What is the role of monetary policy in business cycles?
Economists view monetary policy as the first line of defense against economic slowdowns because the Federal Reserve can act faster than the President or Congress, and it is better equipped to judge the appropriate timing and magnitude of economic stimulus.
The Federal Reserve can adjust monetary policy more quickly than the President and Congress can adjust fiscal policy. Because most contractions in economic activity last for only a few quarters, the timeliness of the policy response is crucial. Fiscal policy in practice responds slowly to changes in economic conditions: it takes time first to enact a stimulus bill and then to implement it, and time for the spending increases or tax reductions to reach consumers’ pockets. As a result, the effect of fiscal stimulus on household and business spending may come too late.
Whether and how much stimulus is needed depends on present economic conditions, on projections of likely future conditions, and on assessments of possible risks to both economic activity and inflation. Forecasting economic conditions—or even determining the current state of the economy—is inherently difficult, given limitations in the data available and in economists’ understanding of the world. But the Federal Reserve’s large and sophisticated team of analysts is better positioned to accomplish this task than any other agency of the federal government. In addition, the Federal Reserve staff carries out this work independent of political considerations.
Bernanke, Ben S. 2015. “How the Fed Saved the Economy.” Wall Street Journal. October 4.
Elmendorf, Douglas W., and Jason Furman. 2008. “If, When, How: A Primer on Fiscal Stimulus.” Tax Notes. January 28.
Elmendorf, Douglas W., and David Reifschneider. 2002. “Short Run Effects of Fiscal Policy with Forward-Looking Financial Markets.” National Tax Journal 55(3): 357–86.
Labonte, Marc. 2015. “Monetary Policy and the Federal Reserve: Current Policy and Issues for Congress.” Washington, DC: Congressional Research Service.