of monetary policy changes. However, the intention here is to have an inverse relationship. For example, during episode 3, inflation was on the rise, which prompted the Fed to use contractionary monetary policy to increase the federal funds rate from 6.6% to 9.2% by 1989, leading to a rise in unemployment from 5.3% to 7.5% by 1992 (Texas Education Agency, 2021).

While not every episode reacts in exactly the same way, modifications to the federal funds interest rate have resulted in changes to the other two factors. Additionally, while inflation and unemployment are impacted as a result of changes in the federal funds interest rate, results are somewhat delayed in that they take time to build up or require more involvement.

The power wielded by the Fed via monetary policy is one that can have a tremendous impact on market conditions, both good and bad. In this section we look at two situations where this type of government intervention led to negative outcomes. The first of which was the recession experienced during 1990 and 1991, which was also touched on above.

As the 1980’s were coming to an end, inflation looked to be increasing as it rose from 2% to 5% by 1989. Seeing this, the Fed stepped in and over a period of time, implemented contractionary monetary policy by raising the federal funds rate with the intention of slowing the rate of GDP growth and decreasing inflation. Unfortunately for the U.S. and our economy, the Gulf war began to take shape as of August 1990 and added to the economic problems being faced during this time. Increased oil prices and decreases in economic activity were also a result.

The effects of monetary policy during this time were not fully able to prevent the recession during this time, however, as the Fed continued to apply contractionary measures, things began to turn around as of March 1991 (Feldstein, 1992). Based on my research, I feel the Fed could have reacted quicker to indications of rising inflation prior to 1990 and introduced a stimulus package following the Gulf War to help get things back on track.

Another example of government interference in the economy deals with Nixon’s oil crisis between 1971 and 1973, also known as the 1973 Oil Embargo. Prior to the embargo of 1973, 37th president Richard Nixon implemented a new economic policy aimed at fighting inflation, by freezing wages and prices for a 90 day lockout period. This intervention worked in that it helped stabilize the economy, however, once removed, inflation again started to rise which led the president to implement the same controls and hopeful for the same results. The difference during the second undertaking of this initiative was that it took place during the 1973 Oil Embargo where Arab participants of the Organization of Petroleum Exporting Countries (OPEC) refused to sell oil to the U.S. due to the support they provided to the Israeli military along with other factors that contributed. This resulted in sky high oil prices in the U.S., long lines at the gas pump, and record losses in the stock market (Palmer, 2020).

Although it is tough to say what could have been done differently during this time, one thought is that the U.S. could have been quicker to initiate talks with members of OPEC to help resolve the issue or Nixon and his administration could have done more analysis of the results they were seeing and taken a different approach to combat the inflation being faced. Despite the hardships during this time period, there were several benefits that resulted from this event such as initiatives dedicated to energy conservation, the 55 mile per hour speed limit, and investing in energy research (Hunt, 2014).

In many circumstances, government involvement seems to be an unavoidable fact of life as there are numerous opportunities for their agencies to become involved. In this paper, we first focused on the involvement of the Fed by way of implementing monetary policies and how this directly impacts the factors used to calculate GDP. Next we looked at countercyclical monetary policies and how they are used to inhibit or promote the flow of money and growth within our economy and that at times, this can be a lengthy process that requires frequent monitoring. Finally, we reviewed examples of government involvement and how they played out during the 1990 recession as well as during the 1973 Oil Embargo. In some instances, this involvement eventually provided the benefits needed to get things back on track, while in other situations, this involvement proved to hinder and lead to additional problems. As markets and the conditions that impact their outcomes continue to evolve, the way in which governments get involved and the actions they take will also continue to develop, hopefully, leading to a prosperous economy.