Definition: Monetary policy is how central banks manage liquidity to create economic growth.

Liquidity
is how much there is in the money supply. That includes credit, cash, checks and money market mutual
funds. The most important of these is credit. It includes loans, bonds and mortgages.

Objectives of Monetary Policy

Objectives of Monetary Policy

The primary objective of central banks is to manage inflation.

The second is to reduce unemployment, but only after they have controlled inflation.

The U.S. Federal Reserve, like many other central banks, has specific targets for these objectives. It seeks
an unemployment rate below 6.5 percent. The Fed says the natural rate of unemployment is between 4.7
percent and 5.8 percent. It wants the core inflation rate to be between 2.0 percent and 2.5 percent. It
seeks healthy economic growth. That's a 2-3 percent annual increase in the nation's gross domestic
product.

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They have many tools to do this.
The most common are raising interest rates and selling securities through open market operations.

They use expansionary monetary policy to lower unemployment and avoid recession. They lower interest
rates, buy securities from member banks and use other tools to increase liquidity.

Monetary Policy versus Fiscal Policy

Ideally, monetary policy should work hand-in-glove with the national government's fiscal policy. It rarely
works this way. That's because government leaders get re-elected for reducing taxes or increasing
spending. That means rewarding voters and campaign contributors, to put it bluntly.

As a result, fiscal policy is usually expansionary. To avoid inflation in this situation, monetary policy
must be restrictive.

Ironically, during the Great Recession, politicians became concerned about the U.S. debt. That's because
it exceeded the benchmark debt-to-GDP ratio of 100 percent. As a result, fiscal policy became
contractionary just when it needed to be expansionary. To compensate, the Fed injected massive amounts
of money into the economy with quantitative easing.

Tools of Monetary Policy

All central banks have three tools of monetary policy in common. Most have many more. They all work
together in an economy, by managing banks' reserves.

The Fed has six major tools. First, it sets a reserve requirement, which tells banks how much of their
money they must have on reserve each night. If it weren't for the reserve requirement, banks would lend
100 percent of the money you've deposited. Not everyone needs all their money each day, so it is safe for
the banks to lend most of it out.
The Fed requires that banks keep 10 percent of deposits on reserve. That way, they have enough cash on
hand to meet most demands for redemption. When the Fed wants to restrict liquidity, it raises the reserve
requirement.

The Fed only does this as a last resort because it requires a lot of paperwork.

It's much easier to manage banks' reserves using the Fed funds rate. This is the interest rate
that banks charge each other to store their excess cash overnight. The target for this rate is set at the eight
annual Federal Open Market Committee meetings. The Fed funds rate impacts all other interest rates,
including bank loan rates and mortgage rates.

The Fed's third tool is its discount rate. That's how it charges banks to borrow funds from the Fed's fourth
tool, the discount window. The FOMC usually sets the discount rate a half-point higher than the Fed
funds rate.

That's because the Fed prefer banks to borrow from each other.

Fifth, the Fed uses open market operations to buy and sell Treasuries and other securities from its member
banks. This changes the reserve amount that banks have on hand without changing the reserve
requirement.

Sixth, many central banks including the Fed use inflation targeting. It clearly sets expectations that they
want some inflation. That's because people are more likely to buy if they know prices are rising.

In addition, the Fed created many new tools to deal with the Great Recession. To find out more,
see Federal Reserve Tools.

EXPANSIONARY MONETARY POLICY

In the United States, when the Federal Open Market Committee wishes to increase the money supply, it
can do a combination of three things:

1. Purchase securities on the open market, known as Open Market Operations

2. Lower the Federal Discount Rate
3. Lower Reserve Requirements

These all directly impact the interest rate. When the Fed buys securities on the open market, it causes the
price of those securities to rise. In my article on the Dividend Tax Cut we saw that bond prices and
interest rates are inversely related. The Federal Discount Rate is an interest rate, so lowering it is
essentially lowering interest rates.
If the Fed instead decides to lower reserve requirements, this will cause banks to have an increase in the
amount of money they can invest. This causes the price of investments such as bonds to rise, so interest
rates must fall. No matter what tool the Fed uses to expand the money supply interest rates will decline
and bond prices will rise.

Increases in American bond prices will have an effect on the exchange market.

Rising American bond prices will cause investors to sell those bonds in exchange for other bonds, such as
Canadian ones. So an investor will sell his American bond, exchange his American dollars for Canadian
dollars, and buy a Canadian bond. This causes the supply of American dollars on foreign exchange
markets to increase and the supply of Canadian dollars on foreign exchange markets to decrease. As
shown in my Beginner's Guide to Exchange Rates this causes the U.S. Dollar to become less valuable
relative to the Canadian Dollar. The lower exchange rate makes American produced goods cheaper in
Canada and Canadian produced goods more expensive in America, so exports will increase and imports
will decrease causing the balance of trade to increase.

When interest rates are lower, the cost of financing capital projects is less. So all else being equal, lower
interest rates lead to higher rates of investment.

WHAT WE'VE LEARNED ABOUT EXPANSIONARY MONETARY POLICY:

1. Expansionary monetary policy causes an increase in bond prices and a reduction in interest rates.
2. Lower interest rates lead to higher levels of capital investment.
3. The lower interest rates make domestic bonds less attractive, so the demand for domestic bonds
falls and the demand for foreign bonds rises.

1. The demand for domestic currency falls and the demand for foreign currency rises, causing a
decrease in the exchange rate. (The value of the domestic currency is now lower relative to
foreign currencies)
2. A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to
increase.

CONTRACTIONARY MONETARY POLICY

As you can probably imagine, the effects of a contractionary monetary policy are precisely the opposite of
an expansionary monetary policy. In the United States, when the Federal Open Market Committee wishes
to decrease the money supply, it can do a combination of three things:

1. Sell securities on the open market, known as Open Market Operations

2. Raise the Federal Discount Rate

1. Raise Reserve Requirements

These cause interest rates to rise, either directly or through the increase in the supply of bonds on the open
market through sales by the Fed or by banks. This increase in supply of bonds reduces the price for bonds.
These bonds will be bought up by foreign investors, so the demand for domestic currency will rise and the
demand for foreign currency will fall. Thus the domestic currency will appreciate in value relative to the
foreign currency. The higher exchange rate makes domestically produced goods more expensive in
foreign markets and foreign good cheaper in the domestic market. Since this causes more foreign goods to
be sold domestically and less domestic goods sold abroad, the balance of trade decreases. As well, higher
interest rates cause the cost of financing capital projects to be higher, so capital investment will be
reduced.