The US and other countries have a handful of tools they use to keep their economies in balance and keep employment rates, prices, and interest rates at a stable level. These various strategies fall under the umbrella of monetary policy.
What Is Monetary Policy?
Monetary policy is a set of tools used to manage the overall money supply and promote economic growth. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment.
Monetary policy is usually the domain of government appointed central banks, such as the Bank of England, the Bank of Canada, and the Federal Reserve System (the “FED”) in the US.
Although there are some differences between them, the fundamentals of their operations are almost identical and are useful for highlighting the various measures that can constitute monetary policy.
Types of Monetary Policies
Monetary policy is commonly classified as either expansionary or contractionary, as explained below.
The goal of a contractionary monetary policy is to decrease the money supply and slow down the economy when the economy is growing too fast and inflation is rising quicker than desired. It can be achieved by raising interest rates, selling government bonds, and increasing the reserve requirements for banks.
The goal of an expansionary monetary policy is to, during times of slowdown or recession, stimulate economic activity. A central bank usually implements it during a contractionary phase of the business cycle — when the GDP in a nation starts to decline.
The expansionary policy encourages spending and borrowing. By lowering interest rates saving becomes less attractive, and consumer spending and borrowing increase, and where more money is available to individuals and businesses at lower costs, it will result in the increased purchase of goods and services and fuel economic growth.
Neither type of monetary policy is perfect and it is the job of the nation’s central bank to balance the two.
Monetary Policies Objectives
Central banks have three main monetary policy objectives: manage inflation, decrease unemployment and maintain currency exchange rates.
Inflation : A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary monetary policy can address this issue and reduce the level of money circulating in the economy.
Unemployment : An expansionary monetary policy decreases unemployment in a way where a higher money supply and attractive interest rates stimulate business activities and expansion of the job market.
Currency Exchange Rates : The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper relative to its foreign exchange.
Tools of Monetary Policy
Open Market Operations: Central banks use open market operations (OMO) to affect the money supply. With OMO, the central bank can create new money by buying government securities, such as Treasury bonds, or sell those securities and remove the money received from circulation. The objective of OMOs is to adjust the level of reserve balances to manipulate short-term interest rates.
Discount rate: Central banks can influence interest rates by changing the discount rate. The discount rate is an interest rate charged by a central bank to banks for short-term loans. If a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.
Reserve Requirements: Reserve requirements are the number of funds that a commercial bank holds in reserve to ensure that it is able to meet liabilities in case of sudden withdrawals. By increasing the reserve requirement, central banks are essentially taking money out of the money supply and increasing the cost of credit. Lowering the reserve requirement pumps money into the economy by giving banks excess reserves, which promotes the expansion of bank credit and lowers rates. Commercial banks can’t use reserves to make loans or fund investments. Since it constitutes a lost opportunity for commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).
Non-traditional and crisis Monetary Tools
In addition to the above-mentioned monetary tools, central banks have other means that are utilized only when there is an economic crisis:
Quantitative Easing (QE): this is a form of open market operation and occurs when the central bank buys long-term securities from the open market in order to increase the nation's money supply and encourage borrowing and investment. QE can be dangerous since, without proper controls, it can lead to high inflation without expected economic growth, a condition known as stagflation.
Forward guidance : Forward guidance relates to the central bank's communication of the ‘stance’ of monetary policy. It lets market participants and the general public know the future path of the policy interest rate, and potentially other aspects of monetary policy are likely to be. Generally, forward guidance is helpful in reducing uncertainty about the economic and financial outlook.
Reverse Repurchase Agreements (RRPs) or “reverse repo”: RRPs is the purchase of securities with the agreement to sell them at a slightly higher price at a specific future date. For the party selling the security (and agreeing to repurchase it in the future), it is a repurchase agreement (RP) or repo. For the party on the other end of the transaction (buying the security and agreeing to sell in the future), it is a reverse repurchase agreement (RRP) or reverses repo. Central banks use RRPs to add money to the money supply.
Practical Monetary Policy: Real-World Examples
The Great Recession
The Great Recession of 2007-2009 is a prime example of an expansionary monetary policy used to curb an economy in free fall. As housing prices began to drop and the economy slowed, the FED began cutting its discount rate from 5.25% in June 2007 all the way down to 0% by the end of 2008. But, because the recession was so severe, the decrease in the FED funds rate and the discount rate to zero was not enough to combat it. FED embarked on quantitative easing, purchasing longer-term government securities (20- and 30-year bonds) from January 2009 until August 2014, for a total of $3.7 trillion.
The FED's quantitative easing is considered to be one of the main reasons why the Great Recession lasted only two years, and the economy recovered, albeit slowly.
Japan's Quantitative Easing
Another example of expansionary monetary policy occurred in modern-day Japan from 2013 to 2016. The Japanese yen had been experiencing deflation for much of this period, which contributed to many companies’ low levels of expansion. However, when Shinzo Abe became prime minister in 2012, he encouraged expansionary monetary policy through inflation targeting and more quantitative easing. The expansionary policies had the intended effect of stoking inflation to its desired 2% level while reducing long-term interest rates and spurring economic expansion. By 2016, the real GDP growth rate was 1.5%, its highest in recent years.
In 2020, when the Coronavirus swept the world and most countries went into lockdown, economies were hit hard by the lack of economic activity. To bolster the economy, the FED implemented a quantitative easing program. On March 15, 2020, the FED announced that it would purchase $500 billion in Treasury securities.
Monetary policy is a powerful tool to regulate macroeconomic variables such as inflation and unemployment. It is in the domain of government appointed central banks, which play a crucial role in ensuring economic and financial stability.
When GDP in a nation is declining and the economy is in a contractionary phase, a nation's central bank will implement an expansionary monetary policy and encourage spending and borrowing.
When the economy is growing too fast and inflation is rising quicker than desired, a central bank will implement a contractionary monetary policy and decrease the money supply, and slow down the economy.
In order to respond to market demands, central banks use different monetary tools and approaches, both traditional and new, depending on the complexity of economic trends and expected crises.
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