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Table of Contents:

Purpose of Monetary Policy:

The purpose of Monetary policy is to either accelerate / decelerate the economy...either to cut unemployment (spur growth),...or to control inflation.

The money supply is controlled by the Federal Reserve (central bank):

"The Federal Reserve Board affects the federal funds rate by using open market operations, which is the purchase and sale of Treasury securities. If it wants to inject money into the economy, then it buys bonds, which also lowers interest rates. If it wants to lower the money supply, it sells bonds, which raises interest rates."

Related Pages from KookyPlan

• federal funds rate
• Fed discount rate
• FOMC
• Fiscal Policy

Table of Contents

Monetary Policy

The Monetary policy is one way in which a government can spur growth (and jobs) in a country.  The other way is fiscal policy.  While the goals of the two systems might be similar, the mechanism and the results are quite different.  Many economists spend their entire lifetimes debating the optimum way to accomplish growth & employment, without causing inflation or high interest rates.

If the government is trying to stimulate the economy (get new jobs):

The key differences between the two are as follows: 

1. Monetary policy: 
   • What: federal funds rate, discount rate
   • Who:  Central Bank (the Federal Reserve)
   • How:  increase / decrease money supply (to raise / lower interest rates, which will encourage investment or savings)
   • Where does the money come from: print new money, which enters the system when the Fed buys Treasury bonds from the market (see details about FOMC - how this proces works)
   • Effects:  interest rates down, currency depreciates
2. Fiscal Policy:
   • What:  government spending
   • Who:  treasury department (its not the central bank, so they can not print more money)
   • How: spend money (new roads, buildings, projects, etc)
   • Where does the money come from:  either (a) raise taxes, or (b) borrow money by issuing new bonds
   • Effects:  interest rates go up, currency appreciates

Federal Balance Sheet:

Data from federal Reserve:

• http://www.federalreserve.gov/releases/ 

Related KookyPlan pages:

• balance of payments
• trade deficit

Question:"what happens when the Fed increases the money supply?" (lowers interest rates)

1. Currency will depreciate (this happens first, within one day)...then later it should appreciate (according to economic theory), but that depends on many factors, and is very hard to predict.
2. inflation will increase (this happens second, over lots of time).

How does it happen?

1. The central bank (actually, the Treasury) prints more money
2. From the treasury department, trucks of money go up 95 to the Fed in New York City
3. The Fed in NYC uses the new money to buy Treasury Bonds from the open market (from whoever in the market that is selling...usually big banks)
4. They sell because the Fed offers a slightly higher price...gives them incentive to sell
5. FOMC = federal open market committee
6. People sell bonds to Fed, who gives them new money in exchange...which increases the money supply

What effect does this have on FX rates?

1. Currency will depreciate (devalue) immediately

2. The immediate effect is that the yield on the treasury bond will go down
3. This is because the Fed offered a higher price, but because the ending price on the bond is fixed, that means that the yield goes down
4. the dollar will devalue (depreciation) immediately.
5. Because the return on USD goes down as the yield on treasury bonds goes down (they are highly correlated)

What effect does this have on inflation?

1.  over time, there will be more inflation as the money supply increases.
2. because there will be more money chasing the same amount of goods, so by supply & demand, the level of prices should go up as sellers are able to charge more for their products.
3. more money in the system chasing the same number of goods is good for sellers, so they can charge more.
4. Also, there is an investment effect...more money leads to lower interest rates, which encourages business investment, which leads to more production.  If the economy overheats, there could be inflation as a result.
5. Time - this process takes a long time, and is confusing because lots of different variables comes into play.  This is different than the FX effect which happens immediately. 

How the Fed controls the money supply:

see our discussion on  FOMC for more details...

What is monetary policy?

The term monetary policy refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit as a means of helping to promote national economic goals.

How does the Federal Reserve implement monetary policy?

The Federal Reserve implements monetary policy using three major tools:

• Open market operations. The buying and selling of U.S. Treasury and federal agency securities in the open market

• Discount window lending. Lending to depository institutions directly from their Federal Reserve Bank’s lending facility (the discount window), at rates set by the Reserve Banks and approved by the Board of Governors

• Reserve requirements. Requirements regarding the amount of funds that depository institutions must hold in reserve against deposits made by their customers.

read more from the Feds website:  http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm

What is the federal funds rate, and why does the FOMC raise or lower the target rate?

The federal funds rate is the rate charged by one depository institution on an overnight sale of immediately available funds (balances at the Federal Reserve) to another depository institution; the rate may vary from depository institution to depository institution and from day to day. The target federal funds rate is set by the Federal Open Market Committee (FOMC). By setting a target federal funds rate and using the tools of monetary policy--open market operations, discount window lending, and reserve requirements--to achieve that target rate, the Federal Reserve and the FOMC seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," as required by the Federal Reserve Act.

• Current rate target.
• Current actual rate.

What is the discount rate?

The discount rate is the interest rate that an eligible depository institution is charged to borrow funds, typically for a short period, directly from a Federal Reserve Bank. By law, the board of directors of each Reserve Bank sets the discount rate independently every fourteen days subject to the approval of the Board of Governors. Originally, each Reserve Bank set its discount rate to reflect the banking and credit conditions in its own District. Over the years, the transition from regional credit markets to a national credit market has gradually produced a national discount rate. As a result, the Federal Reserve maintains a uniform structure of discount rates across all Reserve Banks.

For more information on the discount rate, see The Federal Reserve System: Purposes and Functions.

• Current discount rates.
• Historical discount rates.

read more:  http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm

History of US monetary & FX policy (in Brief)

During the early part of the 1980s, the United States pursued a combination of loose fiscal policy and tight monetary policy, which caused the dollar to appreciate and produced trade and current account deficits that set new records. Rather than altering domestic macroeconomic policy, the first Ronald Reagan administration actively encouraged capital inflows to finance the fiscal and current account deficits. These policies flooded the United States with imports and put pressure on traded-goods producers that was unprecedented in the postwar period. When these producers complained to the Treasury, they were told that Treasury would not attempt to cap the value of the dollar for their benefit. These groups then complained to Congress, which responded by passing the 1988 Act. Proponents intended this legislation to improve congressional oversight and Treasury's accountability on exchange rate policy.

Exchange rates have again become a particularly important issue for Congress in recent years. The issue's return to political prominence has this time been driven largely by objections to China's exchange rate policy. Competition from China has put pressure on US producers, who have complained to Congress that the renminbi is substantially undervalued. Meanwhile, Treasury has refused to cite China in its reports to Congress as a country that "manipulates" its currency, despite unprecedented amounts of foreign exchange intervention by Chinese authorities to restrain the renminbi's appreciation.

Frustrated by what they perceive to be the modest results of these discussions, several members of Congress have proposed legislation that, if adopted, would reform the process by which Treasury identifies and responds to currency manipulation and could impose trade restrictions to compensate for the resulting undervaluation. The stakes are high because such provisions would also apply to countries beyond China whose economic strategies have also included substantial undervaluation of their currencies.

read more:  >> Preview book

Does the Federal Reserve control or set the prime rate?

No, banks set their own rates based on the demand for various kinds of loans, the cost of money to the banks, and the administrative costs of making loans.