What Is Monetary Policy

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank", the Bank of Canada and the Federal Reserve Bank in the United States. According to the Encarta the definition of monetary policy is the following economic principles and programs adopted by a government that manage the growth of its money supply, the availability of credit, and interest rates. In the United States, the Federal Reserve Board determines monetary policy.

The U.S. monetary policy affects many financial decisions for people and, since it is the biggest economy in the world, it also impacts other economies in other countries. The object of the system is to influence factors like inflation, economic output, and employment by affecting demand (the public's willingness to spend on goods and services). The system is conducted by the Federal Reserve System and it influences demand mainly by raising and lowering short-term interest rates. How is the Federal Reserve Structured? The Federal Reserve (the nation's central bank), called the fed for short, was established by congress in 1913 and consists of the Board of Governors in Washington, D.C., and twelve Federal Reserve District Banks. Although the fed is accountable to congress and structured by law, it is totally separate from the departments that manage the country's spending decisions. The governors are appointed by the president for terms of 14 years. The appointments are staggered so no one single president could load the board with his own people. Each reserve president is appointed every five years by the Board of Directors. Along with these measures, the fed is independent because it meets its operating expenses primarily from interest earnings on its portfolio of securities. Although the system works independently from congress, it still conforms to laws and comes under review and audit from the government. Fed officials report regularly to congress and meet with administration officials to discuss their programs. Also, eight times a year the Board of Governors, the President of The Bank of New York, and four other bank presidents meet in Washington to discuss the appropriate discount rate and other subjects.

What are the goals of the monetary policy? One goal of the fed is to affect the economic production and employment, both of which depend on many other factors. But they can be influenced by monetary policy; when demand weakens, the fed lowers interest rates, which in turn stimulates the economy. But continuous stimulus will push the economy's inflation higher and higher, so the fed just tries to smooth out the bumps of natural business cycle. Inflation is an economy wide rise in prices which is bad because it makes it hard to tell if a business product price is going up because of higher demand or inflation. Inflation also adds premium to long-term interest rates. There's a lot of debate about whether zero inflation is a target. Some people say that when inflation is low, interest rates are low so the fed doesn't have much room to boost the economy if it needs to. Also, when inflation is close to zero there is more risk of deflation. Deflation is when there is a nation wide fall in prices. Sounds good if you're a consumer, but really it is just as bad as inflation. A prolonged deflation, like the great depression, can lead to significant declines in home and business values. Also, with low prices come low interest rates, and less room for the fed to stimulate the economy. The main goal is to keep the economy steady, not too high or low. The feds monitor the stock market closely too, for indicators on the economy.

What are the tools of U.S. monetary policy? The feds influence the market mainly by raising or lowering interest rate called the "federal funds". Banks are required to keep a certain amount of money in reserves to pay for overnight checks, stock ATMs, and other payments. When a bank is running low on reserves it may borrow some from a bank with too many reserves. The interest rates on these loans adjust to supply and demand. If the fed wants to raise or lower the rates, it buys or sells securities from banks, in which the bank receives or sells in reserves. They do this until the banks have too many reserves and must loan them out, so the interest rate lowers, or the banks don't have enough reserves and must borrow, causing interest rates to rise. The fed also pays attention to foreign markets. When the dollar is too low, the feds buy out dollars (with foreign currency) to cushion the pressure.

How does monetary policy affect the U.S. economy? Real interest rates are the nominal interest rates (market interest rates quoted in newspapers) minus the expected rate of inflation. Because if a borrower takes out a loan at a low interest rate and there is inflation soon afterward, the money that he is paying back is really worth less than it was when he borrowed it. The fed can't set real interest rates because it can't set inflation. The long-term interest rates are determined by the fed indirectly though. Lenders look at what the fed might do in the future, if it looks like inflation might rise in the next few years, a risk premium is added to their loans. If these real interest rates are low then borrowers are more inclined to buy new homes and cars. Also, lower interest rates make common stocks and other investments more attractive, which in turn makes higher stock prices. Foreign exchange increases, households and businesses are more inclined to spend, and income increases. The monetary policy affects inflation through people's expectations of what the fed will do. If the Fed eases the monetary policy and people suspect that this will increase inflation, they will ask for higher prices and larger wages, which adds to inflation. The U.S. inflation rate does not only depend on the U.S. though. If the Fed drove more dollars into the U.S. it would ultimately drive the value of the dollar down in the foreign markets. People with the extra money in the U.S. would buy foreign products which would make higher foreign prices, which would create higher U.S. prices. It takes a fairly long time for a policy action to take effect. The lag for major effects on output can be anywhere from three months to two years. The effects on inflation usually take even longer, one to three years or more. The policy is a complex chain of events that can alter anywhere