This is one of the two tools the government has to influence the overall economy. With monetary policy, a nation’s central bank takes action to influence the economy. In the United States, the Federal Reserve Board is the central bank. They regulate the interest rates and money supply available in the country to stabilize the national currency and to control inflation. Monetary policy is the sister policy to fiscal policy.
Monetary policy is effective because the Federal Reserve or other central bank is able to change the real cost of money. This allows them to influence business and consumer spending behavior and the amount of money they use. With this policy, central banks are able to mange their nation’s money supply. It allows them to oversee stable economic growth.
The money supply is made up of several components. These include cash, checks, credit, and money market funds. Credit is among the most important and biggest categories of money supply. It covers mortgages, loans, bonds, and other promises to repay.
There are two goals in which central banks utilize monetary policy. They are attempting to manage inflation levels and to lower unemployment rates. The United States Federal Reserve maintains particular target ranges in these two goals.
The Fed desires its core inflation rates to be around 2% and no higher than 2.5%. They are seeking to keep unemployment rates under 6.5%. The U.S. believes a healthy unemployment rate ranges from 4.7% to 5.8%. On top of this, the Federal Reserve is looking for steady rates of economic growth. By this they mean a yearly increase of from 2% to 3% in the Gross Domestic Product.
There are two types of monetary policies from which central banks can choose. They use expansionary monetary policy to increase economic growth. Central banks decrease interest rates, increase liquidity to the markets, and purchase securities from their member banks to affect this.
Central banks employ contractionary monetary policy to slow down economic growth. They may sell securities in open market operations, increase interest rates, and increase liquidity to banks and markets in order to create this impact. Central banks have several different tools they can utilize to pursue their monetary policy. They perform open market operations by purchasing short term government bonds or selling these. Buying bonds increases the money supply while selling them decreases it.
They can also raise or lower their main interest rates like Fed Funds rate in the U.S. or LIBOR in the U.K. This changes the price at which consumers and businesses can borrow money. Cheaper money means consumers purchase bigger, longer term goods using cheap credit. Businesses pursue expansion and hire more people with cheaper priced debt. Savers are encouraged to put their money into stocks and securities to earn higher returns than savings accounts pay when interest rate are low.
Central banks can also change the reserve requirements that banks must keep. Higher reserves reduce their ability to make loans and help to decrease inflation. Lower reserves allow them to make more loans but drive inflation higher.
Since the Great Recession in 2008, different central banks have engaged in more unconventional monetary policy in an effort to kick start declining economies. Quantitative Easing has been among these policies. It involves buying financial assets from banks with money the central banks print.
From 2008 to 2013 the U.S. Federal Reserve massively expanded its balance sheet by trillions of dollars by purchasing mortgage backed securities and Treasury notes. Encouraged by the relative success and so far limited consequences of these actions, the Bank of England, the Bank of Japan, and European Central Bank have also engaged in their own quantitative easing policies. Critics have warned that such quantitative easing will massively increase inflation at some point in the future.