Understanding Monetary Policy

Federal Reserve and the nation’s central bank can influence the amount of money (or supply of money) and credit in the US economy with monetary policy.  The Federal Reserve have many goals, but their main goal is to promote employment (less than 6% unemployment), stable prices (2 to 3% inflation), seek healthy economic growth (2-3% increase in GDP), and stabilize moderate long term interest rates (they have been serving as a bank regulator since 2009), so they can prevent financial crisis like the one from 1907 (their primary objective is inflation, unemployment comes after).  Feds are dual mandate, but they focus on inflation/deflation first before employment.

With monetary policy, the Fed can maintain stable prices, thus supporting conditions for long term economic growth and employment.  The difference between monetary and fiscal policy is that fiscal refers to taxes and government borrowing and spending.  Central banks are independent from other policy makers (government), thus separating itself from fiscal policy.  The fed is subject to oversight from congress, but it doesn’t need approval from president or anyone else in the government for its decisions. Federal Reserve’s core role is to be the last resort lender, meaning they don’t want to provide banks with liquidity to prevent bank failures like the one from 1907.  If they want to be the last lender, they must have some sort of a tool to do this.

One of the tool is called Federal funds rate (the rate that banks charge each other for short term loans).  This is important because it gives them the power to influence the level of short term market interest rates.  By adjusting this, the Federal Reserve can also influence longer term interest rates and key asset prices. Monetary policy can be broken down to two broad types, which are expansionary and contractionary.  Expansionary monetary policy will increase the money supply in order to lower unemployment while contractionary does the opposite and decreases the money supply.  Increasing money supply means lower interest rate, thus increasing consumer spending, which will stimulate economic growth.  If the money supply decreases, it will increase unemployment, depress borrowing, and lower spending by consumers.

A good example of contractionary monetary policy was in 1980s by Federal Reserve’s when they increased the interest rate, causing a recession (They did it to keep spiraling inflation in check). (FOMC) stand for Federal open market committee.  FOMC are the people who formulates the nation’s monetary policy.  FOMC is made up of seven members of the board of governors, the president of the federal reserve bank of New York and presidents of four other reserve banks who serve on a one year rotating basis.  FOMC meets about 8 times a year at the capital to discuss the outlook of US economy and monetary policy options.

There are many monetary policy instruments that Feds use, such as, Open market operations, benchmark interest rate, discount rate, and reserve requirements.  Open market operations is the most used, since Fed can’t
decide on its own who they will do business with (it’s called open market for a reason).  It is basically buying and selling government securities/bonds in open market with dealers competing on the basis of price.  By doing this, they can either contract it (selling bonds means government will hold the money instead) or expand it (buying short term
bonds from people and giving them money plus interest for the bonds they’ve invested in).

Benchmark interest rates (ex: Fed funds) can affect demand for money by either raising or lowering the cost to borrow.  This means less liability, which encourages firms to take on more debt to invest for growth.  In essence, this will make consumers make more purchases, companies hire and expand, and consumers invest in long term stocks or assets instead of keeping their money in the bank (why would they keep money in the bank when there are better places that can promote your asset’s growth?).

Discount rate, which is the interest rate charged by the Federal Reserve to depository institutions on short term loans (what this does is influence the rate at which banks lend to each other as well as savings accounts, student loans, mortgages, and more ) is Fed’s favorite tool.  This is when FOMC set a rate higher than the Fed funds rate so banks can borrow from each other instead. The reserve requirements are portions of deposits that banks must maintain either in the vaults or on deposit at the bank reserves.  Higher requirements means less money, which is done to control inflation.  If it weren’t for this requirements, banks would lend 100% of the money consumer’s deposit.  This was actually quite common before 1913, and many people couldn’t take cash out from their own bank. Money and credit can affect numerous factors that revolves around us, such as the interest rates and the performance rate of US economy.  There are many ways to apply monetary policy to better control the performance of the economy.  Quantitative easing (purchase of varying financial assets from
commercial banks) raise the price of securities, therefore lowering their yields, as well as increase total money supply.

Credit easing involves the purchase of private sector assets to boost liquidity (how fast it can turn
into cash).  Finally, there is signaling, which tells the markets to not worry about policy changes because they promise not to change the interest rates for a given number of quarters. Conducting the country’s monetary policy is the Federal Reserve Bank’s job. It’s made to pursuit good employment percentage, supervise and regulate
other banks, ensure safety and protect the credit rights of the people, maintain financial markets and prices, provide financial services to the US government, institutions, foreign official institutions, play a role in operating and overseeing nation’s payment systems, and much more.

Fiscal policy is almost always expansionary, however, during the great recession fiscal policy became contractionary when it needed to be expansionary.  This was because the politicians became too concerned about the US debt (ironic, isn’t it?).  It was good thing that the Fed used quantitative easing to increase the supply of money at the time. In an ideal world, fiscal and monetary policies should work together, but it will never happen since the Feds main goal is to control inflation.

3 thoughts on “Understanding Monetary Policy

  1. The term “monetary policy” refers to what the Federal Reserve, the nation’s central bank, does to influence the amount of money and credit in the U.S.

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