A major factor in a nation's economy is its monetary policy, which determines the amount of money flowing through the economy.
Set by the Federal Reserve in the United States, monetary policy influences economic activity by controlling the country's money supply and credit. The Federal Reserve can control 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 the power over the country's monetary policy. Since then, the importance of monetary policy has increased tremendously.
The goals of monetary policy, as stated in the Federal Reserve Act of 1913, are to encourage maximum employment, stabilize prices and moderate long-term interest rates. When implemented correctly, monetary policy stabilizes prices and wages, which, in turn, leads to an increase in jobs and long-term economic growth. U.S. monetary policy plays a significant role in not just the economy as a whole but also specific decisions consumers make, such as buying a home or a 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) determine monetary policy. The key to setting monetary policy is finding the perfect balance; letting the money supply grow too rapidly increases inflation, and allowing it to grow too slowly stunts economic growth. A common misperception 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. Fiscal policy refers to the tax and spending policies of the federal government.
Types of monetary policy
There are two main types of monetary policy:
Contractionary monetary policy. This type of policy is used to decrease the amount of money circulating throughout the economy. It is most often achieved by actions such as selling government bonds, raising interest rates and increasing the reserve requirements for banks. This method is used when the government wants to avoid inflation.
- Expansionary monetary policy. The purpose of this type of monetary policy is to increase the money supply within the economy by completing actions such as decreasing interest rates, lowering reserve requirements for banks and purchasing government securities by central banks. This type of monetary policy helps to lower unemployment rates as well as stimulate business activities and consumer spending. The overall goal of this policy is to fuel economic growth. Nevertheless, it can also have an adverse effect, occasionally leading to hyperinflation.
Tools of monetary policy
When setting monetary policy, the Federal Reserve has several tools at its disposal, including open market operations, the discount rate and reserve requirements. 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 both short- and long-term interest rates and 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.
What are the three objectives of monetary policy?
No matter what type of monetary policy is being used, it is always connected to one of the following three objectives:
Manage inflation. Most economists consider this the one true objective of monetary policy. In general, low inflation is most conducive to a healthy, thriving economy. Therefore, when inflation is on the rise, the Federal Reserve may adjust monetary policy to reduce inflation.
Reduce unemployment. During depressions and recessions, unemployment rates tend to soar. However, monetary policies also play a major role in unemployment rates. Once inflation issues have been addressed, expansionary policies can then be implemented to help reduce unemployment rates. This works because the increase in the money supply helps to stimulate the business sector, which also helps to create more jobs. While there may be no way to fully achieve true full employment, the goal is to reduce the rate of unemployment among those who are ready and willing to work for the existing wages.
- Balance currency exchange rates. Given that stable exchange rates play such a major role in international trade, it's essential to find ways to keep them balanced. Central banks have the power to regulate exchange rates between foreign and domestic currencies. For instance, if the central bank opts to issue more currency to increase the money supply, domestic currencies become cheaper than foreign currencies.