Monetary policy in macroeconomics

Monetary Policy

In the United States, the Federal Reserve system is charged with implementing monetary policy (Investopedia, 2013). Monetary policy is essentially any the output of any central bank that seeks to manage an economy by means of manipulating the supply of money in the economy (Investopedia, 2013). The Federal Reserve (2013) defines monetary policy as what it does to "influence the amount of money and credit in the U.S. economy." Thus, monetary policy affects not only the quantity of money but the cost of money and these factors directly affect the broader market with respect to investment, manufacturing output and overall economic activity.

The Federal Reserve uses monetary policy for three main purposes. The first is to management the GDP, the second is to manage inflation and the third is to manage unemployment. The Fed seeks to strike a balance between these three objectives with its policy, and the result of this approach is that it will use the different monetary policy levers to stimulate growth, or in other cases to slow growth if the inflation rate is getting too high. The two approaches are known as expansionary and contractionary, for their effects. The current monetary policy is expansionary in nature. This is because GDP growth is slower than where it should -- there is a gap between the actual GDP level and the potential GDP level (Gavin, 2012). In addition, the unemployment rate is higher than it should be, and inflation rates are still low. Thus, expansionary monetary policy is necessary to stimulate economic growth, by adding more money into the banking system. The following chart illustrates the GDP gap and why the current monetary policy strategy is expansionary:

There are three main tools of monetary policy. These are the discount rate, the reserve requirements and open market operations. These things affect the supply and cost of money in order to have an impact on the supply of money in the economy. This paper will discuss these different factors in turn, explaining their relevance to monetary policy.

The discount rate is the rate at which the central bank lends to different financial institutions. This rate is critical because it sets the baseline for the rate at which the banks will lend out to their customers. What the discount rate does is that it sets the cost of money in the economy. Most monetary policy affects the supply or demand for money, while this method affects the price money directly. This of course does have an effect on the supply of money but ultimately it is important to understand the supply of money in the economy is affected by the price.

What happens is that when the central bank raises the interest rates, the result is as follows. The cost of borrowing increases for banks. This does not necessary affect the amount that the banks will borrow, but it could. It does, however affect the rates at which those banks will lend out. What typically happens is that the banks will take money in, and then the lend out at a higher rate. The spread between the rate at which the banks borrow and which the banks lend is their profits. So when the central bank charges the banks more, those banks will then charge the consumers more. Most consumers are price-takers and not particularly price sensitive, so they will generally pay the cost that is associated with the increase, but some will avoid spending if the cost of money is too high. Thus the demand for money will decrease in the economy. This will begin to slow down the economy, something that would be the objective of such a policy.

The second method is to adjust the reserve requirements. How it works is this. Banks run their business by taking deposits and then investing them But, to ensure the safety and security of the banking system, the banks cannot lend out the entire balance of deposits. Some of it they must hold back as something of a safety net against bad problems in credit later on. So what happens is that the reserve requirement exists to protect the bank and the people who are stakeholders in the banks. The more the bank is allowed to lend, the riskier the banking system is. The less the bank is allowed to lend, the less risky the banking system is. It is unusual for the reserve requirements to be changed, because tightening reserve requirements (increasing them) sends a fairly massive shock throughout the economy. To avoid that situation, the Federal Reserve Bank has chosen to seldom change the reserve requirements.

The third method is with the open market transactions. There are transactions where the Fed either buys Treasury securities or sells them. This affects the supply of money in the economy. When the Fed buys Treasuries, what happens is that these securities are paid for by the government, which puts money into the economy. When the Fed sells securities, this takes money out of the economy because banks buy these securities and the Fed sets the money aside, rather than leaving it in the economy. The result is that the Fed is taking money out of the economy.