How Monetary Policy and the Federal Reserve Create Loans, Combat Inflation, Encourage Growth

The Federal Reserve System (FED), the central bank of the United States, was created in 1913 to help stabilize the country’s financial system and regulate the money supply. But in the 1930s, it made a huge mistake, allowing several large banks to fail, causing widespread panic and runs on other banks. As a result, a third of banks collapsed because they had neither enough liquidity nor public confidence. This prolonged the Great Depression. FED leaders later conceded that they should have offered emergency loans to banks to keep them afloat and to insure they had liquid assets to make loans to businesses and credit-worthy individuals.

The FED, a supposedly independent federal agency free from political interference by short-sighted politicians mainly interested in re-election, is largely responsible for the nation’s monetary policy — setting interest rates on short-term borrowing, and controlling the money supply in an attempt to reduce inflation, keep prices stable, and to generally promote trust in the country’s financial system. The FED decides to either print money or decrease the money supply by raising interest rates or reducing reserves, to speed up or slow down the overall economy.

Aside from the 1930s, FED policies have been critical in history: in the mid-1970s and early 1980s to reduce stagflation — double-digit inflation and unemployment; in the 1990s and 2000s, when it let “irrational exuberance” create economic bubbles among the dot coms, which popped in 2000, and real estate, which popped in 2007, and sparked the Great Recession, 2008-12.

Monetary Policy and the Federal Reserve

This video from Crash Course Economics in 2015 is a bit dated, in that it focuses on former Fed Chairman Janet Yellen, who retired in 2018 and was replaced by Jerome Powell. But it provides decent background on the FED and its role in shaping monetary policy.

Crash Course Economics: “The reality of the world is that the United States (and most of the world’s economies) are, to varying degrees, Keynesian. When things go wrong, economically, the central bank of the country intervenes to try and get things back on track. In the United States, the Federal Reserve is the organization that steps in to use monetary policy to steer the economy. When the Fed, as it’s called, does step in, there are a few different tacks it can take. The Fed can change interest rates, or it can change the money supply.” Transcript.


Interest Rates

High interest rates

Low interest rates

Money supply

Tight money

Loose money

Expansionary Monetary Policy

Contractionary Monetary Policy



Liquid Assets




Fractional Reserve Banking

Reserve Requirement

Excess Reserves

Discount Rate

Open Market Operations

Quantitative Easing

Treasury bills

Mortgage Backed Securities




Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.