What is Monetary Policy?
The federal Reserve is in charge of the United States’ monetary policy. Monetary Policy refers to the powers and abilities of the Federal Reserve System, also known as the Fed, to influence the economy by influencing the amount of money in the economy at any given time. If the amount of money in the economy increases it helps spur economic growth. If the amount of money in the economy decreases it slows the economy down.
Today, we want to go over monetary policy as it relates to the Federal Reserve System. Monetary policy as it relates to the Federal Reserve System, or “the Fed”. The Fed is actually not a government agency. It’s private, but the Fed helps banks and has three tools at its disposal to either increase or decrease the money in circulation in the economy at a given time to either help speed it up if it slows down or to help slow it down if it’s sped up too much and inflation is creeping up.
They influence the supply of money, and they have three tools at their disposal to help influence the supply of money in the economy at any one time. The first tool is they adjust the required reserve ratio of member banks. The reserve ratio is the amount of money that a bank must have on hand in relation to the amount deposited there. It influences how much they can loan out.
If the reserve ratio is low, that gives more money at disposal for the bank to loan out, and, therefore, lowered ratio means the money supply increases. If they have a higher ratio, they have to keep more on hand based on how much is deposited there. Then, there is less money to lend, and the money supply decreases. They adjust the required reserve ratio for member banks. If they lower that ratio, money supply increases. If they raise the ratio, money supply decreases.
The second thing that they have, and this is probably one of their most powerful tools, is the open market operations of buying and selling government securities. By doing this, they strongly influence the amount of money in circulation at any one time. They have that market. Third, they can adjust the discount rate. The discount rate is the interest rate that the Federal Reserve Bank charges to member banks to borrow money from the reserve.
You’ve got this Federal Reserve Bank which is loaning money to member banks. If that rate is favorable, if it’s a low interest rate, that encourages the member bank to borrow more money from the Fed to loan out to others and thereby increases the amount of money supply in the economy at large. If they increase the reserve rate, there’s a less favorable interest rate for them to borrow money.
It disincentivizes them to want to borrow money from the Fed, and, therefore, they have less to loan out themselves and decreases the amount of money, generally speaking, in circulation in the economy. This has been a basic overview of monetary policies that relates to the Fed. Its three main tools to influence the supply of money in the economy.
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Last updated: 04/24/2018
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