How can the Fed increase aggregate demand?

Aggregate demand is a measure of the total consumption of goods and services over any time period and is the most important ingredient that can be targeted by the government through fiscal or monetary policy.

The Federal Reserve's direct effect on aggregate demand is mild, although the Fed can increase aggregate demand in indirect ways by lowering interest rates. When it lowers interest rates, asset prices climb. Higher asset prices for assets such as homes and stocks boost confidence among consumers, leading to purchases of larger items and greater overall spending levels. Higher stock prices often lead to companies being able to raise more money at cheaper rates.

The mandate of the Fed is to balance the competing goals of employment and price levels. However, aggregate demand is an important component in both of these measures. Therefore, the Federal Reserve is deeply concerned with it. When resources are constrained and there is an increase in aggregate demand, inflationary risks increase. If the total consumption of goods and services in the economy decreases, businesses have to let go of workers in response to the declining revenue.

Fiscal policy is a much more direct way to affect aggregate demand as it can put money directly in the hands of consumers – especially those who have the greatest marginal propensity to spend. This increased spending leads to positive spillover effects such as businesses hiring more workers.

Some typical ways fiscal policy is used to increase aggregate demand include tax cuts, military spending, job programs and government rebates. In contrast, monetary policy uses interest rates as its mechanism to reach its goals.

The Federal Reserve's largest effect in boosting aggregate demand is to create supportive financial conditions. It lacks the tools to generate aggregate demand in the way of fiscal policy, but it can create an environment in which low interest rates lead to lower borrowing costs and higher asset prices, which is supportive of increased spending and investing.

Of course, spending and investing play a large role in determining economic activity in the short- and long-term. Therefore, in some ways, the Federal Reserve is like an accelerator for the economy.

In certain circumstances, monetary policy can be quite ineffectual in increasing aggregate demand. One such time period was the recovery after the Great Recession. The financial crisis left serious scars on consumers and businesses. During this time, fiscal policy was not aggressive enough to close the gap between the actual measure of aggregate demand and the ideal level of aggregate demand. While the economy limped along – growing at an anemic pace – all sorts of financial assets were very strong.

Bond markets, stock markets and commodities hit all-time highs within five years of the bottom in asset prices of March 2009. Economic conditions slowly improved, but many people were left out of the recovery. This divergence highlights the limitations of monetary policy in such circumstances.

Meanwhile, gridlock in Congress led to a complete halt to any discussions of fiscal policy. The Federal Reserve started buying billions of dollars worth of bonds to improve liquidity and financial conditions. Given the lackluster recovery, it failed to generate aggregate demand.

Critics of the Federal Reserve highlight this as evidence its policies are ineffective in helping the middle class. Additionally, they say that the fruits of easy financial conditions flow to those who own assets. Easy financial conditions lead to asset bubbles, which can create wasteful investment, wealth destruction and harm to the economy.

Defenders of monetary policy argue that without monetary policy, the economy would be much worse. However, it is difficult to quantify. One comparison is the relative outperformance of the United States versus Europe or Japan. The Federal Reserve was much more aggressive than these central banks, and it resulted in higher growth rates.