What is monetary policy?

General definition: A tool used by governments to

affect the economy
• Monetary policy is geared towards influencing
interest rates
• If government can affect interest rates, then the
government can affect
consumer and firm behavior
• Example: increasing interest rates slows
the economy by making funds more
expensive to firms, and promotes
consumer savings which decreases
revenues by firms.
• Central Bank (Federal Reserve Bank -
Founded 1913) is the central authority
appointed by the government to implement
monetary policy
• Monetary policy is the process a
government, central bank, or monetary
authority of a country uses to control (i) the
supply of money, (ii) availability of money,
and (iii) cost of money or rate of interest to
attain a set of objectives oriented towards
the growth and stability of the economy
Monetary theory provides insight into how
to craft optimal monetary policy.
• Monetary policy is referred to as either
being an expansionary policy, or a
contractionary policy, where an
expansionary policy increases the total
supply of money in the economy, and a
contractionary policy decreases the total
money supply.
Monetary Policy and the Federal Reserve Bank
Tools used by the FRB (FED) for implementing
monetary policy
1. Open market transactions: Buying and selling of
treasury securities changes the money supply in
the economy, affecting interest rates. Perhaps
the most frequently used tool available by the
FED.Decisions are made by the FOMC (Fed
Open Market Committee)
2. Reserve requirements: changes the amount of
reserves that banks must hold, affecting the
amount of money creation, and thus supply.
Powerful tool, but infrequently used (once a
decade or so) because of the disequilibrium that
it creates
3. Discount window lending: Sets the base lending
rate among financial institutions. A somewhat
imaginary rate since few institutions actually
borrow from the Fed, so this requires nothing
other than a statement by the Fed Chairman
The role of Banks in Monetary Policy
• Banks can be viewed as counterfeit operations
controlled by the government, and are an
essential tool in affecting monetary policy
• Banks lend money that they don’t have!. Loans
made by banks are not backed 100% by
reserves, so they are essentially minting their
own currency. Reserve requirements set by the
government determine the extent to which banks
can counterfeit . Fewer required reserves means
more counterfeiting and increased money supply
(more loans means more available funds)