Do you ever wonder who is controlling the money in the US? Who can have a say in whether to increase the interest rate? The president?
No. it’s the central bank.
In our country, the Federal Reserve System serves as a central bank. By drafting, announcing and implementing the plan, the Fed controls the quantity of money and the channels by which new money is supplied. All these procedures are called monetary policy.
What is Monetary Policy?
Monetary policy is made by central bank, controlling the money supply and interest rates. It aims at achieving macroeconomic objectives such as controlling inflation, liquidity and others. Therefore, central bank can effectively influence output, employment and process.
The Fed has two mandates: to achieve maximum employment (with around 5 percent unemployment) and stable prices (with 2 to 3 percent inflation)
Types of Monetary Policies
In general, monetary policies can be categorized as expansionary or contractionary.
An expansionary monetary policy can be used during an economic slowdown or a recession to increase economic growth. The central bank usually will lower the interest rates to promote spending. Also, it increases money supply in the market to boost investment and consumer spending. Lower interest rates mean that businesses or individuals can take loans in a lower rate so they can expand productive activities.
When there’s too much money in the market, inflation will be high. in that case, the central bank will use a contractionary monetary policy, which can slow economic growth. The central bank will increase the interest rate and encourage people to save money in banks. Therefore, the money in the market is reduced. The inflation rate will decrease as well.
Tools to Implement Monetary Policy
Central banks have multiple tools to implement monetary policy.
First is buying and selling short-term bonds. This is known as open market options. By buying assets, the central bank adds money into the banking system. Banks have more money, then it will respond with lower interest rate, until the central bank’s interest rate target is met.
Second is changing the interest rates and required collateral that the central bank needs for emergency direct loans to banks. This is known the discount rate in the US. Charging higher rates and requiring more collateral, banks will be cautious to lend money, thus, the interest rate will be higher.
Third is the reserve requirements, which means the funs that banks must retain as proportion of the deposits made by customers in order to ensure that they still have money for easy withdrawal. Lowering the reserve requirement releases more money in the bank, so the interest rate is lower.