Economic Factors - Monetary Policy
Exam Tips and Tricks
Any discussion of economic policy will inevitably touch on the relationship between the economy's health and investments. You should understand the primary differences between monetary and fiscal policies.
Monetary policy is mainly concerned with private sector efficiencies and the money supply, and it derives many of its theories from Nobel prize-winning economist Milton Friedman.
The fundamental idea behind monetary policy is that the quantity of money, or the money supply, is the major determinant of price levels. Monetarists believe that price stability allows private businesses to plan their growth, invest in their businesses and keep the economy growing at a steady pace without an over- or undersupply of goods and services. The primary driver of all monetary policy decisions is the Federal Reserve Board.
Monetary Policy and the Role of the Federal Reserve Board
The Federal Reserve Board (FRB) consists of seven members appointed by the President of the United States, subject to Senate confirmation, who serve 14-year terms. It governs the regional Federal Reserve Banks and a system of hundreds of state and national banks, all of which make up the Federal Reserve System.
Very few organizations can move the market like the Federal Reserve. Read more about what the Fed does and how it influences the economy within the tutorial The Federal Reserve.
Learn more about the tools the Fed uses to influence interest rates and general economic conditions in the article Formulating Monetary Policy.
The Fed determines monetary policy and banking policies and acts in a number of governing capacities:
- as agent of the U.S. Treasury;
- as regulator of the U.S. money supply, through open market sales and purchases, discount rate adjustments and reserve requirement changes;
- as implementer of its members' reserve requirements;
- as supervisor of currency printing;
- as clearer of fund transfers; and
- as examiner of members' compliance to federal banking regulations.
Changing Interest Rates and the Money Supply
The Federal Reserve buys and sells U.S. government securities on the open market to expand and contract the money supply. These actions are governed by the Fed's Open Market Committee (FOMC).
Expanding the Money Supply
- When the Fed wants to expand the money supply, it buys securities from banks, which receive direct credit in their reserve accounts.
- As such, banks are able to make more loans and lower interest rates.
Tightening the Money Supply
- If the money supply is too expansive and needs "tightening", the Fed will sell securities to the banks by charging the banks' reserve balance.
- As a result, banks are unable to lend money as readily and must reduce their credit activities and raise interest rates.
The Fed can also raise or lower the discount rate, which is the interest rate it charges its members for short-term loans. A lower discount rate reduces the cost of money that banks must pay for loans and is considered to be stimulative to the economy, while a higher discount rate results in a shrinking demand for the loans and is considered to be a tightening move by the Fed.. Banks will alter the federal funds rate - the rate one bank charges another to borrow money - to compensate for these fluctuations in the discount rate.
The Federal Reserve Board and the U.S. Treasury are two separate entities. The Fed buys and sells the securities that the Treasury issues, but it has no jurisdiction over the Treasury, which is connected to the executive branch of the government.
The Fed uses the following strategies to expand or contract funds in the banking system:
- Buying or selling government securities in the open market
- Increasing or decreasing member bank reserve requirements
- Increasing or decreasing the discount rate to member banks who borrow reserves from the Fed
- Changing the percentage of credit required to buy securities on margin
The Fed can expand the money supply so that credit is easier to obtain and interest rates are lowered, which increases spending. When it tightens the money supply, the reverse occurs.
Exam Tips and Tricks
You should understand the fundamental role of the Fed in monetary policy, including its defined functions and the manner in which its actions affect the overall economy.