Monetary Policy: Simple Explanation in 3 Easy Steps

What is Monetary Policy?

Monetary policy is explained as the management of a country’s economy by controlling the amount of money in circulation. Economic conditions rely so much on this control. Inflation is a state of unmanageably high levels of monetary circulations, caused by among other things, low-interest borrowing. On the other hand, high unemployment can be managed by increasing monetary supplies, creating jobs as a result. 

Monetary Policy vs Fiscal Policy

These two are both instruments of macroeconomic control, with their competitive effectiveness a constant debate. Fiscal policy controls monetary supplies only indirectly, but does so well in regulating employment and price levels. In most jurisdictions, monetary policy is the mandate of the dominion’s central bank. In the US it’s the Federal Reserve Bank (the Fed), while in the UK it’s the Bank of England. Fiscal policy on the other hand, is controlled by the government of the day, through legislative processes provided for by the country’s law. The Congress oversees the fiscal policy in the US, which is ultimately approved by the executive. 

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The two most common fiscal policy tools are taxation and regulation of government spending. In times of crisis, the government has been a premium savior of the day. During financial breakdowns, the government bails out banks and other institutions so as to protect depositors and investment bankers. 

Aims of Monetary Policy

These ones differ from place to place, but the most common goals of monetary policy and central banks at large are to control interest rates, moderate prices and achieve maximum employment rates. These are the goals of the US’ Federal Reserve Bank.

• Controlling interest rates is a directive meant to curb inflation, and the same time keep the economy growing. While the Fed has in notable instances increased the interest rates to check inflation in the past, the high interest rates resulted in a major set-back in economic growth. On the other hand, the Fed, so as to salvage an economic recession has in the past reduced interest rates to an almost zero level. This did the magic in reviving the economy, but often led to an inflation surge. Financial regulation is thus a roller coaster, and the central bank has to be in active watch to maintain a moderate economy.
• Price control is arguably better done through fiscal measures such as tax waivers and government subsidies. However, monetary policies have significant roles to play too. Inflation is sometimes defined as the rise in price of basic commodities, a phenomenon that is significantly caused by low interest rates. The central bank (the Fed in USA) attempts to control these prices by regulating the interest rates charged on loans.
• Maximum Employment is also largely controlled by non-monetary factors in the labor market. In the US, the Federal Open Market Committee (FOMC) considers prevailing employment conditions; the number of jobs created, number of jobs lost, and current unemployment. Its role in employment maximization? Communication of these findings and the constant monetary measures used to control other aspects of the economy.

Monetary Policy Tools

1. Federal Funds Rate

The term is only used in the US, but the monetary tool is universally applied by central banks worldwide. Federal funds rate is the interest rate charged on bank-to-bank transactions, and the interest rates charged on reserve lending to commercial lenders. The central bank may not control consumer interest rates by decree as much as it does by regulating the funds rate.  

In the US alone, the Fed documents over $ 1 trillion daily of non-cash transfers within banks and from one bank to another. The Federal Reserve facilitates the settlement of these transfers through daily bank-to-bank exchanges of cash deposits at the reserves. The Fed also issues daily loans to banks against these transfers, and limits the frequency of these loans by adjusting the funds rate. A lower funds rate is used to ease financial regulations and encourage bank liquidity. Loans will in turn become so cheap, and customers will be encouraged to borrow heavily. That way, monetary supply multiplies within days.

In the build-up to the 2008 Financial Crisis, the Fed had reduced the federal funds rate from 6.5 to 1.75%, leading to so much liquidity in the hands of commercial banks. People borrowed in droves, and the banks still had extra left. The extent of this was sub-prime lending to under-qualified borrowers. This now is the risk with reduced funds rate, as massive defaults would cripple the economy.

2. Reserve Requirements

This is the amount of banks’ cash reserves held in the central bank as a fraction of customer deposits. By regulating the net to capital ratio, the central bank controls the liquidity held by banks and consequently the amount of money in supply.

3. Open Market Operations (OMO)

During the COVID-19 pandemic, the US Federal Reserve reduced the net to capital ratio to zero, allowing banks to hold so much liquidity and in turn pump funds to the economy, as a responsive monetary policy to the pandemic economic breakdown. 

Another effectively proven monetary tool is Open Market Operations. This is the purchase and sale of government securities in the open market, conducted by the central bank on behalf of the government. The OMO strategy is direct; the Fed buys securities and pays cash to release money into circulation, and sells the securities to repossess the monetary supplies. 

Government securities include treasury bonds and bills, savings bonds, and treasury notes. These securities differ in the rate of interest accrued depending on maturity periods. Treasury bills, for instance, mature in four weeks on the least, accruing a minimal interest rate of sub-1%. Treasury bonds, on the other hand, mature at 10 years on the least and may go up to 30 years, but accrue yields of up to 5%. 

In the US, the Federal Open Market Committee trades on behalf of the government’s Federal Reserve Board. Depending of the prevailing circumstances, the FOMC sets a target for interest rates, and directs the Trading Desk to either buy or sell government securities. Impacts on interest rates can be felt in as soon as 4 weeks.

4. Quantitative Easing

This is almost similar to OMOs, but now the government implements a massive shake-up in the market to respond to an economic emergency. Quantitative easing involves the bulk purchase of government securities and other financial instruments such as mortgage-backed securities so as to boost a stagnating economy. Notable instances of Quantitative Easing in the US and other governments include the 2008 financial crisis and during the COVID-19 economic breakdown. 

Key Take-Away: Monetary Policy is a roller coaster, and a country’s central bank has to be vigilant to detect any miniature changes to the economy, and respond suitably. A monetary policy response to a crisis may aggravate to another crisis in the opposite direction, thus a balance has to be sought. 

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