What is monetary policy?
Monetary policy is the control of the money supply (and sometimes credit conditions) to achieve or satisfy macroeconomic goals.

A country's central bank controls the nation's money supply, enacts monetary policy and acts as a clearinghouse between banks. The Federal Reserve is the central bank in the U.S.; in Canada, the central bank is the Bank of Canada.

The central bank has three tools to control the nation's money supply:

  1. Setting of Reserve Requirements - In general, banks will use their reserves to make loans and turn a profit. In doing so, they increase the nation's money supply. Increasing (decreasing) the reserve ratio decreases (increases) the amount of funds available to loan, thereby decreasing (increasing) the nation's money supply.
  2. Open Market Operations - The Federal Reserve can purchase or sell U.S. government securities on the open market. When they purchase (sell) government securities, it increases (decreases) the nation's money supply. The monetary base is equal to bank reserves (vault cash plus reserves held at the Federal Reserve), plus money in circulation. The nation's money supply is a multiple of the monetary base. The Federal Reserve's open market operations directly impact the size of the monetary base.
  3. The Discount Rate - The discount rate is the interest rate charged by the Federal Reserve to banks that borrow money from them. Typically this is done in order to meet temporary shortages of reserves. Note that banks do not automatically have the right to do so. An increase (decrease) in the discount rate will discourage (encourage) banks from letting reserves go to very low levels, thereby tending to decrease (increase) the money supply.

So if the central bank wishes to pursue an expansionary monetary policy, it will lower reserve requirements, purchase government securities on the open market and/or decrease the discount rate.

A restrictive monetary policy implies that the central bank will increase the reserve requirements, sell government securities and/or increase the discount rate.

Problems Associated with Measuring an Economy's Money Supply
·Changes in Checking Accounts - The introduction of interest-earning checking accounts and money market mutual funds (some with check-writing privileges) have made M1 money supply figures for the 1980s and later not comparable to figures for private years

·Debit Cards - Debit cards transfer funds from the cardholder's checking account when used for purchases and may induce some people to hold less cash.

·Holding of the U.S. dollar Outside of the U.S. - The amount of currency held by people outside of the U.S. has greatly increased. These holdings are difficult to measure. The impact is greater on M1 than M2 because currency accounts for a relatively smaller portion of M2.

· Greater Availability of No-load Mutual (Stock and Bond) Funds - It is now easier for investors to purchase mutual funds without paying an up-front commission (load). These holdings are not counted in M1 or M2. Many mutual funds companies let investors cash out or move their stock and/or bond holdings to a money market account over phone or on the internet.

Money, Interest, Real GDP, and the Price Level

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