What are monetary policy?

Monetary policy definition: Monetary policy is an economic strategy used to achieve macroeconomic goals laid down by a central bank. It involves managing money supply and interest rates used by the government to achieve demand-side macroeconomic objectives like inflation, consumption, growth and liquidity.

Central banks apply monetary policy to address economic volatility and achieve price stability. Invariably, the spin-off of this policy is low inflation. Central banks in developed economies have set inflation targets, while other nations are implementing them.

They adjust their monetary policy by changing the amount of money available. Typically, banks accomplish this by buying or selling securities on the open market.

Open market operations affect short-term and long-term interest rates, and the economy.

The efforts by a central bank to slow a growing economy by raising interest rates, raising the minimum amount of capital reserves required of banks, and selling United States Treasury bonds are known as tight monetary policy. In short, when interest rates go up, monetary policy is tightening.

On the other hand, when central banks offer low-interest rates, monetary policy is easing. Loose monetary policy aims to boost economic growth by lowering interest rates, reducing bank reserve requirements, and purchasing United States Treasury securities.

What are monetary policy tools?

The nation’s exchange rate is closely related to its monetary policy. Because of this, interest rates have an impact on a country’s currency’s value. Therefore, nations with fixed exchange rates have less latitude for independent monetary policy, so effective inflation targeting requires an adaptable exchange rate policy.

To implement monetary and banking policy in the economy, tools of the central bank may include:

Open market operations

Open market operations are used as a monetary policy tool to affect bank reserves and interest rates in the United States. When central banks engage in open market operations, it sells or buys U.S. Treasury bonds. The Federal Open Market Committee (FOMC) decides on these open market operations at biweekly meetings.

Changing reserve requirements

The central bank can alter the reserve requirement to conduct monetary policy. Legally, bank deposits must be kept in cash or at the central bank.

Consequently, by reducing this reserve requirement, banks have more money to lend out or spend on other assets. Increasing the requirement slows growth and restricts bank lending.

Changing the discount rate

The Federal Reserve was founded in response to the Financial Panic of 1907. When banks can’t lend money, they can’t make a profit and no bank can withstand this kind of pressure for long. Without sufficient cash flow, no bank can survive a bank run.

A Bank Run

A bank run occurs when customers withdraw their deposits due to fears about the bank’s solvency, increasing the probability of default. Bank runs are not a new phenomenon. They were present during the Great Depression and the 2008 financial crisis.

Solid banks could borrow as much money as they considered necessary from the Fed’s discount “window” in the event of a bank run to stop it. The discount rate refers to the interest rate charged for these loans.

In a setting where policy is being eased, the central bank lowers interest rates to encourage economic expansion. Consumers borrow more due to lower rates, leading to an increase in money supply. Central banks adopt a tight monetary policy when an economy is growing too quickly, or inflation is rising too fast.