Monetary Policy

Monetary Policy

The Fed’s primary goal is to ensure that the amount of money and credit are balanced to foster continue economic growth without causing inflation. When inflation is so high that currency loses its value, the Fed needs to restrict the money supply in the system. If recession is threatening the healthy growth of the economy, the Fed needs to expedite the growth of the money supply. It does this by using three tools: the discount rate (interest rate that the Fed charges the banks for short-term loans), reserve requirement (amount of reserve banks are required to have in their cash vault or with the Fed), and most important, open market operations (buying and selling of government securities to and from the general public on the open market).

Restrictive Monetary or Tight Money Policy:

When excessive spending pushes the economy into inflation, the Fed will try to limit the supply of money in the economy by applying the restrictive monetary policy or tight money policy. First of all, the Fed will sell government bonds to the commercial banks and raise the required reserve ratio of these commercial banks. By doing so, the excess reserves of the commercial banks will reduced by having to make payments for the government bonds, and at the same time, leaving more required reserve in the account; this in turn, reduces the lending ability of the commercial banks. Moreover, the Fed will increase the discount rate to discourage banks to borrow from the Fed. When discount rate is high, banks tend to borrow from other banks. Borrowing from the Fed will increase supply of money in the system while borrowing among commercial banks only redistributes the money but has no change in the amount of money in the system.

Expansionary Monetary or Easy Money Policy:

Contrarily, when the economy is facing recession and high