Monetary policy is regulating of the amount of money in the economy for the purpose of reducing the challenges of inflation and unemployment and securing the business cycle (Amos-Web, n. d.). The main objective of money policy is to maintain the economy healthy and flourishing. In the past, monetary policy was implemented by regulating the amount of paper currency.
Currently, monetary policy in implemented by regulating the money creation process. The Federal Reserve System (Fed) in the US has three tools that it can use to control the money creation process and the money supply. These are open market operations, reserve requirements, and the discount rate (Wells, 2004).
The open market operations are incredibly accurate and simple to execute. When using it, the Fed either buys or sells Treasury bonds. The trading affects the quantity of excess reserves available for banks to give out as loans. When the Fed buys the bonds, banks benefit by having sufficient reserves that they can give out as loans at lower interest rates. This encourages public borrowing and, therefore, raises the amount of money in the economy.
On the other hand, when the amount of money in the economy is too much, it uses the same tool to reduce the amounts. It sells Treasury bonds to withdraw the excess money and, therefore, leaves banks with fewer reserves that they can use as loans.
Due to the reduction of the money at the banks’ disposal, the banks react by increasing the rates of interest on loans that they give to the public. The increase in interest rates discourages borrowing and, therefore, leads to decrease in money supply in the economy (Wells, 2004).
The Fed also uses the discount rate as a tool to keep the economy stable and flourishing. It can increase interest rates it charges banks for borrowing reserves. If it increases the rates, banks retain limited reserves for trade. Further, it can increase charges on interests to make more profit. This discourages borrowing and reduces money supply in the economy. Fed can also lower the discount rate and give banks the opportunity to borrow more reserves.
The banks can utilize the reserves to give out loans at more affordable rates and increase money supply in the economy (Wells, 2004). Fed often uses changes in the discount rate as an indicator for monetary policy actions.
The last monetary tool that Fed uses is reserve requirements. It sometimes adjusts the reserve ration, which is the proportion of reserves that banks are permitted to keep as outstanding deposits. The ration affects the amount of reserves that can be in the custody of banks. The Fed can either lower or increase the reserve requirements.
If it lowers the reserve requirements, banks have access to more reserves and can give out more loans at lower interest rates, therefore, influencing banks to lower their interest rates. As banks lower interest rates, money supply in the economy also increases. This encourages investment.
On the other hand, the Fed can reduce the money supply if the amount in the market is unhealthy for the economy (Amos-Web, n.d.). If it raises reserve requirements, banks encounter stiffer regulations and use existing reserves to make fewer loans at higher rates. The reduction in the borrowing rate leads to the decrease in the money supply.
The Fed seldom use reserve requirements. However, it can use any of the three tools to control money supply (Amos-Web, n.d.). By controlling the money supply, the monetary policy manages the levels of inflation and unemployment. As a result, a secure economy is developed in which savings and interests occur.
Amos- Web: Economic Encyclonomic. (n.d.). Economics with a Touch of Whimsy. Web.
Wells, D. R. (2004). The Federal Reserve System. Jefferson, N.C.: McFarland & Co.