Tips & AdvicePersonal FinanceMonetary Policy: What it is and How it is Implemented

Monetary Policy: What it is and How it is Implemented

-

People often ask, “how much money is there in circulation?” The government estimates that about $2 trillion is in circulation, but this figure is somewhat rough. And while having a simple, solid answer to this commonly asked question would be nice, coming up with anything remotely accurate can be rather complicated. For starters, the amount of money in circulation changes every second. Additionally, while these terms might seem intuitive, both “money” and “circulation” have several different definitions.

Monetary policy—a term that broadly describes the many mechanisms used to change the amount of money in circulation—is something that can have a considerable impact on our daily lives. Both increases and decreases in the general supply can change how much things cost, whether you’ll qualify for a mortgage (or other loans), and even whether you’ll be able to get a job.

In this article, we will discuss some of the most important things you should know about monetary policy, including what it is, how it works, and how it might affect you.

What is Monetary Policy?

Monetary policy is a term used to describe a set of tools that can be used to control the money supply. It is primarily implemented by a nation’s central bank, which in the United States is the Federal Reserve.

Note that monetary policy is different from fiscal policy. Fiscal policy affects tax rates and a nation’s budget and is enacted by the federal government. Both monetary and fiscal policies can affect different components of the economy, including the cost of goods, the employment rate, GDP, average income, and other key metrics.

Who Is In Charge of Implementing Monetary Policy?

The Federal Reserve uses several tools to enact monetary policy, which we will further explain below. According to the Federal Reserve’s Board of Governors, the central bank “provides the nation with a safe, flexible, and stable monetary and financial system.”

The Federal Reserve generally tries to pursue a dual mandate that involves keeping employment relatively high and inflation relatively low. These tools involving employment and inflation often require a tradeoff, which is why effective monetary policy is so important.

While the central bank does include the word “Federal,” the Federal Reserve is actually not a direct department of the national government. The bank is technically a private institution, though it is heavily regulated by the government, and elected officials (such as the President and Senate) can control who is a member of the Fed. Currently, the Chairman of the Federal Reserve is Jerome Powell.

Both Powell and other essential decision-makers at the Fed utilize the following tools to enact monetary policy and influence the money supply:

1. Reserve Requirements

Banks and other financial institutions must keep a certain amount of cash on hand to prevent bank runs, which occurred during the Great Depression and created a domino effect of customers withdrawing funds from banks. And when the Federal Reserve wants to change the amount of money in circulation (sometimes called “M1”), they might consider altering reserve requirements.

If banks aren’t required to keep as much cash on hand, they will be able to lend more to their customers. As a result, interest rates will decrease, and the amount of money available will increase. If the Fed decides to create stricter reserve requirements, banks will have less money available to lend. This “contractionary” measure will make it more challenging to secure a loan but can also be used to combat inflation.

2. Open Market Operations

“Open market operations” describes when the Federal Reserve decides to buy or sell securities to banks and other financial institutions. Every time the Fed decides to buy securities, it will give these banks cash, ultimately expanding the available money supply. On the other hand, selling securities will tighten the money supply.

Through open market operations, the Fed can alter the Fed Funds Rate, which is probably the most widely used of the Fed’s available monetary policy tools. Ultimately, the Fed Funds Rate is the rate that banks use to lend to each other. Due to the requirement to have minimum reserves on hand, banks borrow money from each other quite a bit. The target Fed Funds Rate is established by the Federal Open Market Committee (FOMC) and is frequently altered depending on the general state of the economy. So, whenever you hear a financial analyst claim “the Fed is raising rates,” they mean “the Fed is increasing their current open market target rate.”

3. Discount Rates

Banks usually prefer to borrow from each other whenever cash is needed, but they typically turn to the Federal Reserve when they can’t. The Fed sits on a large amount of cash but will lend at a rate higher than most banks (who use the Fed Funds Rate), which is why the Fed is often called the lender of last resort

The discount rate is a term used to describe the rate at which the Fed is willing to lend to its members. When the Fed increases the discount rate, banks will need to pay more for emergency cash, which may affect other components of their lending policies. With only a few exceptions, any bank looking to borrow from the Fed is most likely rejected by other member banks. In other words, any bank borrowing from the Fed is probably having some serious financial problems.

4. Interest Rates for Excess Reserves

Following the 2008 financial crisis, it became apparent that financial institutions (as a whole) tend to take many risks, some of which cannot be easily justified on paper. In general, encouraging financial institutions to keep a lot of money in their reserves will discourage them from taking on excess risk. However, if they go above and beyond with their reserves, these financial institutions expect to be compensated.

Since 2008, the Federal Reserve has joined the Bank of England and the European Central Bank (who controls the Euro) in offering small amounts of interest to any member institution that chooses to hold excess reserves. When these central banks want to encourage banks to increase their reserves, they’ll increase the interest rate. This is often a preferable alternative to simply changing minimum reserve requirements, which is an action that can have undesirable economic consequences.

Conclusion

The amount of money in circulation affects just about every component of our lives. Enacting monetary policy, which the Federal Reserve does, is essential for creating economic stability and balancing competing economic interests (such as managing both inflation and employment). Through the combination of minimum reserve requirements, open market operations, discount rates, and interest payments for excess reserves, monetary policy can be put into action.

 

Andrew Paniello
Andrew Paniello
Andrew is a freelance writer that primarily focuses on real estate and finance topics. He graduated from the University of Colorado with degrees in Finance and Political Science and has since worked in the real estate, life insurance, and digital marketing industries. When he is not writing, Andrew enjoys skiing, playing piano, painting, and spending time with his wife (Maggie) and cat (Crow).

Recent posts