What Is Monetary Policy?
Let me explain monetary policy directly: it's the set of tools a nation's central bank uses to control the overall money supply and promote economic growth. This involves strategies like adjusting interest rates and changing bank reserve requirements. In the United States, the Federal Reserve Bank, or Fed, implements this to meet its dual mandate from Congress: achieving maximum employment while keeping inflation in check.
Understanding Monetary Policy
You need to understand that monetary policy controls the quantity of money available in an economy and the channels by which new money is supplied. Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry-specific growth rates influence the strategy. A central bank may revise the interest rates it charges to loan money to the nation's banks. As these rates rise or fall, financial institutions adjust their rates for customers, such as businesses or home buyers. This can either slow or encourage borrowing, spending, business activity, hiring, and economic growth. It can also affect the rate of inflation. Additionally, a central bank may buy or sell government bonds, target foreign exchange rates, and revise the amount of cash that banks are required to maintain as reserves.
Types of Monetary Policy
Monetary policies are either expansionary or contractionary, depending on the economy's growth or stagnation. A contractionary policy increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where prices of goods and services rise and reduce money's purchasing power. During times of slowdown or recession, an expansionary policy supports economic activity by lowering interest rates, making saving less attractive, and increasing business and consumer borrowing and spending.
Goals of Monetary Policy
One key goal is managing inflation: contractionary policy tempers it by reducing money in circulation, while expansionary policy increases money and fosters inflationary pressure through greater activity. For unemployment, expansionary policy decreases it as a larger money supply and attractive interest rates stimulate business activities and job market expansion. Exchange rates between domestic and foreign currencies can also be affected; an increase in money supply makes the domestic currency less attractive and cheaper relative to others.
Tools of Monetary Policy
The Fed uses three main tools: reserve requirements, the discount rate, and open market operations. In open market operations, the Fed buys bonds from investors or sells them to adjust money available in the economy, aiming to manipulate short-term interest rates that affect others. For interest rates, the central bank changes rates or required collateral; in the U.S., this is the discount rate, which influences what banks charge customers and how freely they loan. Reserve requirements govern funds banks must retain as a proportion of deposits to meet liabilities; lowering them releases capital for loans or assets, while increasing them curtails lending and slows growth.
Monetary Policy vs. Fiscal Policy
Monetary policy is enacted by a central bank to sustain a level economy, keep unemployment low, protect currency value, and maintain activity through interest rates, reserve requirements, or open market operations. Fiscal policy, used by governments but not central banks, involves spending and taxing; the U.S. Treasury creates money and implements tax policies to add money into the economy, increasing spending and growth. Both were used in response to the COVID-19 pandemic.
Frequently Asked Questions
You might wonder how often monetary policy changes: the Federal Open Market Committee meets eight times a year to determine changes, and the Fed may act in emergencies, like during the 2007-2008 crisis or COVID-19. On curbing inflation in the U.S., contractionary policy slows growth and can increase unemployment but is necessary; in the 1980s, the Fed raised rates to 20%, spurring a recession but reducing inflation to 3-4%. The Fed is called a lender of last resort because it provides liquidity and regulatory scrutiny to prevent bank failures and financial panic.
The Bottom Line
In summary, monetary policy employs strategies and tools to keep a nation's economy stable while limiting inflation and unemployment. Expansionary policy stimulates a weakening economy, while contractionary slows an inflationary one. It's often coordinated with fiscal policy.
Key Takeaways
- Monetary policy controls a nation's overall money supply for economic growth.
- Strategies include revising interest rates and changing bank reserve requirements.
- It is classified as either expansionary or contractionary.
- The Fed uses three main tools: reserve requirements, the discount rate, and open market operations.
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