Question

Discuss the various monetary policy levers used by politicians and bureaucrats to guide the economy in the direction they deem most beneficial. Why do these policy levers produce unexpected results? How do these policy actions change your behavior regarding spending and saving?

Answer 1

The monetary policy:

• Monetary policy is the use of monetary levers, interest rates, money supply, foreign exchange rates, by governments to achieve some control over the performance of the economy. We have monetary theory to provide insight into how to draft a monetary policy. Monetary policy is implemented through open market operations. Monetary policy is the process by which the monetary authority of a country controls, the supply of money, availability of money, and cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy is either an expansionary monetary policy, or a contractionary monetary policy. The idea of monetary policy as independent of executive action began to be established with the creation of the Bank of England in 1694 which acquired the responsibility to print notes and back them with gold.
• Expansionary monetary policy increases the total supply of money in the economy, and a contractionary monetary policy decreases the total money supply. Expansionary monetary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary monetary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation. The central bank controls its national money supply by buying and selling government securities, or other financial instruments. Monetary targets, such as interest rates or exchange rates, are used to guide this implementation.

Monetary policy refers to the policy that change the availability and cost of money. Monetary policy is operated through the central bank of country or Federal Reserve. Following are levers:

Federal Fund rate: it is rate which is charged by the one bank from another ones.
Open market operation: it concerns with buying and selling government securities in open market thereby affecting the money supply in india.
Discount rate: it is rate at which Federal Reserve lends out commercial banks.
These policy tools do not affect the economy positively sometimes. Inside lag effect is smaller in monetary policy but outside lag effect is greater , thus economic conditions might be different when monetary policy starts showing up effects in economy.

What are the goals of monetary policy?

• The goals of monetary policy are to promote maximum employment, stable prices and moderate long-term interest rates. By implementing effective monetary policy, the Fed can maintain stable prices, thereby supporting conditions for long-term economic growth and maximum employment.

What are the tools of monetary policy?

The Federal Reserve’s three instruments of monetary policy are open market operations, the discount rate and reserve requirements.

Open market operations involve the buying and selling of government securities. The term “open market” means that the Fed doesn’t decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an “open market” in which the various securities dealers that the Fed does business with – the primary dealers – compete on the basis of price. Open market operations are flexible, and thus, the most frequently used tool of monetary policy.

The discount rate is the interest rate charged by Federal Reserve Banks to depository institutions on short-term loans.

Reserve requirements are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank.

What are the open market operations?

The Fed uses open market operations as its primary tool to influence the supply of bank reserves. This tool consists of Federal Reserve purchases and sales of financial instruments, usually securities issued by the U.S. Treasury, Federal agencies and government-sponsored enterprises. Open market operations are carried out by the Domestic Trading Desk of the Federal Reserve Bank of New York under direction from the FOMC. The transactions are undertaken with primary dealers.

When the Fed wants to increase reserves, it buys securities and pays for them by making a deposit to the account maintained at the Fed by the primary dealer’s bank. When the Fed wants to reduce reserves, it sells securities and collects from those accounts. Most days, the Fed does not want to increase or decrease reserves permanently, so it usually engages in transactions reversed within several days. By trading securities, the Fed influences the amount of bank reserves, which affects the federal funds rate, or the overnight lending rate at which banks borrow reserves from each other.

The federal funds rate is sensitive to changes in the demand for and supply of reserves in the banking system, and thus provides a good indication of the availability of credit in the economy.

What is the role of the Federal Open Market Committee (FOMC):

• FOMC formulates the nation’s monetary policy. The voting members of the FOMC consist of the seven members of the Board of Governors (BOG), the president of the Federal Reserve Bank of New York and presidents of four other Reserve Banks who serve on a one-year rotating basis. All Reserve Bank presidents participate in FOMC policy discussions whether or not they are voting members. The chairman of the Board of Governors chairs the FOMC meeting.