One of the most powerful tools the Fed has to accomplish this is open market operations- the buying and selling of government bonds by the Fed (Mankiw, 2012, p. 94). According to the monetary policy, if the interest rate is not at the Fed’s target level, the Fed can buy or sell government bonds to either decrease or increase the money supply, respectively. Decreasing the money supply means that the demand for money rises because there is less available. An increase in demand results in an increase in price; the price of money is the interest rate. Similarly, increasing the money supply decreases its demand and thus lowers the interest rate. The Fed can also affect the interest rate by changing the reserve ratio requirements, which are a component of the money multiplier in the money supply equation, or by changing the Federal Funds Rate, the rate at which the Fed lends reserves to banks (Mankiw, 2012, p. 91). The interest rate affects GDP, unemployment, and prices.
The interest rate is inversely related to the level of investment. This means that a higher interest rate results in a lower level of investment, and because investment is a component of the national accounts identity, this results in GDP decreasing as well (Mankiw, 2012, p. 96). The changed interest rate also changes the amount of money people demand, as the interest rate represents an opportunity cost of holding money. As the interest rate rises, the demand for money decreases and vice versa. But as money demand and money supply in equilibrium determine the price level, a changed money demand curve changes the equilibrium and thus the price level (Mankiw, 2012, p. 113). The interest rate can also have an effect on employment. If the interest rate decreases, investment rises, GDP rises, and people are willing to consume more in all forms because it is cheaper to borrow. This means there is higher aggregate demand and so employers must hire more labor to meet demand, and because it is cheaper to borrow they are willing to spend the extra money on labor.
Mankiw, Gregory N. (2012). Macroeconomics, Eighth Edition. International Version. UnitedStates of America: Worth Publishers.