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FKD 101

FKD 101: What Is Monetary Policy?

shutterstock 334002650
shutterstock 334002650

If you remember, the Fed’s three main goals are to encourage stable prices, keep moderate interest rates and maximize employment.

These goals might seem intangible and lol-worthy, but we’re talking about an agency with the power to write a blank check to the government and create our money supply; so let’s make Aretha Franklin proud by showing some R-E-S-P-E-C-T.

“Mo’ Money, Mo’ Problems”

The Fed deals with a lot of money; the entire country’s money, in fact. Monetary policy is how the Fed regulates the amount of money and credit available in the economy. By raising/lowering money and credit as necessary, this creates a domino effect on the rest of the economy. This is why you might’ve seen the Fed in the news recently talking about interest rates (more on this shortly).

The Fed regulates monetary policy in three ways: reserve requirements, discount rate and open-market operations.

The monetary policy toolkit

The Fed uses the three tools just mentioned to tweak things here and there to stabilize the economy.

-Reserve requirements, also called reserve ratios, are the percentage of reserve money a bank is required to have stashed away. Decreasing this allows banks to lend more money to people looking to borrow. This means more money in the economy.

-The discount rate is the interest rate that the Fed charges to banks when they borrow money from the Fed for additional reserves. When the Fed keeps this low, banks are encouraged to borrow more money from the Fed. When banks have more money that means they can lend more to people who need it. Awesome!

-Open-market operations influence the bank reserves available for lending. To increase reserves, the Fed buys securities (treasury bonds, notes, and bills) from banks and/or securities dealers. The Fed pays for these transactions by adding credit to the bank’s reserve or the dealer’s account for the purchase price. This is another way to stimulate the economy because banks have more money to lend. The Fed can also lower reserves by selling securities, effectively taking money out of the economy.

Janet Yellen, here to save the day

Fed Chairwoman Janet Yellen and her crew influence monetary policy to help the economy out if it’s threatened or in need of a boost. When the Fed adds money to the economy (via lowering reserve ratios, lowering the discount rate and buying securities), it creates growth. When it shrinks the money supply (by raising reserve ratios, raising the discount rate and selling securities), it helps balance the scales against inflation to ensure that the economy remains stable and avoids dramatic spikes and drops.

The Fed hasn’t raised interest rates in nine years because it was giving the economy time to recover from the Great Recession. Now, the Fed is considering raising interest rates by the end of 2015 to offset inflation. Yellen and co. have held off doing so because the inflation rate and economic growth overall aren’t quite where they want it yet. Stay tuned for further developments.

Have something to add to this story? Comment below or join the discussion on Facebook.

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