Monetary Policy

What It Means

The size of the money supply (the amount of money in circulation) is one of the most powerful influences on an economy. In general, when more money is circulating in an economy, there is more demand for goods and services, so businesses produce more, and more people have jobs. By contrast, when the money supply shrinks, there is less demand for goods and services, businesses restrict their activities, and fewer people have jobs. Monetary policy is the government practice of adjusting the money supply in order to bring about a change in the economy.

In developed, capitalist economies (in which businesses are generally owned by private individuals rather than the government), there are central banks that regulate the banking industry and oversee the country’s money supply. For instance, the United States’ central bank, the Federal Reserve System (often called the Fed), keeps watch over the U.S. economy and makes adjustments to the money supply in the hope of reaching certain economic goals. These goals usually include making sure there are enough jobs for people who want them, guarding against inflation (the general rising of prices), minimizing the damage caused by cycles of economic boom and bust, and otherwise promoting the long-term health of the economy.

Monetary policy does not adjust the money supply by changing the amount of currency (government-issued bills and coins) in circulation. Much of a country’s money supply is actually paperless money created by bank loans. When banks loan money to consumers and businesses, they pump far more money into the economy than actually exists in the form of currency. This money takes the form of balances in individual checking and other bank accounts.

When Did It Begin

Prior to the Great Depression (a decline in the world economy that began in 1929 and lasted through much of the following decade), countries did not have well-defined economic policies. The so-called classical economists, who at the time dominated economic thought in capitalist countries, believed that economies regulated themselves through market forces (such as supply and demand) and should remain free from government intervention. In capitalist countries there was actually some amount of regulation by the government; in the United States, for instance, the Federal Reserve System had been established in 1913 in response to financial panics that caused many banks to fail. But individual banks still had more control over the money supply than the government did. The problems facing the economy during the Depression, however, could not be solved by market forces. Roughly one-third of the American labor force was out of work and so did not have any wages to spend on goods and services (in economic terms, there was a drop in demand). As a result, companies had no incentive to produce goods and services, which (to complete the circle) meant that they could not hire new workers. The U.S. economy was in a deep hole, and classical economic principles offered no ideas for how to get out of it.

Against this backdrop the British economist John Maynard Keynes (1883–1946) published The General Theory of Employment, Interest, and Money (1936), which revolutionized the study of economics as well as the relationship between government and the economy. Among other ideas, Keynes argued that the government could compensate for the loss of demand (the desire to purchase goods and services) that characterized the Depression (and that characterized milder forms of economic downturn, called recessions). He said that governments could do this by spending money on public works projects (such as building roads and dams) and by providing relief payments to people who were out of work. Additionally, governments could use tax policy to affect demand: when the government reduces the amount of money that people pay in taxes, people can spend more of their money on goods and services. The reverse can be expected to happen when governments raise taxes. This use of government spending and taxes to regulate the economy is called fiscal policy.

Keynes also suggested that governments could adjust the money supply to manage demand in the economy, thus laying the groundwork for the Fed’s more active role in the economy in the years after World War II (which ended in 1945). For decades after the Depression, Keynes’s ideas dominated economic thought. U.S. presidents and Congressional leaders attempted to steer the economy through difficulties using fiscal policy, while the Fed attempted to control inflation and unemployment through monetary policy.

More Detailed Information

To understand the Fed’s (or any central bank’s) monetary policy, it is necessary to understand the basics of the banking system.

Banks take in money from some customers (called depositors) and lend it out to other customers. People who borrow money from a bank pay interest (a fee for the use of that money), and this interest is the chief source of profits for most banks. Banks therefore typically want to make as many loans as possible at any given time. If they loaned all the deposited money out, however, depositors might worry that they would not be able to get their money back in cash. To give the public confidence in the banking system, every time a bank receives a deposit from a customer, it must set aside a portion of that money and keep it in the bank’s reserves. In the United States the Fed decides what the size of that portion will be. Because very few depositors will ask for the majority of their money in cash at any given time, the Fed only requires banks to set aside a small fraction of those deposits. The excess can be loaned out to other customers.

For instance, imagine for simplicity’s sake that the Fed currently requires banks to set aside 10 percent of all deposits before making loans. If you deposited $10,000 in your bank, then your bank would have to set aside $1,000 of that money to make sure that it can meet depositors’ needs. It could then lend the remaining $9,000 of your account balance to someone who wanted it and who qualified for a loan.

The effect this has on the money supply is tremendous. Notice that the bank has turned your initial deposit of $10,000 into $19,000. This is possible because your $10,000 exists only on paper, as a bank balance. You have full use of your bank balance, and anytime you take money out of your account, you will put it to work in the economy. If you write a $500 check to your landlord, she will deposit that check in her bank account, and her bank will set aside a portion of that money for its reserves and lend out the rest. Meanwhile, the person who borrowed $9,000 from your bank will similarly use that money to pay for goods and services. The businesses that sell these goods and services will then deposit their profits in their own banks, which will use those deposits to finance more loans.

Anytime a bank can add to its reserves, it can (and probably will) make more loans. When a bank makes loans, it increases the country’s money supply. Therefore, the Fed changes the money supply by changing the amount of money banks have in reserve. It has three tools for affecting reserve amounts.

First, the Fed can simply change reserve requirements. If, as in the above example, current Fed requirements specify that 10 percent of deposits must be set aside, and the Fed wants to restrict the money supply, it might instruct banks to begin setting aside 12 percent of deposits. Because that extra 2 percent represents money that must be kept in reserve rather than loaned out and thereby allowed to multiply, this would have an immediate and drastic effect on the money supply. Conversely, lowering reserve requirements to 8 percent would cause an enormous increase in the amount of money circulating through the banking system. Because the effects of changing reserve requirements are so broad, the Fed does not use this monetary policy tool very often.

The Fed’s second monetary policy tool is to change an interest rate called the discount rate. The Fed provides banks with a special service called the discount window. The discount window is not literally a window but rather an outlet for borrowing money. If a bank suddenly found that it did not have enough money to meet the minimum reserve requirements, it could use the Fed’s discount window to cover its shortfall. Just as an individual pays a fee called interest to borrow from a bank, so does a bank when it borrows from the Fed. If the interest rate charged at the discount window is high, banks are not very likely to borrow money from the Fed in this way. If the interest rate charged at the discount window is low, banks are more likely to borrow and, by extension, make loans. In reality, many banks worry that borrowing from the discount window will signal to the Fed that they are having financial difficulties; therefore, most banks choose to borrow money from each other to cover reserve shortfalls.

The third tool the Fed uses is open-market operations. This is the process of buying or selling government securities (low-risk, government-backed investments in the form of Treasury bills, Treasury notes, and Treasury bonds) on the open market. In other words, the Fed acts just like any other investor in the financial markets, contacting a dealer of securities to purchase or sell its securities, depending on how it wants to affect the money supply. If the Fed buys securities, it injects money into the economy, because money is coming out of the government’s own checking account and being placed in the bank accounts of securities dealers, where it will multiply according to the loan process outlined above. If the government sells securities, however, securities dealers write checks to the Fed, which means that the money represented by those checks leaves the commercial banking system, diminishing the money supply. Open-market operations are by far the Fed’s most commonly used monetary policy tool today.

Recent Trends

Starting in the 1990s there was a great deal of media coverage of the Fed’s actions in regard to interest rates, but few people understand what the Fed really does or what interest rates newscasters are talking about when they mention the Fed.

While the Fed controls the discount rate directly, the discount rate is not the most important interest rate to the wider economy. As noted above, banks usually borrow from one another when they are short on reserves. The interest rate at which they borrow this money is called the federal funds rate. Because this represents one of the main ways, other than deposits, that banks get their money in today’s economy, changes in the federal funds rate have a large effect on the money supply.

Therefore, while the Fed’s tools for monetary policy do not strictly include the ability to set the federal funds rate, in actuality it does so by announcing its goals for that rate. If the Fed’s chairman says that he would like to see the federal funds rate drop by 0.5 percent, the federal funds rate will drop by 0.5 percent. This happens because the Fed backs up its target for the federal funds rate with open-market operations that change the money supply. When more money is in circulation, banks charge less for the use of borrowed money. If the Fed wants a drop of 0.5 percent, then, it increases the money supply by buying enough government securities to bring about that amount of fluctuation.

All other interest rates in the economy tend to be based on the federal funds rate. For instance, the prime interest rate (the rate banks use to determine how much interest to charge people who take out home or business loans), is usually about 3 percentage points higher than the federal funds rate.