A major factor in a nation’s economy is its monetary policy, which determines the amount of money circulating throughout the economy. In the United States, the Federal Reserve sets monetary policy, which influences economic activity by controlling the country’s money supply and credit. The Federal Reserve controls monetary policy by altering rates of interest and changing the amount of money banks must have in their reserves.
The Federal Reserve Act of 1913 officially gave the Federal Reserve power over the country’s monetary policy. Since then, monetary policy’s importance has increased tremendously.
The goals of monetary policy, as stated in the Federal Reserve Act of 1913, are to encourage the following:
When implemented correctly, monetary policy stabilizes prices and wages, which, in turn, increases available jobs and long-term economic growth. U.S. monetary policy plays a significant role not only in the economy as a whole but also in specific decisions consumers make, such as buying a home or car, starting and expanding a business, and investing money.
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) determines monetary policy. The key to setting monetary policy is finding the perfect balance – letting the money supply grow too rapidly increases inflation, but allowing it to grow too slowly stunts economic growth.
A common misconception about monetary policy is that it is the same as fiscal policy. While both can be used to influence the economy, the federal government, as opposed to a central bank like the Federal Reserve, sets fiscal policy.
The government uses fiscal policies to set a target for the country’s level of spending and to determine how money is being used in an economy. For example, if the government doesn’t see enough stimulus, it can encourage spending by increasing its own expenditures. Monetary policy, on the other hand, is mainly a tool for inflation and growth. It doesn’t have as large an impact on the economy as fiscal policy.
Fiscal policy affects consumers by influencing their tax bills or providing them with government employment. Monetary policy impacts consumers by creating a boost in spending and changing the interest for loan rates and credit cards. [Read related article: How to Accept Credit Cards at Your Businesss]
There are two main kinds of monetary policy: contractionary and expansionary.
Monetary policies can either increase or decrease the money supply circulating within the economy.
When setting monetary policy, the Federal Reserve has several tools at its disposal, including open market operations, the discount rate, reserve requirements and interest rates on excess reserves. The FOMC, which comprises members of the Board of Governors of the Federal Reserve System and five Reserve Bank presidents, is responsible for open market operations, while the board of governors sets the discount rates and reserve requirements.
Open market operations, the most flexible and commonly used way of implementing monetary policy, revolve around the buying and selling of government securities on the open market. Open market operations expand or contract the amount of money in the U.S. banking system.
Adjusting the amount of money in the banking system alters the federal funds rate, which is how much it costs banks to borrow money from each other. A low federal funds rate stimulates the economy by encouraging consumer spending through lower interest rates, while a high federal funds rate slows the economy by raising interest rates and discouraging consumers from spending.
Changes in the federal funds rate can affect a wide range of economic conditions, including short- and long-term interest rates, as well as foreign exchange rates.
Another tool the Federal Reserve uses in setting monetary policy is raising and lowering the discount rate, which is the rate the Federal Reserve Bank charges other banks to borrow money on a short-term basis. Higher discount rates signify a more restrictive policy, while lower rates signal a more expansive policy.
The third tool used is the reserve requirement, which is the amount of cash all commercial banks, savings banks, savings and loans, credit unions, and U.S. branches and agencies of foreign banks must have on hand or as reserve account balances at a Reserve Bank. When the reserve requirement is lowered, there’s more capital for banks to gain assets.This increases the amount of loans available for consumers. When the reserve requirement is raised, the exact opposite effect occurs, and there are fewer loans and less capital to spend.
The fourth tool is not a traditional one, as it was created during the 2008 financial crisis when the amount of reserves in banks increased so much that it exceeded requirements. To mitigate this, the Federal Reserve began to pay interest on the excess. In times of financial crisis, the Federal Reserve will lower the excess reserve interest rates if it wants to increase lending and will raise rates to decrease lending.
No matter what type of monetary policy is being used, it is always connected to one of the following three objectives.
Monetary policy has an indirect effect on businesses, mainly through interest rates. As the Federal Reserve changes the economy, banks will choose their interest rates for loans and credit cards. For example, low interest rates are seen as favorable changes since businesses have lower interest expenses and consumer spending increases. These changes can also have an influence over stock prices which can impact the consumer’s comfort level for purchases.
Changing interest rates may also alter exchange rates and can affect companies that outsource employees or work with businesses in other countries. When the rate is higher, the dollar is closer to the amount of other countries’ currencies. This lowers the import and export costs for businesses in the United States. Lower interest rates can decrease the exchange rate and create higher import and export costs.
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