Monetary Policy: Key Takeaways

This picture was sourced from Pepi Stojanovski on Unsplash

The Covid-19 pandemic has introduced an era of profound strife and uncertainty. In the simplest terms, this pandemic has created two huge problems in the areas of public health and economics. To make matters worse, these public policy domains are, generally speaking, at odds with one another. This post will focus on the economic dimensions of this crisis at a high level.

When a national economy experiences macro level shocks there are two primary policy tools at the disposal of government and quasi-government actors – Monetary Policy and Fiscal Policy. The former is focused on addressing interest rates and the supply of money in circulation, it is generally managed by a central bank (such as the Federal Reserve). The latter addresses taxation and government spending, it is generally determined by legislation. Specifically, this post will proved an overview of monetary policy and explain how it is utilized by the Federal Reserve to promote certain outcomes within the national economy.

Monetary Policy

Monetary policy is typically carried out by Central Banking authorities, in the United States it is carried out by the Federal Reserve – often referred to as “The Fed.” Monetary policy involves two primary actions:

  • Establishing base interest rates.
  • Influencing the supply of money (most often carried out through policies of “quantitative easing” which increase the supply of money in the nation.

The Fed has typically used monetary policy to stimulate the economy or check its growth. When the Fed cuts interest rates, it’s sending a signal to individuals and businesses that they should borrow money and spend it in the economy. Conversely, when the Fed increases interest rates the aim is to encourage saving, rather than spending. This acts as a brake on inflation and other issues associated with rapid growth.

More specifically, the Fed has looked to three primary policy levers when influencing rates and borrowing activities – Open market operations, changing reserve requirements for other banks, and setting the discount rate.

Open market operations refer to measures carried out on a daily basis. These operations occur when the Fed buys or sells U.S. government bonds, thereby injecting or withdrawing money out of the national economy.

The second, changing reserve requirements, relates to the percentage of deposits that banks are required to keep in reserve (i.e. cash on hand at any given time). The key takeaway here is that through it’s control over reserve requirements, the Fed is able to directly influence the amount of money created when banks make loans to individuals and businesses. This is important to keep in mind in the present, as reserve requirements have become relatively lax.

Finally, the Fed has dominion over the discount rate. The discount rate is the interest rate the Fed charges on loans it makes directly to financial institutions. The key takeaway here is that the discount rate has an overarching impact on short-term interest rates across the entire national economy.

Conclusion

Ultimately, monetary policy is more of a high level tool. It’s focus lies on expanding and contracting the money supply while influencing borrowing and saving behaviors, however it has less of an impact on the real economy. The key takeaway with monetary policy is that it exists to dictate banking behaviors in the national economy through its control of interest rates and the money supply.

In normal times, the Fed’s focus will be placed on contractionary or expansionary measures. In times of crisis, however, their focus shifts to providing enough liquidity in the financial system to maintain solvency. This, in large part, helps explain the measures taken by the Fed over the last couple of weeks.

If you made it this far, thank you for taking the time to read this! I will be following up on this post with a post that provides a similar overview of fiscal policy. If you found this information valuable, please like and share it with others.

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