When we drive a car, we need to adjust our driving speed to match the road conditions.

Similarly, the Fed will tighten or loosen monetary policy accordingly.

In this video, we will learn what contractionary monetary policy and expansionary monetary policy are

and how monetary policy can steer our lives and investments.

Contractionary monetary policy

Suppose the economy is too hot and inflation remains high.

What could the Fed do?

Yes, it's time to cool down the economy.

The Fed tends to tighten monetary policy like tapping the brakes.

The Fed could raise the target range for the federal funds rate and send a negative signal with the forward guidance.

What might happen next?

1. Borrowing costs may rise

Banks increase interest rates for consumer and business loans.

Many people would be under heavy pressure from car and home loans.

Many companies tend to reduce costs and even lay off employees for profitability.

2. Prices of daily necessities may go down

Under increasing financial pressure, people are likely to save money and, therefore, less confident to spend.

But when supply gradually exceeds demand for a good, prices may slowly return to normal.

3. Less US dollars are in circulation

Currency liquidity tightens, and the dollar appreciates against other currencies.

It is good for US imports, not for exports.

US companies relying on overseas sales are likely feeling the pain.

4. As for investments, you may have heard the saying, "Don't fight the Fed."

It is a phrase coined by Martin Zweig, a famed investor, in his book "Winning on Wall Street".

It suggests the strong relationship between Fed policy and the stock market.

Historically, some growth stocks could face challenges at this time.

Investors generally want to avoid risks.

Therefore, growth stock prices may have substantial volatility, but value investing may become more attractive.

Investors are more likely to save money and move towards interest-bearing assets for safety and higher interests.

With such efforts, the Fed could dampen inflation and stabilize the economy.

Expansionary monetary policy

Conversely, what could happen if the economy is in recession and many people are already unemployed?

The Fed may consider easing monetary policy, like stepping on the gas for the economy.

The Fed may consider lowering the target range for the federal funds rate and sending a positive signal with the forward guidance.

1. As a result, the borrowing costs may decrease

Banks are willing to lend money.

Companies are encouraged to borrow money to invest in new equipment and hire more employees.

2. Consumer confidence may rise

Economic expectations of households and businesses become optimistic.

Instead of savings, people would be more willing to spend more on cars, houses, and services.

3. More US dollars are in circulation

Currency liquidity is easing, and the US dollar depreciates.

It helps US exports and encourages foreigners to travel to the US.

4. More active Investments

Some entrepreneurs and investors tend to take more risks, and many asset prices could potentially rise.

The stock market would likely be in full swing again.

QE and QT: The unconventional monetary policies

When the federal funds rate is zero or too high, the conventional monetary policy can't play a useful role.

In this situation, the Fed could employ unconventional monetary policies including Quantitative Easing (QE) and Quantitative Tightening (QT). QE is an expansionary monetary policy that increases market liquidity by purchasing government bonds, while QT is a contractionary monetary policy that typically occurs when the Fed sells government bonds or allows their holdings to mature without replacement.

Conclusion: The transmission of monetary policy

The main goals of the Fed are price stability and maximum employment.

To achieve its goals, the Fed could change the target for federal funds rates that help to determine short-term debt credit.

Moreover, the Fed's forward guidance could also send a signal.

Finally, these actions influence our overall financial conditions, including our lives and investments.