How Do Modern Monetary Policies Work?

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Table of Contents

Introduction
Indicators of Monetary Policy
How the Monetary Policy Works
Conclusion
Works Cited

Introduction

Globalization has made the world a global village and thus any country’s economy is affected both by its internal monetary policies and those of other countries it interacts with. Depending on the way these monetary policies are made they can work toward developing the economy of one country to the detriment of the others or promote economic growth in both the country where they are enacted and to other trading countries.

The United States of America has experienced economic expansion for a very long period (from 1990 to 2000) until the last half of the year 2000 when the country’s economy growth became slow and sluggish. In order to contain the slow growth and improve the economy of the country “the Federal Reserve between mid-1999 and May 2000 raised the target for the federal funds rate to 6½ % from 4¾ %”( Labonte & Makinen 7).

his did not auger well as the economy growth continued to decline and thus the policies had to be loosened in order to allow more production and spending for the economy to grow.

Government policies that are aimed at controlling the supply of money in the market through the Central Bank make up monetary policies.

In the legislation and enacting of monetary policies several bodies coordinate together in order to achieve an acceptable money supply as not only does it affect the country’s economy but also other countries economies, which trades with the United States of America. The major banks making policies in the United States of America are however two (both the nation’s Central Bank and the Federal Reserve).

In relation to the United States of America, we can define monetary policies as those policies that “consist of the directives, policies, pronouncements, and actions of the Federal Reserve that affect aggregate demand or national spending” (Labonte & Makinen 8). Monetary policies works at either increasing or decreasing the supply of the money in the market influencing how trade and spending goes on within a country.

The only unfair characteristic of monetary policies is that they are short term in nature since their enactments are usually designed only to solve a short term crisis. In short the monetary policy tries to solve economic crisis and once the normal economic environment is regained the monetary policies are also adjusted to suit the situation.

Monetary policies try to solve macro economic issues such as spending, income levels, unemployment, and inflation among other macroeconomic factors. Evidence showing monetary polices trends can be described by the fact that:

Between January 3, 2001, and June 25, 2003, the target rate for federal funds was reduced to 1% from 6½%. This policy was reversed beginning June 30, 2004. In 17 equal increments of ¼% ending on June 29, 2006, the target rate was raised to 5¼% from a base of 1%. No additional changes were made at the three subsequent meetings. (Labonte & Makinen 4)

In order to understand how monetary policies work it is advisable to understand its two indicators.

Indicators of Monetary Policy

Money Supply

A common market rule is that when the supply of a commodity decreases its demand increases resulting in increased prices and the opposite happens when the supply is high the demand decreases thus driving the prices down. This same law also applies to the supply of the money in the market. Most of the times, monetary policies are described either as easy if in influences an increased money supply and tight if its main aim is to reduce the money supply.

Interest Rates

In his interest theory, John Maynard Keynes argued that interest rate is monetary phenomena determined in the money market but not influenced by savings as classical economists used to argue. He argued that not all people who save that do so with an intention of earning interest thus it should be in the monetary market where funds are borrowed and their rates determined. Thus, changes in money supply (whether an increase or a decrease) leads to an increase or a decrease in the cost of the money.

The changes in interest rates are important to the government as they influence spending in an economy thus creating or reducing employment. However, experts warn that the interest rates experienced due to the changes in aggregate demand and supply of the money are not the real market rates; the real market rates should be the existing market rates less inflation rates in the country. It is thus assumed that a high economic growth reduces interest rates in the short run.

Given that countries have future expectations of how inflation rates will be the fall in market rates is always seen as a fall in the real interest rates. However, market rates can change for other reasons for example an increase in income increases the market interest rates thus increasing the demand for money since more people can afford the money and the public expects lower inflations in future (Schabert 17).

How the Monetary Policy Works

Monetary policies works through the following instruments which either increases or decreases the supply of money in the market as it is explained below.

Open Market Operations

To increase or decrease the supply of money in the market, the Federal Reserve can engage in open market operations; this involves selling and buying of bonds in the market.

When the federal Bank engages in selling the bonds or securities it aims at reducing the money supply in the market to avoid inflation of the money; the opposite occurs if the federal bank realizes that the money supply in the market is less as it repurchases the bonds and the securities thus making more money available in the market and this helps in ensuring that the commodity prices remain at a stable position by increasing both the money supply and the aggregate demand (Taylor 4).

Reserves Deposit Requirement

The government through the federal government can also increase or decrease the required reserve deposits that the commercial banks in the country deposits in the federal government in order to control an economic problem which may be brought about by the existing economic conditions.

In order to reduce money supply in the market, the Federal Bank instructs the regional or commercial banks to increase their reserve requirements; this increases the amount of money withheld and in return reduces the amount of money which can be lend to the customers thus reducing the money supply.

The lowering of the reserve deposit required in these banks by the Federal Bank works in the opposite way. In order to meet these Fed requirements, banks lend among themselves creating a multiplier effect and the rate on such loans determines how loose or tight the monetary policy at that time (Feinman, Deschler & Hinkelmann 1).

Discount Rate

Federal Reserve lending rates to commercial banks are described as discount rates. An increase in the discount rate makes the cost of borrowing increase thus reducing the amount of money which the Federal Reserve can lend to the commercial banks within the state. The high interest rates are transferred down to the customers and the high rates discourage borrowing thus reducing the money supply in the market (U S Department of State 28).

Interaction between Central Bank, the Treasury, and the Financial System

The Central Bank is a special bank within the ministry of finance but independent from interference by the executive. The bank has the mandate to preserve financial stability and enhance financial development by controlling the money supply in the market. Its’ autonomy can be described in terms of;

the ability to set the terms and conditions on the items in the central bank’s balance sheet – this is essential for the conduct of monetary policy; having the means to bear any losses that arise from central bank operations and having appropriate rules to allocate profits (including rules that govern the accumulation of capital and reserves); and the ability to cover operating expenses, and in particular to set salaries (typically the single largest component of operating costs) in a manner that allows the Central Bank to attract and retain the professional talent it requires (Boehm 59).

There have been interactions between the treasury and the federal reserve board in an attempt by the government to overhaul the regulatory system but some Fed officials were seeing it as an attempt by the government to interfere with the independence of the bank and thus there was no way they could accept.

They argue that the Fed was established by the congress thus it is not part of the executive thus interference should no be expected from the treasury (Torres & Schmidt 1). The interaction between the central bank, the treasury, and the financial institutions is best described in the way the monetary policies work and the role played by each.

Policy Proposals Relating to Reforming the Financial System

One of the proposals being forwarded by the congress is that of establishing a new systemic risk regulator bearing in mind the country is just recovering from the economic crisis. The regulator is expected to supervise the growth of the financial institutions.

There has also been the proposal of changing how the Federal Bank functions. This has not augured well as it would curtail the independence of the Federal Bank and make it prone to political interference.

While many think that this will work well in the long run it may work against the goals of making the financial institutions and monetary policies effective as political interests might be fulfilled to the expense of American citizens. There have been further proposals from the House and the Senate for the creation of a Risk Based Systemic Fund whose source would be from the institutions. While the policy might be good, it is not without a flaw since it fails to address the appropriate levels through which the financial institutions can be evaluated.

Other proposals have been aimed at making stricter standards on capital and liquidity requirements among the most risky institutions. As the United States of America recovers from the economic crisis there have been calls to create or establish a mechanism through which failing financial institutions can be rescued before they can file into bankruptcy through receivership so as to reduce the uncertainties in the monetary system (Acharya, Cooley, Richardson, & Ingo 16).

Finally, the executive has had interests in controlling the actions of the Fed and thus they had been proposing for law reviews which would allow the central bank become the lead regulator for all the financial institutions (Torres & Schmidt 1).

Conclusion

From the study we can conclude that monetary policies are ways through which the government regulates the supply of money in the bank and while the policies are good they are only enacted for short term purposes as the economy is never static. Thus, policies also need to evolve and should be legislated in a way that suits the prevailing economic conditions.

Works Cited

Acharya, Viral, Cooley F. Thomas; Richardson, Matthew., & Ingo, Walter. “Real Time Solutions for US Financial Reform.” VoxEU.org, 2009. Web.

Boehm, Moser. “The Relationship between the Central Bank and the Government.” Bis, 2006. Web.

Feinman, Joshua; Deschler Jana., & Hinkelmann, Christoph. “Reserve Requirements: History, Current Practice, and Potential Reform.” Federalreserve, 1993. Web.

Labonte, Marc., & Makinen, Gail. “Monetary Policy: Current Policy and Conditions”. CRS Report for Congress. The Library of Congress, 2006.

Schabert, Andreas. Money supply and the implementation of interest rate Targets: Working Paper Series. London: European Central Bank. 2005

Taylor, John. “Expectations, Open Market Operations, and Changes in the Federal Funds Rate.” Stanford University. 2001. Web.

Torres, Craig., & Schmidt Robert. “Fed Rejects Geithner Request for Study of Governance Structure.” Bloomberg, 2009. Web.

U.S. Department of State. “Monetary and Fiscal Policy.” Countrystudies, 2010.

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