What Is the Purpose of Monetary Policy?

July 27, 2023
10 MIN READ
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Central banks use monetary policy to govern the distribution of money in a country's economy. A central bank uses monetary policy to raise or reduce the quantity of money and credit in circulation in an ongoing attempt to keep inflation, growth, and employment on track. The Federal Reserve is in charge of monetary policy in the United States. Congress has given the Fed a "dual mandate" to accomplish with monetary policy: promote employment while maintaining stable prices. This indicates that the Fed wants to keep unemployment low, but not at zero, to boost productivity while avoiding rising inflation. There is no formal goal range, although traditionally, the Fed has aimed to keep unemployment between 3.5% and 4.5%. Regarding inflation, the Fed usually aims for a 2% average annual price rise.

What is monetary policy?

Monetary policy is a fiscal strategy that governs the amount and growth rate of an economy's money supply. It is an effective instrument for controlling macroeconomic factors like inflation and unemployment. These policies are achieved through many mechanisms, including the purchase or sale of government assets, interest rate adjustments, and changes in the cash circulating in the economy. The central bank or a comparable regulatory entity develops these policies.

Perception monetary policy

The monetary policy regulates the amount of money accessible in an economy and the routes through which new money is provided. Economic indicators such as inflation, GDP, industry, and sector-specific growth rates impact the monetary policy approach.

A central bank may change the interest rates it charges on loans to the country's banks. As interest rates rise or fall, financial organizations, such as corporations and property buyers, modify rates for their customers. It may also set foreign exchange rates, purchase or sell government bonds, and modify the cash banks must keep as reserves.

Types of monetary policy

Monetary policy may be classified into two types based on the economic situation: expansionary monetary policy and contractionary monetary policy.

·       Expansionary monetary policy

Expansionary policy, often known as loose monetary policy, expands the availability of money and credit to stimulate economic development. During difficult economic circumstances, a central bank may use expansionary monetary policy to reduce joblessness and stimulate growth.

It normally achieves this by decreasing the standard federal funds rate or the interest rate at which financial institutions lend to one another to meet reserve requirements. Although the Federal Reserve cannot enforce a particular federal funds rate in the United States, it may set guidelines and affect the rates banks charge each other by changing the availability of money. As a result, other interest rates, such as those used by banks when lending money to customers, may fall, boosting consumer spending through greater credit and lending across the country.

·       Contractionary monetary policy 

Contractionary policy, often known as tight monetary policy, reduces a country's money supply to control inflation and maintain the economy in balance. A central bank will almost certainly raise interest rates to curb the expansion of money and prices.

For example, during the start of the 1980s, when inflation in the United States reached about 15%, the Fed rapidly hiked interest rates to nearly 20%. While this action caused a countrywide recession, it also restored inflation to about 3%, laying the groundwork for a healthy U.S. economy for the rest of the decade.

Monetary policy purposes

Monetary policy's principal goals are controlling inflation or unemployment and stabilizing currency exchange rates.

·       Inflationary pressures

Inflationary policies can be targeted. A low amount of inflation is thought to be beneficial to the economy. When inflation is high, a contractionary policy can help.

·       Lack of employment

Monetary policies can alter the degree of joblessness in the economy. For instance, an expansionary monetary policy typically reduces unemployment because an increased money supply increases economic activity, which leads to job market expansion.

·       Currency rate of exchange

A central bank can manage exchange rates between local and foreign currencies using its budgetary authorities. The central bank, for instance, may raise the money output by issuing additional currency. In such a circumstance, the native currency becomes less expensive than its international counterparts.

Strategies of monetary policy

     i.   The federal funds rate

This is the target interest rate established by the Federal Open Market Committee (FOMC) at its eight annual conferences. It is sometimes referred to as the fed funds rate or the fed funds target rate. When commercial banks lend surplus reserves to one another overnight, they use the fed funds rate as a reference.

    ii.   Requirements for reserves

The Fed monitors reserve requirements, or the amount of cash banks must maintain to comply with banking laws. To guarantee that money is accessible should clients want it, those reserves must be secured in bank vaults or deposited with a licensed Federal Reserve Bank. The Fed could motivate banks to lend more money by decreasing the cash they must maintain. Yet boosting that threshold might have the opposite effect.

   iii.   Market operations are now open

The Fed buys and sells sovereign securities on the open market, such as Treasury bills and bonds. The Fed raises the quantity of money circulating by buying back assets; selling securities reduces the supply. Originally, open market operations have been the most often employed technique for implementing monetary policy.

    iv.   The rate of discount

The Fed charges this interest rate on short-term loans to financial organizations. These loans are often intended to fulfill reserve requirements or liquidity difficulties that banks cannot meet through loans from other banks that provide a lower fed funds borrowing rate. Discount rates are often rather high when the U.S. economy runs on all cylinders because the Fed does not need to make taking out loans cheap to promote activity. However, when the economy is in a recession, the Fed frequently reduces interest rates to stimulate lending and credit to people and firms.

     v.   QE (quantitative easing)

Like the Federal Reserve, a central bank utilizes its huge cash reserves to purchase large-scale financial assets through QE, such as government and corporate bonds and equities. This might seem comparable to open markets, but quantitative easing frequently occurs on a much larger scale in more dire circumstances, involves purchasing more than just shorter-term government bonds, and in general, comes about when interest rates have reached at or near 0%, indicating that the Fed has fully extended one of its main weapons. Nevertheless, central banks must exercise caution with QE since continuous large-scale asset purchases might lead to economic situations that monetary policymakers do not desire, such as increased inflation and asset bubbles.

    vi.   Public service announcements (PSAs)

A central bank will declare to financial markets and the broader public its general perspective on the economy and any policy steps it takes while conducting a country's monetary policy. These PSAs may impact the financial platform and economic sector in approaches the central bank seeks.

The contrast between monetary policy and fiscal policy

A central bank implements monetary policy to maintain a stable economy, keep unemployment low, safeguard the currency's value, and promote economic growth. A central bank influences borrowing, spending, and savings rates by adjusting interest rates or reserve requirements or conducting open market operations.

Fiscal policy is an instrument employed by governments rather than central banks. While the Federal Reserve can impact the money supply in the economy, the United States Treasury Department can issue new money and impose new tax policies. It injects money into the economy, either directly or indirectly, to encourage expenditure and stimulate growth.

Several government and Federal Reserve policies implemented in response to the COVID-19 epidemic included monetary and fiscal mechanisms.

Mechanisms of transmission

Monetary policy changes have a significant impact on aggregate demand and, consequently, on production and prices. Policy acts can be transferred to the actual economy in various ways.

People have usually focused on the interest rate channel. Borrowing prices rise when the central bank tightens, for example, and people are less inclined to buy products they would typically finance, such as houses or vehicles. At the same time, firms are less likely to invest in new equipment, software, or structures. Lower inflation would be compatible with this lowered level of economic activity because lower demand normally equals lower pricing.

An increase in interest rates also tends to decrease the net worth of enterprises and people (the so-called balance sheet channel), making it more difficult for them to be eligible for loans at any interest rate, decreasing expenditure and pricing pressures. A rate rise also makes banks generally less lucrative and less likely to lend—the bank lending channel. High-interest rates typically contribute to currency appreciation as foreign investors seek bigger returns and raise their demand for the currency. Exports fall as prices rise, but imports climb as prices fall. As a result, GDP decreases.

Through expectations—the automatic aspect of inflation—monetary policy has a significant extra influence on inflation. Many pay and price agreements are made in advance, depending on inflation estimates. If officials raise interest rates and convey that further rises are on the way, the public may be convinced that authorities are serious about controlling inflation. Long-term contracts will thus include relatively modest pay and price increases over time, keeping real inflation low.

A decline in rates

Following the global financial crisis in 2008, central banks worldwide slashed policy rates dramatically, in certain instances to zero, thereby exhausting the capacity for decreases. Nonetheless, they have developed novel methods to maintain policy easing.

One strategy has been to buy huge volumes of financial products on the open market. This is known as quantitative easing, and it involves the central bank expanding its balance sheet and injecting fresh money into the economy. Banks receive extra reserves (deposits at the central bank), and the money supply expands.

Credit easing, a very similar alternative, may likewise increase the size of the central bank's balance sheet, but the emphasis is on the contents of that balance sheet—the sorts of assets bought. Many specialized credit markets were blocked during the crisis, causing the interest rate channel to fail. Central banks responded by explicitly targeting certain troubled markets. For example, the Fed established a special facility to purchase commercial paper (extremely short-term corporate debt) to ensure that firms could continue obtaining operating cash. It also purchased mortgage-backed securities to keep housing financing afloat.

Some claim credit easing combines monetary and industrial strategy, with the central bank assuring money circulation to specific market segments. However, quantitative easing is not without controversy. It requires acquiring a more "neutral" asset, such as sovereign debt, but it shifts the central bank's focus to supporting the government's budget imbalance, thereby jeopardizing its independence.

Monetary policy utilization in controlling inflation in the United States

A contractionary strategy can delay economic development and even raise unemployment, yet it is frequently viewed as vital to level the economy and keep prices under control. During the 1980s' double-digit inflation, the Federal Reserve hiked its standard interest rate to 20%. Even though high-interest rates caused a recession, inflation decreased from 3% to 4% in the following years.

What is the Fed's role as a lender of last resort?

The Fed usually serves as a lender of last resort, supplying banks with capital and regulatory oversight to keep them from collapsing and causing economic panic.

Conclusion

Monetary policy refers to central bankers' methods to keep a country's economy steady while minimizing inflation and joblessness. A deflationary economy is stimulated by expansionary monetary policy, whereas an inflationary economy is slowed by contractionary monetary policy. Monetary policy is frequently linked with fiscal policy in a country.