What is Monetary Policy?
What is Monetary Policy
Monetary Policies are tools used by the central bank to promote stable economic growth and the stability of the value of a currency
Federal Reserve (Central Bank of USA) - Regulate the bank system - Control the size of the money supply Have a target inflation of 2% - Jerome Powell is the chairman who speaks on what the Federal Reserve will do to encourage Store of Value - Higher Interest Rate = Lower Investment/Slower Movement of Money - Lower Interest Rate = More Investment/Faster Movement of Money
3. Different Stances on Monetary Policy
a) Hawkish/Contractionary/Quantitative Tightening = Increasing Interest Rates and Reducing Money Supply
b) Dovish/Expansionary/Quantitative Easing = Decreasing Interest Rates and Increasing Money Supply
Limited Reserves vs Ample Reserves
Limited reserves refer to a situation in which banks have minimal excess reserves beyond what is required by regulation. - Charges in the money supply have a big effect on interest rates
Ample reserves indicate a situation where banks possess surplus reserves beyond regulatory requirements. - Charges in money supply have little effect on interest rates - Central banks cannot use open market operations as effectively - Occurs when the central bank injects too much money into the economy during quantitative easing
What Tools Could a Central Bank Use? Is the Tool Better For Limited or Ample Reserves?
Open Market Operations - buying or selling of government securities by a central bank to increase or decrease money supply which then affects interests nominal interest rates
Since OMO is used to control the money supply, this tool works best under limited reserves
Central Bank Purchases Bonds: The central bank buys government bonds or other assets from banks or the open market. It typically does this by creating new money electronically.
Increase in Bank Reserves: The sellers of the bonds receive payment in the form of newly created central bank reserves. These reserves are essentially deposits that banks hold at the central bank.
Lending and Investment: With increased reserves, banks have more capacity to lend to businesses and individuals. They can also invest in other assets or securities, which inject new money into the economy.
Bonds Increase Value: Once these government bonds increase in price as the central bank buys them, their yield rates will go down. The yields on government bonds are used as benchmarks for other interest rates in the economy, such as mortgage rates, corporate borrowing rates, and other forms of lending.
*If a central bank sells bonds, their value will go down and their yields will go up; this will raise the interest rates overall
Minimum Reserve Requirement(Reserve Ratio) - minimum amount of funds that banks and financial institutions are required to hold in reserve
The minimum amount is a ratio of the deposits/liabilities that a bank holds
The reserve ratio(money multiplier) is the percentage of liabilities that a bank must hold in reserves
This is best used in limited reserves because the reserve ratio primarily affects the money supply.
Decreasing the Reserve Ratio: This will increase the money supply because it lowers the amount of money that banks need to keep. They then can loan out more money, increasing the money supply which lowers interest rates
Increasing the Reserve Ratio: This will decrease the money supply because it raises the amount of money that banks need to keep. They then need to loan less money, decreasing the money supply which raises interest rates.
Interest Rates
Federal Funds Rate: This is the interest rate at which banks lend excess reserve balances to other banks overnight on an uncollateralized basis. It is the primary tool used by the Federal Reserve to implement monetary policy and is set by the Federal Open Market Committee (FOMC), the monetary policymaking body of the Fed.
The federal feds are heavily affected by Open Market Operations so it is most affected in limited reserves
Discount Rate: The discount rate is the interest rate at which the Federal Reserve lends to commercial banks and other depository institutions.
Since the discount rate serves as a backstop for the federal funds rate, it can affect interest rates during ample reserves when shifting the money supply will have minimal effect on interest rates
Interest on Reserves: The interest paid by central banks to commercial banks on the reserves they hold at the central bank.
If interest on reserves is lowered, then banks would rather loan out their reserves than keep them in the central bank, which will decrease the demand for money and lower interest rates.
* The opposite will happen if the central bank raises interest on reserves
This is best used when in ample reserves because the central bank can directly change interest on reserves which targets the demand of money instead of money supply.
Sources Cited:
Team, The Investopedia. “Monetary Policy Meaning, Types, and Tools.” Investopedia, 20 Mar. 2023, www.investopedia.com/terms/m/monetarypolicy.asp.
Moffatt, Mike. “Expansionary vs. Contractionary Monetary Policy.” ThoughtCo, 23 Dec. 2018, www.thoughtco.com/expansionary-vs-contractionary-monetary-policy-1146303.
“What’s an Interest Rate? Napkin Finance Answers All Your Questions!” Napkin Finance, 2 Dec. 2020, napkinfinance.com/napkin/interest-rate/.
Kenton, Will. “What Is the Reserve Ratio, and How Is It Calculated?” Investopedia, 23 Nov. 2022, www.investopedia.com/terms/r/reserveratio.asp.
Hayes, Adam. “What Are Open Market Operations (OMOS), and How Do They Work?” Investopedia, 20 Jan. 2023, www.investopedia.com/terms/o/openmarketoperations.asp.
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