Monetary Policy – A Comprehensive Guide

While often used interchangeably, monetary policy and fiscal policy are very different things. Monetary policy involves changing the interest rate and influencing the money supply to attain economic stability. In contrast, fiscal policy uses government spending and tax rate adjustments to impact economic growth. While both can be equally effective and have their place in the U.S. economy, this article centers on monetary policy.

Infographic that explains what monetary policy is, the difference between expansionary and contractionary fiscal policy, and the functions of the Federal Reserve.

History of Monetary Policy

Monetary policy has gone through a sea of change over the centuries. It all started with the building of a framework to manage the standard currency that we use today. Monetary policy centered around the altering of coinage and later the paper money.

The paper money that we use today emerged from promissory notes called “jiaozi” in 7th century China. It was used alongside the metallic currency but was made the primary currency by succeeding dynasties. Over time, governments and rulers realized that monetary policy could not be as simple as carving coins and printing currency notes. Problems like hyperinflation occurred while printing excessive money.

A gold standard was established to counter such issues. The Bank of England adopted this fixed exchange rate system in 1694. As such, the value of the currency was pegged to gold. Central Banks held gold reserves equivalent to the value of the currency in circulation. Thus, at all times, Central Banks were ready to exchange gold at a fixed price for the circulating currency. This ensured a stable and disciplined supply of money.

The gold standard, however, limited the Central Banks’ capacity to fight the economic crisis. Unlike today, money could not have been printed freely because an equivalent amount of gold reserves was required. As a result, the only source of growth in the money supply was newly mined gold and new gold discoveries. Thus, economists blamed the gold standard for the prolonged impact of the Great Depression of 1929 and a painfully slow economic recovery because Central Banks could not increase the money supply to stimulate the economy, support insolvent banks, and fund government deficits.

Later, the gold standard was abolished to adopt the current “fiat currency” model. In this model, banknotes are just promissory notes or “legal tender” backed by the Central Bank. With the gold standard out of the way, Central Banks got the power to print unlimited money. However, the potentially severe negative effects of unlimited money-printing kept them from doing that. Monetary authorities instead focused on maintaining a stable value of the currency.

Decades later, the role of Central Banks as the lender of last resort was established. Central Banks were given additional responsibilities to promote moderate long-term interest rates, inflation rates, and exchange rates. They also became the ultimate banking authority of countries, regulating the entire credit market in their nations.

This article explains how central banks enact monetary policy and perform all the roles associated with managing the money supply, interest rates, and inflation.

Money Supply in Monetary Policy

When it comes to the money supply, there is much more than what meets the eye. The presence of a wide variety of financial institutions (banks) and credit markets have upped the money supply game quite remarkably. Banks create a multiplier effect in a country’s money supply. Thus, they can have a significant economic impact, even with only small tweaks in the money supply. Here is an example of how the multiplier effect works.

In today’s monetary system, a $1,000 bank deposit is worth much more in the economy than $1,000. Let’s assume you have $1,000, which you deposit in the only depository institution in your city. The bank collects the money, keeps a 10% reserve to meet its liquidity requirements, and loans out the balance of $900 to a firm seeking a loan to fund its capital expenditures. This firm uses the money to pay an equipment supplier, who goes and deposits the $900 in the same bank.

The bank repeats this drill – takes the deposit, creates a 10% reserve, and loans the balance ($810) to Tom to buy a car. Tom goes to the car dealership and buys a car using the money. The car dealer comes to the same bank and deposits the $810, and the same cycle continues. After 10 bank deposits, the money supply has grown from $1,000 (initial deposit) to $6,513.73. That is an increase of $5,513.73 of the money supply!

Money Supply Multiplier Effect Table

With endless such iterations, bank deposits worth $10,000 can be created with only $1,000 in initial deposit ($1,000 + $900 + $810…. = $10,000). Economic activity worth $9,000 can be supported by an initial deposit of only $900 ($900 + $810… = $9,000).

That’s how the money supply works – smaller injections create a ripple effect in the economy. This is why market pundits observe even the tiniest of the Central Banks’ monetary policy rate actions because these actions can profoundly alter the economic situation.

That said, let’s try to understand how Central Banks use their monetary policy to inject or withdraw money from the economy to manage the money supply.

Central Banks and Monetary Policy

The Central Bank is the banker’s bank and the ultimate authority in the financial system. It formulates rules and monetary policy that the country’s banking system needs to follow.

Banking is a critical industry. A lot rides on the nation’s banks when it comes to economic activity. People will only deposit money in the banks if they trust the banking system. They look at banks for loans and trust the banks to perform their day-to-day business activities efficiently.

The banking industry is highly vulnerable. The banking business requires little equity capital compared to the amount of money involved in a bank’s loans and advances. The deposits do the majority of heavy lifting. However, even if a small percentage of the bank’s borrowers defaults, depositors can lose their hard-earned money when the bank’s capital falls short in absorbing losses.

Therefore, an industry as critical and vulnerable can’t be left to self-regulate. It requires an independent and empowered regulator like the Central Bank to oversee that the banking system works as it is supposed to and does not falter. Central Banks, such as the U.S. Federal Reserve, have vested regulatory powers by the Constitution. They are powerful institutions that frame and implement regulations the banking industry has to follow. Central Banks have many responsibilities. They set interest rates, oversee banking licenses, reserve requirements, ownership requirements, lending disciplines, and much more.

Besides the critical tasks of printing money and regulating banks and credit markets, Central Banks are responsible for various other jobs.

Central Banks also hold the tap to the money supply in the economy. One of the most important purposes served by the money supply is controlling inflation. Too much money in the system creates excess aggregate demand and increases inflation. However, too little money in the economy will reduce demand, cause deflation and hurt economic growth. Therefore, as part of their monetary policy, Central Banks have to release the right amount of money to keep inflation stable and economic growth steady.

Last but not least, another function that Central Banks perform is managing volatility in the currency markets. Central Banks take direct and indirect actions to achieve currency stability and prevent extreme volatility. They intervene directly as buyers to support a rapidly depreciating currency and as sellers to tame a rapidly appreciating currency. That’s only in times of extreme volatility. Other times, they focus on maintaining the right interest rates to keep the currency flows in check.

In a nutshell, Central Banks act as the banker’s boss. As part of their monetary policy, they print money, control the money supply, keep inflation in check, and help stabilize a currency’s value.

The Fed’s Monetary Policy Tools

In the United States. The Federal Reserve has several tools in its arsenal to control the money supply, tweak interest rates, and control inflation. The tools differ across the world in nomenclature, but their nature and intended impact remain the same worldwide. Here are the monetary policy tools the Fed has at its disposal.

An infographic that explains the 5 different monetary policy tools of the Federal Reserve: Reserve requirements, the discount rate, open market operations, interest on reserves, and the Federal Funds Rate.

The Discount Rate

The Federal Reserve lends short-term money to commercial banks for their liquidity requirements. The rate charged on those borrowings is called the discount rate. This rate is higher than the Fed Funds rate. This is why banks only use it when they cannot get a loan from other banks to meet their reserve requirement.

It is a general tendency for people and corporations alike to borrow more when borrowing money is cheap. The discount rate solely works on that mechanism. Whenever the Fed wants to increase the money supply, it reduces the discount rate, prompting banks to borrow more and, in turn, lend more to their customers at lower interest rates. The opposite happens when the Fed increases the discount rate; banks borrow less. Because the cost of money increases, the bank’s customers also borrow less, reducing the overall demand for money.

Reserve Requirements

Reserve requirements are the minimum amount of money that banks must keep on hand as reserves to meet their liabilities in case of unexpected high withdrawals. The Central Bank sets the reserve requirements (in a percentage) and the interest rate banks earn on excess reserves. Banks can keep the reserve either as cash in their vault or as deposits at the Central Bank. Reserves cannot be used for lending.

When the Federal Reserve lowers the reserve requirements, the money supply will increase. Lower reserve requirements prompt banks to take money out of reserves to lend to others to stimulate demand and economic growth. Lowering the reserve requirements is an example of an expansionary monetary policy as it increases the money supply. Alternatively, when the Fed wants to reduce liquidity and slow down the economy, it increases its reserve requirements. This is an example of a contractionary monetary policy.

Open Market Operations

Open market operations refer to the purchase and sale of securities to stabilize the economy and prevent uncontrolled inflation and deflation.

The Fed is a prominent participant in the U.S. Treasury securities market. U.S. Treasuries are government bonds and are typically considered safe investments by individuals and financial institutions alike.

When the Federal Reserve wants to increase the money supply, it buys government securities in large quantities from other banks on the open market. This adds cash to the banks’ reserves, increases the money supply, makes loans easier to obtain, and results in interest rates declining. This extra cash then stimulates demand. In contrast, when the Federal Reserve sells Treasuries to other banks and financial institutions, it reduces the banks’ cash reserves. Consequently, this results in a decrease in the money supply and rising interest rates.

During the financial crisis of 2008-2009, the Fed did not just buy U.S. Treasuries but all sorts of other securities as well. The Fed even bought securities not issued by the government, including subprime mortgage-backed securities. This strategy was extremely beneficial, pulling the economy out of the slump pretty quickly.

The Federal Funds Rate

The federal funds rate is the rate that banks and credit unions charge each other for overnight loans. This rate essentially is the interbank lending rate and is not specifically set by the Fed. However, The Federal Open Market Committee does set a target for the fed funds rate regularly. As a result, the federal funds rate is a benchmark and impacts all other interest rates, such as credit card rates, home mortgage rates, and savings deposit rates.

The Fed manages and guides the federal funds rate by using its open market operations and interest rates on reserves. The idea is to pump enough liquidity into the economy to make money cheaper and take enough liquidity out of the economy to make money more expensive.

In the subprime crisis of 2008-2009, the Fed reduced the target rate to 0%-0.25% to support the economy. It then introduced humongous open market operations in multiple phases as Quantitative Easing, flushing the system with liquidity, to maintain the rates in that range before increasing its target rate to 0.25%-0.5% in December 2015.

Interest on Reserves

Another tool that the Fed has at its disposal to adjust the money supply is the interest it pays on the reserves that banks keep with them. For example, when it wants to increase the money supply, it reduces the interest rate on these reserves. A reduced rate discourages banks from keeping excess reserves. This will give banks an incentive to put the extra money to use by lending it to people and businesses. This, in turn, will increase the money supply and stimulate demand. Alternatively, when the Fed decides to reduce the money supply, it increases the interest on reserves, incentivizing banks to keep higher reserves on hand.

Expansionary and Contractionary Monetary Policy

As discussed in the previous section, the Federal Reserves’ goal is to manage the money supply and inflation. To do its job, it has various monetary policy tools at its disposal. The only monetary policy tool that it does not have direct control over is the federal funds rate. However, it does have indirect control over this tool by setting a target federal funds range.

When Central Banks choose to pursue an expansionary monetary policy, they often use all their tools to achieve their objective. Expansionary monetary policy is enacted during a contractionary phase of the business cycle. In other words, during a recession, when economic growth is declining, GDP is decreasing, inflation is under control or below its target level, unemployment is higher than its desired level, and consumer confidence is down.

When this happens, a Central Bank will increase the money supply and make it easier and cheaper to borrow and spend money. So, in the US, the Fed will use all its monetary policy tools to stimulate economic growth and increase demand. It will lower interest rates, decrease the reserve requirement, and buy US Treasuries.  

In contrast, Central Banks do the opposite when the economy is growing too fast and inflation is getting out of control. Then, they pursue a contractionary monetary policy to curb this unsustainable growth. They will use all the tools to take excess liquidity out of the system, make money scarce, and suppress aggregate demand. Implementation of such monetary policies is crucial when over-optimism rules, all economic indicators point toward the sky, and risk management is nonexistent.

Although expansionary monetary policy is pretty common, the use of contractionary policy is rare. The reason being that typically governments want their economy to grow, and inflation is not often uncontrollable. The trick with contractionary monetary policy is to slowly curb economic growth but never stop it completely.

The Federal Reserve’s Response To Covid 19

The Covid-19 pandemic with its associated business shutdowns, extremely high unemployment rate, and work-at-home policies triggered the worst blow to the U.S. economy since the 1929 Great Depression. The fiscal policy response by Congress with its stimulus packages worth trillions of dollars has been unprecedented. Besides the fiscal stimulus, the monetary policy enacted by the Federal Reserve has also surpassed any previous monetary relief efforts. Many believe that because of the decisive action early on by both the government and the Fed, a deeper and longer recession was prevented.

At the beginning of the pandemic, the Federal Reserve deployed its whole arsenal of monetary tools to combat the economic crisis. It cut the target range for the federal funds rate by 1 1/2 percentage points to a range of 0% to 0.25% to stimulate spending. It also cut the discount rate to only 0.25%. In addition, it made the promise to keep this near-zero target range until the economy is on track to achieve maximum employment and price stability goals.

Secondly, on March 26, 2020, the Fed reduced the reserve requirement to zero. This near-zero rate encouraged banks to lend all their money to increase liquidity in the market. To increase liquidity, even more, the Fed also enacted open market operations by buying Treasuries and mortgage-backed securities. They did this at a level never seen before to try to reduce interest rates.

Besides enacting monetary policy to stimulate the economy and provide help, the Federal Reserve also implemented non-traditional emergency lending initiatives. For example, due to the pandemic, its lender of last resort role expanded by providing loans to nonbank markets and firms. To facilitate this, it established 9 temporary Federal Reserve emergency facilities and programs. Each program is set up differently. Some focus on shorter-term credit markets, others on longer-term credit markets. In some programs, the Fed has a direct impact on the market by either buying or making loans. In others, it buys or makes loans to institutions or investors to encourage them to intervene in affected markets.

The Fed’s response to the COVID-19 crisis is unprecedented. With its crucial support to the economy early on and its continued contributions, economic recovery is well on its way in 2021.

Conclusion

The Central Bank’s monetary policy and actions work very smoothly, like an automated system. When the Central Banks raise the interest rates, and money becomes more expensive, banks swiftly pass on the rate hike to their customers. If they wouldn’t, they would have to take a hit on their profits when they borrow expensive and lend cheap. Banks will also swiftly pass on rate cuts to attract more borrowing customers, luring them with lower rates.

The Central Banks’ actions have a ripple effect on the economy in the long run as the money multiplier that we talked about earlier takes time to settle in. In the short run, they boost the mood and cure any acute illness that the economy is going through.

Recently, the Central Banks’ response to economic downturns and recessions has become more aggressive, but luckily, severe economic hardships have been averted. In addition, the Central Banks’ role as the lender of last resort has also become stronger. As a result, the Federal Reserve has purchased many “toxic” securities that it may not find buyers for. This is risky, and although the Fed’s monetary policy has been successful so far, many believe that inflation or even hyperinflation is a real possibility in the near future. But, until inflation shows up in a significant manner, the Fed will most likely continue with its current monetary policy.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.