In its broadest sense, monetary policy includes all actions of governments, central banks, and other public authorities that influence the quantity of money and bank credit. It therefore embraces policies relating to such things as choice of the nation’s monetary standard; determination of the value of the monetary unit in terms of a metal or foreign currencies; determination of the types and amounts of the government’s own monetary issues; establishment of a central banking system and determination of its powers and rules for its operation; and policies concerning the establishment and regulation of commercial banks and other related financial institutions. A few even extend the meaning of monetary policy to include official actions affecting not only the quantity of money but also its rate of expenditure, thus embracing government tax, expenditure, lending, and debt management policies.
It has become customary, however, to define monetary policy in a more restricted sense and to exclude from it choices relating to the broad legal and institutional framework of the monetary and banking system. This narrower concept will be employed here. Monetary policy in this sense refers to regulation of the supply of money and bank credit for the promotion of selected objectives.
Like all economic policies, monetary policy has three interrelated elements: selection of objectives, implementation, and at least an implicit theory of the relationships between actions and effects. All three elements present problems of choice and are continuing subjects of controversy.
Monetary policy can be directed toward achieving many different objectives. For example, the supply of money can be regulated to provide the government with cheap or even costless funds, to maintain interest rates at some selected level, to regulate the exchange rate on the nation’s currency, to protect the nation’s gold and other international reserves, to stabilize domestic price levels, to promote continuously high levels of employment, and so on. Such multiple objectives are unlikely to be fully compatible at all times. Rational policy making therefore requires identification of the various objectives, analysis of the extent to which they are or can be made compatible, and choices from among those that conflict with one another. A later section will stress changes in the objectives of monetary policy and some of the problems of reconciling them.
The role played by monetary policy in promoting selected economic objectives depends greatly on the nature of the economic system and on attitudes toward the use of other methods of regulation. This role is usually secondary in economies characterized by government operation of most economic enterprises and government control of resource allocation, distribution of output, and prices of in-puts and outputs. Even in these economies monetary policy is not trivial. An excessive supply of money can create excessive demand and inflationary pressures, which are evidenced in black markets, hoarding, and bare shelves. On the other hand, a deficient supply of money can impede the flow of production and trade. Yet the major function of monetary policy in such economies is that of passive accommodation, that is, to provide the amount of money needed to facilitate the operation of other government controls; it is not to serve as a prime regulator.
Monetary policy usually plays a more positive regulatory role in economic systems that rely heavily on market forces to organize and direct processes of production and distribution. In such economies, decisions of business firms relating to rates of output, amounts of labor employed, rates of capital formation, and so on, are strongly influenced by relationships between costs and actual and prospective demands for output. If aggregate demands are deficient, firms will not find it profitable to employ all available labor, to utilize fully existing capacity, or to purchase all the new capital goods that could be produced. On the other hand, excessive aggregate demands for output are inflationary. A major function of monetary policy, therefore, is to regulate the behavior of aggregate demand for output in order to elicit a more favorable performance by the economy. This function is shared with fiscal policy in many countries and in many different combinations or “mixes.” Although the deliberate use of fiscal policy for this purpose has increased considerably in recent decades, monetary policy continues to be a major instrument.
Primary responsibility for administering monetary policies is usually entrusted to central banks, although there are varying degrees of government control of central banks and their policies. Central banks regulate the money supply and influence the supply of credit in two principal separate but closely related capacities: as controllers of their own issues of money and as regulators of the amount of money created by commercial banks. Both are important, but their relative importance depends in part on the stage of financial development of the country and on the types of money employed. In countries where bank deposits have not yet come to be widely used, notes issued by the central bank often constitute a major part of the money supply. In such cases the central bank may regulate the money supply largely by controlling directly its own note issues. However, in countries that have reached a later stage of financial development, central bank notes constitute a smaller part of the money supply; deposits at commercial banks are the major component, and the actions of commercial banks directly account for a large part of the fluctuations of the money supply. In such countries, the central bank is primarily a regulator of the commercial banks, although control of its own money creation remains important and is a part of the process.
The terms “monetary policy” and “credit policy” are often used interchangeably or with only slightly different shades of meaning. This has come about primarily because in most modern systems the creation and destruction of money by central and commercial banks are so closely intertwined with their expansion and contraction of credit. They typically create and issue money (currency and deposits) by making loans or purchasing securities, usually debt obligations. Thus, one side of the transaction is the issue of money; the other is the provision of funds to borrowers or sellers of securities, which tends to lower interest rates. Central and commercial banks typically withdraw money (currency and deposits) by decreasing their outstanding loans or by selling securities, usually debt obligations. Thus there is both a decrease in the supply of money and a decrease in the funds available to borrowers and to purchasers of the securities sold by the banks, which tends to increase interest rates.
Those who speak of monetary policy tend to focus on the behavior of the stock of money, while those who speak of credit policy tend to focus on the quantity of loan funds available from the central and commercial banks. Such differences in focus need not lead to differences in either analysis or conclusions. Yet they sometimes do. Those who focus on the stock of money are more likely to stress “real balance effects” on both consumption and investment spending, while those who focus on credit are likely to put more stress on the direct effects on interest rates, the availability of funds, and investment. Monetary theory has made considerable progress in reconciling and integrating these approaches, but much remains to be done.
The third element in monetary policy is at least an implicit theory of the relationships between actions and effects. If its actions are to promote its objectives, the monetary authority needs some theory as to the nature, direction, magnitude, and timing of the responses. The relevant responses are numerous and on several levels. For example, they include the response of the supply of money and credit; the response of aggregate demand for output; and the responses of real output, employment, and prices. There are still disagreements among both economists and central bankers on many of these theoretical and empirical issues, and these disagreements underlie many continuing controversies over the proper nature and scope of monetary policy. Some of these will be treated in a later section.
Monetary policy, in the modern sense of deliberate and continuous management of the money supply to promote selected social and economic objectives, is largely a product of the twentieth century, especially the decades since World War i. In the earlier period, when most countries were on either a gold or a bimetallic standard, the primary and overriding objective of monetary policy was to maintain redeemability of the nation’s money in the primary metal, both domestically and internationally. A decline of the nation’s metallic reserves to dangerously low levels, or any other threat to redeemability, became a signal for monetary and credit restriction, whatever might be its other economic effects. When redeemability seemed secure, monetary policy was used to promote other objectives—to deal with panics, crises, and other credit stringencies and even to expand money somewhat when business was depressed. But such intervention was sporadic rather than continuous and its purposes limited rather than ambitious. The international gold standard of the pre-1914 period was not purely automatic, but it was managed only marginally.
Many forces have contributed to the change and growth of monetary policy since World War i. One set of forces includes the breakdown of the international gold standard and other changes and crises in monetary systems—inflation during and following World War I and the long period of suspension of gold redeemability in most countries, the changed and insecure nature of the gold and gold exchange standards re-established in the 1920s, the renewed breakdown of gold standards during the great depression of the 1930s, and world-wide inflation during and following World War n. All these had profound effects on attitudes toward monetary policy. Both countries that had too little gold and those that had too much shifted to the view that the state of their gold reserves was no longer an adequate guide to policy and that new objectives and guides should be developed. Monetary actions became increasingly less sporadic and limited and more continuous and ambitious in scope.
The objectives of monetary policy have also been powerfully influenced by changes in attitudes concerning the responsibilities of central banks and governments for the performance of the economy. The 1920s witnessed growing demands that some central agency reduce instability of price levels and business activity. These demands were strengthened immeasurably by the economic catastrophe of the 1930s and by fears that World War n would be followed by another world-wide depression. Within a few years after that war the governments of almost all Western nations had formally assumed responsibility for promoting continuously high levels of employment and output. And within a few more years almost all of these governments had signified their intentions to promote economic growth. Monetary policy is required, in some cases by government and in others by the force of public opinion and pressure, to contribute to such objectives.
Although often phrased in different terms, it is now common for monetary authorities to state four major or basic objectives of monetary policy: (1) continuously high levels of employment and output, (2) the highest sustainable rate of economic growth, (3) relatively stable domestic price levels, and (4) maintenance of a stable exchange rate for the nation’s currency and protection of its international reserve position. In some countries monetary policy is also influenced by other considerations, such as a desire to maintain low interest rates to facilitate government finance or other favored types of economic activity.
Some of the most basic problems of monetary policy relate to the compatibility of such multiple objectives. Can all these be achieved simultaneously and to an acceptable degree even if a nation has precise control of the behavior of aggregate demand for output? Of course, the answer depends in part on the ambitiousness of the goals; perfection in all respects is hardly to be expected.
The answer also depends to an important extent on the responses of output, employment, money wage rates, and prices to changes in aggregate demand. The most favorable case is that in which the supply of output is completely elastic at existing price levels up to the point of “full employment” and capacity output. In such cases, increases of demand would elicit only increases in output until the economy reached its maximum capacity to produce. Price inflation would appear only when demand became excessive relative to productive capacity.
Problems of reconciling objectives relating to output, employment, and price level stability arise, however, when the supply of output does not respond in such a favorable manner to increases of demand—when prices rise before the economy has neared its capacity to produce. Even in the face of considerable amounts of unemployment, average money wage rates may rise faster than average output per man-hour, thereby tending to raise costs of production. And for this, or other reasons, business firms may raise the prices of their products even though considerable amounts of excess capacity persist. Under such conditions it may be impossible to achieve all objectives, to acceptable degrees, solely by controlling aggregate demand. Levels of demand sufficient to elicit “full employment” and capacity output may bring inflation, while levels of demand low enough to assure stability of price levels may leave large amounts of unemployment and unused capacity.
Because of such difficulties, many economists and other observers have come to believe that objectives relating to output, employment, and price levels can be reconciled satisfactorily only if regulation of aggregate demand through monetary and fiscal policies is supplemented by measures designed to elicit more favorable responses by the economy. These measures are of several types, which can only be listed here: (1) reform of wage-making processes in order to avoid inflationary increases of money wage rates, (2) decrease of monopoly power in industry, and (3) increase of regional and occupational mobility of labor.
The above discussion related to possible conflicts among a nation’s multiple domestic objectives. One, or more, of these domestic objectives may also conflict with the nation’s international objectives of maintaining a stable exchange rate for its currency and of protecting its international reserve position. Fortunately, domestic and international objectives do not always conflict. For example, a nation may have a deficit in its balance of payments primarily because of excessive domestic demands and rising prices. In such cases, restrictive monetary policies may be appropriate for both domestic and international reasons. On the other hand, a nation may have a surplus in its balance of payments primarily because of unemployment and depressed output and incomes at home, which depress its demands for imports. In this case an expansionary monetary policy will promote both its domestic and international objectives.
Cases do arise, however, in which domestic objectives and the objectives of maintaining stable exchange rates and a balance in international payments come into conflict. For example, a nation may have a large and persistent surplus in its balance of payments while demands for its output are so large as to bring actual or threatened inflation. An expansionary monetary policy, aimed at reducing the surplus in its balance of payments, would increase inflationary pressures at home; while a restrictive policy, aimed at inhibiting domestic inflation, would continue, and perhaps even increase, the surplus in its balance of payments. A nation faced with this situation may be compelled to sacrifice its domestic objective of preventing inflation or to increase the exchange rate on its currency in order to decrease the value of its exports relative to its imports.
Considered by most countries to be even more serious is the situation in which there is a large and persistent deficit in the balance of payments combined with actual or threatened excess unemployment at home. Employing expansionary monetary and fiscal policies to increase domestic demand and eradicate excess unemployment would tend to widen the deficit in the nation’s balance of payments and to drain away its international reserves. But employing restrictive policies to eradicate the deficit in its balance of payments would increase unemployment at home. The nation may be forced to sacrifice its domestic objectives relating to employment, output, and growth or to lower the exchange rate on its currency.
Because of such conflicts, many economists have become critical of arrangements under which ex-change rates remain fixed over long periods of time. They see little merit in stable exchange rates as such and would alter them whenever they conflict with important economic objectives. However, their prescriptions vary widely. For example, some favor stability of exchange rates most of the time with adjustments only in case of “fundamental disequilibrium.” Others favor continuously flexible exchange rates, with or without official intervention to influence their behavior. The entire field of ex-change rate policy remains highly controversial. [SeeInternational monetary economics, article Onexchange rates.]
The preceding sections dealt with some of the problems that would be encountered in promoting multiple economic objectives simultaneously, even if the monetary authority possessed precise control over the behavior of aggregate demand for output. But it is unsafe to assume without analysis that the monetary authority, or even the monetary authority together with the fiscal authorities, can control aggregate demand precisely. The monetary authority has no direct control over aggregate demand for output or over any of its major components, such as demands for consumption, for investment or capital formation, for government use, or for export. Its powers are largely confined to regulation of the supply of money and credit. Even at this level its controls may lack precision. Presumably the central bank can accurately control its own creation and destruction of money; but its control of the creation and destruction of money and credit by the commercial banking system, exercised largely through its control over the reserve position of the banks, may be less accurate. And even if the monetary authority has precise control of the money supply, aggregate demand for output may not respond in a uniform or precisely predictable manner; the income velocity, or rate of expenditure, of money may fluctuate. Thus there are many links in the chain of causation from central bank action to the reaction of aggregate demand and many possibilities of slippage.
The effectiveness of monetary policy as a regulator of aggregate demand does not depend on the existence of some fixed relationship between the supply of money and aggregate demand. It requires only that changes in the money supply influence aggregate demand in the desired direction and in a predictable way and that the monetary authority have power to change the money supply to the extent required to offset adverse variations in the income velocity of money. However, the possibility of control of aggregate demand does suffer to the extent that changes in money supply fail to affect aggregate demand, that the power of the monetary authority to change the money supply is limited, and that the relationship between the money supply and aggregate demand is unpredictable.
Few economists doubt the ability of monetary policy, in the absence of strong cyclical forces, to regulate effectively the secular behavior of both the money supply and aggregate demand for output. Secular changes in the velocity of money are usually gradual and can be allowed for in determining the appropriate rate of change of the money supply. There is much less agreement, however, concerning the effectiveness of monetary policy alone for offsetting cyclical forces and stabilizing aggregate demand over the various phases of the business cycle.
Monetary policy meets its most severe test in dealing with the strong forces that cause recessions or depressions. Consider the extreme case in which an economy has slipped into a severe depression with widespread unemployment and unused capacity. Under such conditions businessmen are likely to view the future pessimistically and to see few opportunities for investment in capital facilities that promise favorable rates of return. Their demand functions for output to be used for capital formation may be so low that only extremely low interest—rates, perhaps rates approaching zero, would induce them to invest enough to lift the economy back toward full-employment levels.
But monetary policy may be incapable of depressing interest rates, and especially long-term rates, to such low levels. The monetary authority may encounter difficulties in increasing the money supply under such conditions because the banks prefer to hold excess reserves rather than lend and take risks. Interest rates, and especially long-term rates, may fall only sluggishly, even in the face of large increases in the money supply. One reason for this is the fear of default by borrowers under depression conditions. John Maynard Keynes suggested another reason—his famous “liquidity trap.” He argued that there was some long-term rate of interest, not far below that previously prevailing, that the public considered “normal,” in the sense that it would again prevail. No one would hold securities at lower yields because of fear of capital losses when interest rates returned to their normal levels. Below this normal rate the public would increase its holdings of money balances indefinitely rather than lend at a lower rate.
Thus monetary policy may be incapable of lowering interest rates enough to offset the decline of investment demand functions, and recovery may be delayed until something increases the expected profitability of private investment or until the government adopts expansionary fiscal policies.
In how many cases would a well-conceived and well-executed monetary policy prove incapable of dealing with depressive forces? On this there is still lack of agreement among economists. Some have argued that experience during the great depression proved the ineffectiveness of monetary policy. This experience is hardly relevant to the present question, however, because the monetary policies of that period were hardly exemplary. To protect gold standards or for other reasons, many countries actually followed deflationary monetary policies for a considerable period. Expansionary policies were in many cases initiated only after a long delay, during which excess capacity had be-come widespread, expectations had deteriorated, and the entire financial system had come under serious strain. It may well be that in this and other recessions an ambitious expansionary monetary policy introduced promptly after the downturn would have proved effective in arresting the decline of aggregate demand. However, many economists—including some who are optimists about the effectiveness of monetary policy—believe that monetary policy alone may not be potent enough to offset strong depressive forces and that expansionary fiscal policies should also be employed under such conditions.
It is generally conceded that well-conceived monetary policies can be more effective in restricting increases in aggregate demand during the prosperity phases of business cycles. However, such prosperity periods are usually characterized by increases in aggregate demand relative to the money supply. This increase in the income velocity of money, or “economizing of money balances relative to expenditures,” reflects several forces that usually accompany prosperity—greater optimism on the part of both households and business firms concerning their future receipts of income, which decreases the amounts of money held against contingencies; more profitable opportunities for investing idle balances held by business firms; and rising interest rates. Theorists have tended to stress, perhaps to overstress, the role played by rising interest rates. The rise of investment demand during prosperity tends to raise interest rates, and the rise of rates is accentuated by a restrictive monetary policy. In turn, the availability of higher yields on other assets induces both business firms and households to economize their holdings of money balances that yield no interest.
Such increases of velocity—induced in part, but only in part, by restrictive monetary policy—do constitute a slippage in the operation of monetary policy. This does not mean that monetary policy is rendered ineffective; it means only that larger restrictive actions are required to achieve any specified amount of restriction of aggregate demand. Of course, the monetary authority may be unable or unwilling to restrict money to the required extent. For example, it may be inhibited by inadequacy of the control instruments currently at its disposal, fear that further restriction would precipitate a recession, dislike of high interest rates, or charges that credit restriction discriminates against both new and small business firms. However, these are not limitations on the capability of monetary policy to restrict aggregate demand. They are only considerations affecting the willingness of the monetary authority to use its powers of restriction.
The effectiveness of monetary policy as a countercyclical instrument depends heavily on the quickness of policy action and the quickness of response of the economy. Ideally, policy actions would be taken as soon as adverse developments appeared, or even in anticipation of such developments; and there would be an immediate and full response of aggregate demand and of such policy objectives as employment and output. Under such ideal conditions a high degree of stability might be maintained continuously. In practice, of course, such ideal performance is not realized. Economists have long recognized three lags in monetary policy: (1) the recognition lag—the interval between the time when a need for action develops and the time the need is recognized; (2) the administrative lag—the interval between recognition and the actual policy action; and (3) the operational lag—the interval between policy action and the time that the policy objectives, such as output and employment, respond fully.
Both the length and significance of these lags depend heavily on the reliability of economic forecasting. If developments could be reliably forecast well in advance, the first two lags could be eliminated and actions could be taken soon enough to allow for the operational lag. But when economic forecasting is unreliable the monetary authority is likely to wait until a development appears before taking action to deal with it. In such cases the length of the operational lag becomes highly important for countercyclical policy. Those who favor flexible countercyclical monetary policies implicitly assume that the operational lag is rather short, that all or most of the effects of a monetary action will be achieved within a few months or a year. [See Prediction and forecasting, economic.]
This view has been challenged by some economists, notably by Milton Friedman. These economists contend that the responses to a given monetary action are distributed over time and that the full effects are realized only after a lag of considerably more than a year. Because of this, monetary actions taken to counter cyclical fluctuations may actually produce, or at least accentuate, these fluctuations. For example, expansionary policy actions taken to counter recession may have little effect for several months and then achieve their full expansionary effects on aggregate demand only when the economy is in its next boom phase. And actions taken to restrict aggregate demand during a boom may in fact precipitate and accentuate an ensuing depression.
For this and other reasons, members of this school oppose flexible countercyclical monetary policies. They believe that a greater degree of stability will be achieved by a monetary policy aimed at a steady growth of the money supply, regardless of cyclical conditions. This growth should be at an annual rate approximating the growth rate of real gross national product.
This whole question, which is obviously crucial for countercyclical monetary policy, remains unresolved and controversial. Friedman’s theoretical and statistical arguments have been strongly challenged but not wholly refuted. Much more research is needed on both the magnitude and timing of responses to monetary policy actions. The same applies to the various types of fiscal policy actions.
Nations face complex problems in determining the relative roles to be played by monetary policies and by the various types of government expenditure and tax policies in promoting the economic objectives described earlier. Only a few of the considerations determining these relative roles can be mentioned here. One is, of course, the whole set of cultural, institutional, and political conditions determining the actual availability of these policy instruments. For example, in some countries it is in fact acceptable to use government tax and expenditure policies in a timely and flexible manner. Other governments are not yet in this position. Still others may find it possible to reduce taxes or increase expenditures to support aggregate demand but not to restrict it by fiscal measures. There can also be comparable differences in the actual availability of monetary policy instruments.
Also relevant are judgments concerning the relative effectiveness of monetary and fiscal policies in achieving some desired behavior of aggregate demand. For example, an expansionary fiscal policy may be judged to be necessary to promote quick recovery from depression conditions but to be no more effective than monetary policy in restricting increases of demand.
The optimum mix of monetary and fiscal policies also depends in part on the nature of economic objectives and on their relative priorities. Suppose that it is possible to achieve some selected level of aggregate demand with various combinations of monetary and fiscal policies—with, say, some restrictive fiscal policy and some expansionary monetary policy or with some expansionary fiscal policy and some restrictive monetary policy. This level of aggregate demand can reflect various combinations of consumption and capital formation. If the objective is only to achieve some selected level of total output and employment, without regard to the distribution of output between consumption and capital formation, many different combinations of monetary and fiscal policies may be equally acceptable. But this may cease to be true if promotion of economic growth through a higher rate of capital formation is also an objective. For this purpose a restrictive fiscal policy and an easy monetary policy may be most appropriate. Large taxes relative to government expenditures for current purposes can be used to force the nation to consume a smaller part, and to save a larger part, of its total income; and an easy monetary policy, instituted to lower interest rates, can encourage the use of savings for capital formation.
A somewhat different case is that in which a nation wishes to raise aggregate demand for its output while it faces an undesired deficit in its balance of payments. Both expansionary fiscal policies and expansionary monetary policies tend to increase the deficit in the balance of payments to the extent that they succeed in raising aggregate demand, which in turn increases imports. But an expansionary monetary policy, which lowers interest rates, will also tend to increase capital outflows or at least to reduce capital inflows. In such a situation, an optimum policy mix may require more expansionary fiscal policies to raise domestic demand, together with a less expansionary monetary policy to support interest rates and attract capital inflows or at least to retard capital outflows.
These are but a few of the many considerations that determine the relative roles of monetary and fiscal policies. These relative roles have changed markedly in recent decades and are likely to continue to change with changes in the nature and relative priorities of economic objectives, with changes in attitudes toward the flexible use of fiscal policies for stabilization purposes, and with changes in our knowledge concerning the magnitudes and timing of responses to various types of both monetary and fiscal actions.
Lester V. Chandler
[See alsoFiscal policyand Money.]
Commission on Money and Credit 1961 Money and Credit: Their Influence on Jobs, Prices and Growth. Englewood Cliffs, N.J.: Prentice-Hall.
Culbertson, J. M. 1960 Friedman on the Lag in Effect of Monetary Policy. Journal of Political Economy 68: 617–621.
Culbertson, J. M. 1961 The Lag in Effect of Monetary Policy: Reply. Journal of Political Economy 69:467–477.
Friedman, Milton 1961 The Lag in Effect of Monetary Policy. Journal of Political Economy 69:447–466.
Great Britain, Committee on the Working of the Monetary System 1959 Report. Papers by Command, Cmnd. 827. London: H. M. Stationery Office. → Known as the Radcliffe Report.
Scammell, W. M. (1957) 1962 International Monetary Policy. 2d ed. London: Macmillan; New York: St. Martins.
Yeager, Leland B. (editor) 1962 In Search of a Monetary Constitution. Cambridge, Mass.: Harvard Univ. Press.
Monetary policy is the management of money, credit, and interest rates by a country’s central bank. Unfortunately, this short definition is clearly inadequate. What is money? What is credit? What is an interest rate? What is a central bank and how does it control them? And, most importantly, why should anyone care? The purpose of this entry is to answer these questions (for more detail, see the relevant chapters of Stephen G. Cecchetti ).
Money is an asset that is generally accepted as payment for goods and services or repayment of debt; money acts as a unit of account, and serves as a store of value. That is, people use money to pay for things (it is a means of payment); quote prices in dollars, euros, yen, or the units of our currency (it is a unit of account); and use money to move purchasing power over time (it is a store of value). Credit is the borrowing and lending of resources. Some people have more resources than they currently need (they are savers) while others have profitable opportunities that they cannot fund (they are investors). Credit flows from the savers to the investors. And an interest rate is the cost of borrowing and the reward for lending. Since lenders could have done something else with their resources, they require compensation—interest is rent paid by borrowers.
The U.S. Federal Reserve System, the Bank of Japan, and the Bank of England are all central banks. Nearly every country in the world has a central bank. It is easiest to understand a central bank by looking at what it does (for a history of money and central banks, see Glyn Davies ). A modern central bank both provides an array of services to commercial banks (it is the bankers’ bank) and manages the government’s finances (it is the government’s bank). While not universally true, we will assume that only banks and governments have accounts at central banks. As the bank for bankers, the central bank holds deposit accounts and operates a system for interbank payments that enables commercial banks (the ones the public uses) to transfer balances in these accounts to one another. The central bank is also in a unique position to provide loans to commercial banks during times of crisis—more on this shortly.
Like any individual or business, the government needs a bank to make and receive payments. So, the central bank keeps an account for the government. When the government wants to make or receive a payment, it needs a bank just like the rest of us. The central bank does that job. In addition, the government gives the central bank the right to print money—that is the paper currency that people use in everyday life.
At its most basic level, printing money is a very profitable business. A $100 bill costs only a few cents to print, but it can be exchanged for $100 worth of goods and services. It is logical then that national governments create a monopoly on printing money and use the revenue it generates to benefit the general public. Also, government officials know that losing control of the money printing presses means losing control of inflation.
The fact that the central bank has the license to issue money makes it unique. If individuals want to make a purchase, they need to have the resources to do it. So, for example, someone using a debit card to purchase groceries will have to have sufficient balances in a commercial bank account to cover it. If the grocery purchaser does not have sufficient resources of his own, he will need the financial assistance of someone who is willing to make him a loan. The central bank is different. If the central bank wants to buy something—say a government-issued bond—it can just create the liabilities to do it. Essentially it can issue the money. Importantly, the central bank can expand the size of its balance sheet at will. No one else can do this.
The central bank uses its ability to expand (and contract) its assets and liabilities to implement monetary policy. Figure 1 is a simple version of the central bank’s balance sheet, stripped of a number of incidental items (like buildings and gold). When looking at any balance sheet, the most important thing to remember is that assets equal liabilities, so any change in one side must be matched by a change in the other. When a central bank purchases a government security, increasing its assets, this is normally matched by an increase in commercial bank reserve liabilities. Banks hold these reserves both because they are required by law and in order to make interbank payments.
At its technical, day-to-day level, monetary policy is all about buying and selling securities to control the quantity of reserves in the commercial banking system. Modern central banks, like the Federal Reserve or the European Central Bank, use their monopoly over the supply of commercial bank reserves to control an interest rate of their choosing. In some, like the Reserve Bank of Australia, it is the deposit rate the central bank pays commercial banks on the balances in their reserve account. In the United States, it is the federal funds rate —the rate banks charge each other for overnight loans of reserves. The Federal Reserve decides on its target for the federal funds, and then buys and sells securities to set the supply of reserves to hit this target. Twenty-first century monetary policy is not about controlling the quantity of money or its growth rate; it is about interest rates. (For a technical discussion of the use and the abandonment of money
as a target, see Laurence Meyer [2001a]. For a detailed discussion of the monetary policy of the European Central Bank, see Otmar Issing et al. ).
It is important to note that some central banks decide to use their ability to control the size of their balance sheet to target something other than interest rates. The natural alternative is the exchange value of their currency—that is, the value of the number of dollars it takes to purchase the currency issued by another central bank. But, by the beginning of the twenty-first century, this had become increasingly rare. A central bank cannot control the total quantity of money and credit in the economy directly, and no modern central bank tries.
Finally, in addition to the size of their balance sheet, central banks have two additional tools. During times of financial stress, the central bank stands ready to provide loans to banks that are illiquid (so they cannot make payments) but still solvent (so their net worth is positive). Policymakers set interest rates on these loans. When the lending is done properly, this eliminates financial systemwide panics. In addition, central banks in many countries are given the power to set requirements governing how banks hold their assets. So, for example, they may require a certain level of reserve deposits, or prohibit the holding of common stock.
The central bank is part of the government. Whenever an agency of the government involves itself in the economy, people need to ask why. What makes individuals incapable of doing what they have entrusted to the government? In the case of national defense and pollution regulation, the reasons are obvious. Most people will not voluntarily contribute their resources to the army, nor will a country’s citizens spontaneously clean up their own air.
The rationale for the existence of a central bank is equally clear. While economic and financial systems may be fairly stable most of the time, when left on their own they are prone to episodes of extreme volatility. In the absence of a central bank, economic systems tend to be extremely unstable. The historical record is filled with examples of failure, such as the Great Depression of the 1930s, when the American banking system collapsed and economic activity plummeted.
Central bankers adjust interest rates to reduce the volatility of the economic and financial systems by pursuing a number of objectives. The three most important are: (1) low and stable inflation; (2) high and stable real growth, together with high employment; and (3) stable financial markets. Let’s look at each of these in turn.
The rationale for keeping the economy inflation-free is straightforward. Standards, everyone agrees, should be standard. A pound should always weigh a pound, a measuring cup should always hold a cup, a yardstick should always measure a yard, and one dollar should always have the same purchasing power. Maintaining price stability enhances money’s usefulness both as a unit of account and as a store of value.
Prices are central to everything that happens in a market-based economy. They provide the information individuals and firms need to ensure that resources are allocated to their best uses. When a seller can raise the price of a product, that is supposed to signal that demand has increased, so producing more is worthwhile. Inflation degrades the information content of prices, reducing the efficient operation of the economy.
Turning to growth, central bankers work to dampen the fluctuations of the business cycle. Booms are good; recessions are not. In recessions, people lose their jobs and businesses fail. Without a steady income, people struggle to make their auto, credit card, and mortgage payments. Consumers pull back, hurting businesses that rely on them to buy products. Reduced sales lead to more layoffs, and so on. The longer the downturn goes on, the worse it gets.
Finally, there is financial stability. The financial system is like plumbing: when it works, it is taken for granted, but when it does not work, watch out. If people lose faith in banks and financial markets, they will rush to low-risk alternatives, and the flow of resources from savers to borrowers will stop. Getting a car loan or a home mortgage becomes impossible, as does selling a bond to maintain or expand a business. When the financial system collapses, economic activity also collapses.
Central banks use their ability to control their balance sheet to manipulate short-term interest rates in order to keep inflation low and stable, the growth high and stable, and the financial system stable. But what makes monetary policymakers successful? Today, there is a clear consensus that to succeed a central bank must be: (1) independent of political pressure; (2) accountable to the public; (3) transparent in its policy actions; and (4) clear in its communications with financial markets and the public.
Independence is the most important of these elements. Successful monetary policy requires a long time horizon. The impact of today’s decisions will not be felt for a while—not for several years, in most instances. Democratically elected politicians are not a patient bunch; their time horizon extends only to the next election. Politicians are encouraged to do everything they can for their constituents before the next election—including manipulating interest rates to bring short-term prosperity at the expense of long-term stability. The temptation to forsake long-term goals for short-term gains is simply impossible to resist. Given the ability to choose, politicians will keep interest rates too low, raising output and employment quickly (before the election), but resulting in inflation later (after the election).
Knowing these tendencies, governments have moved responsibility for monetary policy into a separate, largely apolitical, institution. To insulate policymakers from the daily pressures faced by politicians, governments must give central bankers control over their budgets, authority to make irreversible decisions, and long-term appointments.
There is a major problem with central bank independence: It is inconsistent with representative democracy. Politicians answer to the voters; by design, independent central bankers do not. How can people have faith in the financial system if there are no checks on what the central bankers are doing? The economy will not operate efficiently unless policymakers are trusted to do the right thing.
The solution to this problem is twofold. First, politicians establish the goals for the independent central bankers, and second, monetary policymakers publicly report their progress in achieving those goals. Explicit goals foster accountability and disclosure requirements create transparency. While central bankers are powerful, elected representatives tell them what to do and then monitor their progress.
The institutional means for assuring accountability and transparency differ from one country to the next. In some countries, such as the United Kingdom and Chile, the government establishes an explicit numerical target for inflation. In others, such as the United States, the central bank is asked to deliver price stability as one of a number of objectives (for a discussion of the structure of central bank objectives, see Laurence Meyer [2001b]).
In the early 1980s, nearly two out of three of the countries in the world were experiencing inflation in excess of 10 percent per year. In the early twenty-first century, this is one in six. Two decades ago nearly one country in three was contracting. By 2005, five in six countries were growing at a rate in excess of 2 percent per year. But not only has inflation been lower and output higher, both inflation and output appear to be more stable. And careful empirical analysis shows that monetary policy is a likely source of this low, stable inflation and high, stable growth (see Cecchetti, Flores-Lagunes and Krause ).
Central bankers’ success can be traced to their ability to control interest rates. And their ability to manipulate interest rates relies on their control of the size of their balance sheet. This, in turn, requires that banks and individuals actually demand central bank liabilities. That is, people have to want to hold the currency issued by central banks, and commercial banks have to demand reserves. Won’t the day come when no one wants this stuff anymore? And when that happens, won’t monetary policy disappear?
The answer is almost surely no. While it is true that the creation of a secure and anonymous substitute for paper currency will ultimately cause dollar bills and euro notes to disappear, reserves are different. The central bank operates an interbank payments system based on reserves. It does this to ensure that, even during periods of crisis, banks can continue to make payments. And to ensure that commercial banks use their payments system, the central bank offers cheap access to this system—that is, it subsidizes the cost of the system’s operation. So long as banks want reserves, there will be monetary policy (for a discussion of the challenges facing monetary policy makers, see Gordon Sellon and Chairmaine Buskas  and Laurence Meyer [2001c]).
SEE ALSO Business Cycles, Real; Inflation; Policy, Fiscal; Treasury View, The; Unemployment
Cecchetti, Stephen G. 2006. Money, Banking, and Financial Markets. New York: McGraw Hill–Irwin.
Cecchetti, Stephen G., Alfonso Flores-Lagunes, and Stefan Krause. 2006. Has Monetary Policy Become More Efficient? A Cross-Country Analysis. Economic Journal 116 (4): 408–433.
Davies, Glyn. 2002. The History of Money from Ancient Times to the Present Day. 3rd ed. Cardiff, U.K.: University of Wales Press.
Issing, Otmar, Ignazio Angeloni, Vitor Gaspar, and Oreste Tristani. 2001. Monetary Policy in the Euro Area: Strategy and Decision-Making at the European Central Bank. Cambridge, U.K.: Cambridge University Press.
Meyer, Laurence H. 2001a. Does Money Matter? The 2001 Homer Jones Memorial Lecture, Washington University, Saint Louis, Missouri, March 28. http://www.federalreserve.gov/boarddocs/speeches/2001/20010328/default.htm.
Meyer, Laurence H. 2001b. Inflation Targets and Inflation Targeting. Remarks at the University of California at San Diego Economics Roundtable, San Diego, California, July 17. http://www.federalreserve.gov/boarddocs/speeches/2001/20010328/default.htm./boarddocs/speeches/2001/20010717/default.htm.
Meyer, Laurence H. 2001c. The Future of Money and of Monetary Policy. Remarks at the Distinguished Lecture Program, Swarthmore College, Swarthmore, Pennsylvania, December 5. http://www.federalreserve.gov/boarddocs/speeches/2001/20011205/default.htm.
Sellon, Gordon H., Jr., and Chairmaine R. Buskas, eds. 1999. New Challenges for Monetary Policy: A Symposium Sponsored by the Federal Reserve Bank of Kansas City. Kansas City, MO: Federal Reserve Bank of Kansas City.
Stephen G. Cecchetti
In the United States, heterodox proposals for monetary manipulation tend to flourish in times of economic crisis. The farm lobbies, in particular, have been disposed to back such measures when seeking relief from agricultural distress. They had done so in the 1870s when supporting the Greenback movement to expand the currency issue. They did so again in the 1890s when rallying behind the Populists and then William Jennings Bryan's campaigns for "free silver."
In 1932, this tradition took on a renewed vitality. The argument for inflationary policies to pump up farm prices was now articulated in more sophisticated form. Through the research of Cornell University agricultural economist George F. Warren and his collaborator, F. A. Pearson, doctrines that could formerly be dismissed as the work of "cranks" and "amateurs" were given at least a pseudoscientific veneer. From their base at the state of New York's land grant college, Warren and Pearson enjoyed proximity and visibility to the state's political establishment. And they had won converts to their views among some who would later occupy high positions in President Franklin D. Roosevelt's administrations—most notably, Henry Morgenthau, Jr., a future secretary of the treasury.
Warren and Pearson rested their arguments on elaborate statistical investigations of the behavior of commodity prices, on the one hand, and the price of gold, on the other. Their findings suggested that there was a high positive correlation between the two. It thus seemed to follow that the answer to depressed farm prices could be found in raising the price of gold. This approach to policy, however, would be incompatible with a U. S. commitment to gold convertibility of the dollar at a fixed parity.
Another version of this line of argument was supplied by Yale University's Irving Fisher, an economist recognized for his analytic ingenuity, though one who was also regarded as a bit suspect for his eccentricities (such as his ardent advocacy of prohibition and the eugenics movement) and for his unfortunate pronouncement in September 1929 that the stock market had reached a permanently high plateau. Fisher's empirical studies in the mid-1920s had indicated that the general price level—with a lag of seven months or so—led changes in the volume of aggregate economic activity. More specifically, a rising price level stimulated the volume of trade, and a declining price level depressed it. Since 1930, the American economy had experienced severe deflation: It was thus not surprising that the Depression had deepened. By 1932, Fisher was convinced that the remedy for this condition was to be found in "reflating" the general price level back to its pre-Depression elevation. When the targeted price level had been reached, the price level should be stabilized and the economy would thereafter enjoy stability. He insisted that monetary expansion—when no longer constrained by the gold standard—could produce the needed reflation. Raising the price of gold should be one of the measures deployed for this purpose.
The state of the American financial system when Roosevelt was inaugurated in March 1933 provided a moment of opportunity when suspension of the dollar's gold convertibility was both necessary and acceptable. Between his election in November 1932 and his assumption of the presidency, the nation had experienced unprecedented runs on banks and drains on the country's gold reserves serious enough to threaten their exhaustion. In the face of this crisis, Roosevelt was obliged to declare a "bank holiday" and to suspend gold convertibility, which he did by executive order as his first substantive official act. Measures taken in the months immediately thereafter effectively nationalized the monetary gold stock by outlawing private holdings.
Rupturing the tie to gold meant that economic policymakers had a much freer hand to experiment. Congress further widened the president's range of options with the passage of an amendment to the Agricultural Adjustment Act of 1933 (known as the Thomas Amendment, in recognition of the Oklahoma senator who sponsored it). This legislation conveyed discretionary power to the president to: (1) issue up to $3 billion in greenbacks (a currency without metallic backing); (2) establish the gold content of the dollar with the restriction that it could not be reduced by more than 50 percent; and (3) fix the value of silver and provide for its unlimited coinage and establish bimetallism. It was not clear, however, which of these powers (if any) would be exercised.
GOLD AND SILVER PURCHASE PROGRAMS
On October 22, 1933, Roosevelt announced that he had ordered a government agency to buy gold "at prices determined from time to time," that "this was a policy and not an expedient," and that this action was "not to be used merely to offset a temporary fall in prices." (The presence of Warren and of James Harvey Rogers—a Yale economist who shared Fisher's views—when this initiative was launched indicated that reflation of the price level was the objective of the exercise.) On each business day in the ensuing weeks, Roosevelt met with Morgenthau to fix the day's buying price. When price-elevating bidding was terminated in January 1934, the price of gold had reached $35 per ounce, at which point it was pegged. Before the country left the gold standard, its official price had been $20.67. Despite this activity, the general price level had not risen as the advocates of the gold purchase program had predicted.
In early 1934, the Roosevelt administration was confronted with mounting political pressures—particularly from senators representing silver-mining constituencies—to do something to raise the price of silver. There was a fundamental difference between the gold purchase program mounted in the autumn of 1933 and the silver purchase program that was later adopted. The former was an instance of a deliberate policy of preference that allegedly had some analytic mooring. The latter was undertaken reluctantly in response to congressional pressures that were difficult to contain. Administration officials counted it as a success that they had at least managed to forestall enactment of legislation that would mandate purchase of prescribed quantities of silver. The agreement struck with Congress in May 1934 instead set out a general goal: Treasury purchases should aim at an accumulation in which silver amounted to one-third of the value of the gold stock. However, no timetable for this outcome was specified. Though the Department of the Treasury was slow to implement this policy, it managed to spend $1.6 billion on silver acquisitions between 1934 and 1941.
Between them, gold and silver acquisitions substantially augmented the nation's monetary base and made major contributions to the swelling of excess reserves in commercial banks. By contrast, the Federal Reserve's contribution to monetary ease in 1933 and 1934 was slight. The Federal Reserve—without enthusiasm—did acquire a modest quantity of government securities between May and November 1933 and then suspended open market operations until 1937. The 1933 purchases appear to have been motivated by the Board's fear that, in the absence of some activity on its part, the administration might be provoked to issue greenbacks. The discount rate, which stood at 3.5 percent in March 1933, was reduced by seven of the twelve District Banks and, in New York, it fell to 2 percent.
RESHAPING THE FEDERAL RESERVE SYSTEM
The Federal Reserve's role began to change in 1935 with passage of a Banking Act that reorganized its structure. This legislation was largely the handiwork of Marriner Eccles, a Utah banker whose views on depression-fighting called for enlarged government spending financed through deficits, who had been recruited to Washington to serve as its chairman. The Banking Act of 1935 was designed to serve three purposes: (1) to change the composition of the governing body by displacing two ex officio members—the secretary of the treasury and the comptroller of the currency—and by restyling the Federal Reserve Board as the Board of Governors of the Federal Reserve System; (2) to restructure the Open Market Committee by placing its decisive weight with the Board of Governors in Washington by reducing the voting strength of the Federal Reserve District Banks; and (3) to increase the power of the central Board over the determination of discount rates and to widen its discretionary latitude over required reserve ratios.
Eccles did not delay long in using his new authority over required reserve ratios. It was then believed that the Board's capacity to restrain lending by commercial banks would be compromised when they held abnormally large sums in excess reserves, as appeared to be the case in 1936 and early 1937. Accordingly, the Board of Governors acted to increase its leverage by exercising its newly-conveyed power to double required reserve ratios. Board action was taken in two steps: (1) required reserve ratios were raised half the distance toward the legal maximum in August 1936; and (2) increases to the full limit allowed by law were ordered in the spring of 1937. All of this was seen as precautionary and not as a retreat from monetary ease. After all, the discount rate in New York in September 1937 was 1 percent and it was set at 1.5 percent by the other District Banks. Eccles insisted that the "supply of money to finance increased production [was] ample."
THE RECESSION OF 1937 AND 1938
The Board's decisions on this matter have been faulted on grounds that they provoked the recession of 1937 and 1938, which set in when the economy was operating well below its full employment capacity. Two latter-day commentators, Milton Friedman and Anna Jacobson Schwartz, have assigned major responsibility for this sharp downturn to the Federal Reserve's actions in doubling required reserve ratios. Their argument rests on the view that excess reserves, which the Board held to be needlessly excessive, were, in fact, desired as liquidity cushions in circumstances of depression. Hence, the Board's intervention in shrinking them led banks to constrain lending activities. A different interpretation—favored by New Deal contemporaries—held that the recession had been triggered by a turnaround in government's fiscal impact on the economy: that is, from being expansionary in 1936 to contractionary in 1937.
The administration's policy response to the recession—when announced in April 1938—emphasized fiscal stimulants in a "spend-lend program." Then, for the first time, Roosevelt embraced deficit financing as a positive good, rather than an unavoidable evil. The Federal Reserve participated by lowering required reserve ratios by one-third. Subsequently the volume of excess reserves again grew. It was not until November 1941, however, that the Board once more set required reserve ratios at the maximum level allowed by law.
Barber, William J. Designs within Disorder: Franklin D.Roosevelt, the Economists, and the Shaping of American Economic Policy, 1933–1945. 1996.
Blum, John Morton. From the Morgenthau Diaries, Vol. 1: Years of Crisis, 1928–1938; Vol. 2: Years of Urgency, 1938-1941; Vol. 3: Years of War, 1941–1945. 1959–1967.
Chandler, Lester V. America's Greatest Depression,1929–1941. 1970.
Eccles, Marriner S. Beckoning Frontiers: Public and PersonalRecollections. 1951.
Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States, 1867–1960. 1963.
Johnson, G. Griffith. The Treasury and Monetary Policy,1932–1938. 1939.
Roose, Kenneth D. The Economics of Recession and Revival: An Interpretation of 1937–38. 1954.
William J. Barber
The central agency that conducts monetary policy in the United States is the Federal Reserve System (the Fed). It was founded by the U.S. Congress in 1913 under the Federal Reserve Act. The Fed is a highly independent agency that is insulated from day-to-day political pressures, accountable only to Congress. It is a federal system, consisting of a board of governors, twelve regional Federal Reserve Banks (FRBs) and their twenty-five branches, the Federal Open Market Committee (FOMC), the Federal Advisory Council and other advisory and working committees, and 2,900 member banks, mostly national banks. By law, all federally chartered banks, that is, national banks, are automatic members of the system. State-chartered banks may elect to become members.
The seven-member board of governors, headquartered in Washington, D.C., is the core agency of the Fed, overseeing the entire operation of U.S. monetary policy. The FRBs are the operating arms of the system and are located in twelve major cities, one in each of the twelve Federal Reserve Districts around the nation. The twelve-member FOMC is the most important policy-making entity of the system. The voting members of the committee are the seven members of the board, the president of the FRB of New York, and four of the other eleven FRB presidents, each serving one year on a rotating basis. The other seven nonvoting FRB presidents still attend the meetings and participate fully in policy deliberations.
MONETARY POLICY AND THE ECONOMY
Being one of the most influential government policies, monetary policy aims at affecting the economy through the Fed's management of money and interest rates. The narrowest definition of money is M1, which includes currency, checking account deposits, and traveler's checks. Time deposits, savings deposits, money market deposits, and other financial assets can be added to M1 to define other monetary measures, such as M2 and M3. Interest rates are simply the costs of borrowing. The Fed conducts monetary policy through bank reserves, which are the portion of the deposits that banks and other depository institutions are required to hold either as vault cash or as deposits with their home FRBs. Excess reserves are the reserves in excess of the amount required. These additional funds can be transacted in the reserves market (the federal funds market) to allow overnight borrowing between depository institutions to meet short-term needs in reserves. The rate at which such private borrowings are charged is the federal funds rate.
Monetary policy is closely linked with the reserves market. With its policy tools, the Fed can control the reserves available in the market, affect the federal funds rate, and subsequently trigger a chain of reactions that influence other short-term interest rates, foreign-exchange rates, long-term interest rates, and the amount of money and credit in the economy. These changes will then bring about adjustments in consumption, affect saving and investment decisions, and eventually influence employment, output, and prices.
GOALS OF MONETARY POLICY
The long-term goals of monetary policy are to promote full employment and stable prices and to moderate long-term interest rates. Most economists believe price stability should be the primary objective, since a stable level of prices is key to sustained output and employment, as well as to maintaining moderate long-term interest rates. Relatively speaking, it is easier for central banks to control inflation (i.e., the continual rise in the price level) than to influence employment directly, because the latter is affected by such real factors as technology and consumer tastes. Moreover, historical evidence indicates a strong positive correlation between inflation and the amount of money.
While the financial markets react quickly to changes in monetary policy, it generally takes months or even years for such policy to affect employment and growth, and thus to reach the Fed's long-term goals. The Fed, therefore, needs to be forward-looking and to make timely policy adjustments based on forecasted as well as actual data on such variables as wages and prices, inflation, unemployment, output growth, foreign trade, interest rates, exchange rates, money and credit, and conditions in the markets for bonds and stocks.
IMPLEMENTATION OF MONETARY POLICY
Since the early 1980s, the Fed has been relying on the overnight federal funds rate as the guide to its position in monetary policy. The Fed has at its disposal three major monetary policy tools: reserve requirements, the discount rate, and open-market operations.
Under the Monetary Control Act of 1980, all depository institutions, including commercial banks and savings and loans, are subject to the same reserve requirements, regardless of their Fed member status. As of October 2005, the structure of reserve requirements was 0 percent for all checkable deposits up to $7 million (the exemption), 3 percent for such deposits from above $7 million to $47.6 million (the low-reserve tranche), and 10 percent for the amount above $47.6 million. Both the exemption and the low-reserve tranche are subject to annual adjustment by statute to reflect changes in reservable liabilities at all depository institutions. No reserves are required for nonpersonal time deposits and Eurocurrency liabilities.
Reserve requirements affect the so-called multiple money creation. Suppose, for example, the reserve requirement ratio is 10 percent. A bank that receives a $100 deposit (Bank 1) can lend out $90. Bank 1 can then issue a $90 check to a borrower, who deposits it in Bank 2, which can then lend out $81. As it continues, the process will eventually involve a total of $1,000 ($100 + $90 + $81 + $72.9 + … = $1,000) in deposits. The initial deposit of $100 is thus multiplied ten times. With a lower (higher) ratio, the multiple involved is larger (smaller), and more (fewer) reserves can be created.
Reserve requirements are not used as often as the other policy tools. Since funds grow in multiples, it is difficult to administer small adjustments in reserves with this tool. Also, banks always have the option of entering the federal funds market for reserves, further limiting the role of reserve requirements. Except for the yearly adjustments of the exemption and the low-reserve tranche, the last change in the reserve requirements was in April 1992, when the upper ratio was reduced from 12 to 10 percent.
The Discount Rate
Banks and other depository institutions may acquire loans through the discount window at their home FRB to meet their short-term needs against, for example, unexpected large withdrawals of deposits. The interest rate charged on such loans is the discount rate. A reduction of the rate encourages more borrowing, and through money creation, bank deposits increase and reserves increase. A rate hike works in the opposite direction. Since it is more efficient, however, to adjust reserves through open-market operations (discussed below), the amount of discount window lending has been unimportant, accounting for only a small fraction of total reserves. Perhaps a more meaningful function served by the discount rate is to signal the Fed's stance on monetary policy, similar to the role of the federal funds rate.
By law, each FRB sets its discount rate every two weeks, subject to the approval of the board of governors. The gradual nationalization of the credit market over the years, however, has resulted in a uniform discount rate. A major revision in the discount window programs took effect in January 2003 to enhance the Fed's lending function. The FRBs began to offer three discount window programs to depository institutions: the primary credit program for financially sound institutions, the secondary credit program for institutions not eligible for primary credit, and the seasonal credit program for small depository institutions that have seasonal fluctuations in funding needs.
Discount-rate adjustments, usually going hand in hand with changes in the federal funds rate, have been dictated by cyclical conditions of the economy, and the frequency of adjustments has varied. For instance, the discount rate moved up from a low of 3 percent in May 1994 to 6 percent in January 2001 to counter possible overheating and inflation from the robust economic growth since the mid-1990s. The rate was then lowered twelve times, to a bare 0.75 percent in two years, to help the economy recover from its 2001 recession. From June 2004 to September 2005, the primary (4.75 percent) and secondary (5.25 percent) credit rates were both raised 11 times to cool off the economy and especially the overheated housing market.
The most important and flexible tool of monetary policy is open-market operations, that is, trading U.S. government securities in the open market. In 2004 the Fed made $7.55 trillion of purchases and $7.51 trillion of sales of Treasury securities (mostly short-term Treasury bills). As of June 2005, the Fed held $721.92 billion of U.S. Treasury securities, roughly 9.2 percent of the total federal debt outstanding.
The FOMC directs open-market operations (and also advises about reserve requirements and discount-rate policies). The day-to-day operations are determined and executed by the Domestic Trading Desk (the Desk) at the FRB of New York. Since 1980 the FOMC has met regularly eight times a year in Washington, D.C. At each of these meetings, it votes on an intermeeting target federal funds rate, based on the current and prospective conditions of the economy. Until the next meeting, the Desk will manage reserve conditions through open-market operations to maintain the federal funds rate around the given target level. When buying securities from a bank, the Fed makes the payment by increasing the bank's reserves at the Fed. More reserves will then be available in the federal funds market and the federal funds rate falls. By selling securities to a bank, the Fed receives payment in reserves from the bank. Supply of reserves falls and the funds rate rises.
The Fed has two basic approaches in running open-market operations. When a shortage or surplus in reserves is likely to persist, the Fed may undertake outright purchases or sales, creating a long-term impact on the supply of reserves. Nevertheless, many reserve movements are temporary. The Fed can then take a defensive position and engage in transactions that impose only temporary effects on the level of reserves. A repurchase agreement (a repo) allows the Fed to purchase securities with the agreement that the seller will buy back them within a short period, sometimes overnight and mostly within seven days. The repo creates a temporary increase in reserves, which vanishes when the term expires. If the Fed wishes to drain reserves temporarily from the banking system, it can adopt a matched sale-purchase transaction (a reverse repo), under which the buyer agrees to sell the securities back to the Fed, usually in fewer than seven days.
see also Federal Reserve System ; International Monetary Fund ; Macroeconomics/Microeconomics
Bernanke, Ben S. (2005, March 30). Implementing monetary policy (Federal Reserve Board Member speech). Retrieved January 23, 2006, from http://www.federalreserve.gov/boarddocs/speeches/2005/20050330/default.htm
Bernanke, Ben S. (2004, December 2). The logic of monetary policy (Federal Reserve Board Member speech). Retrieved January 23, 2006, from http://www.federalreserve.gov/boarddocs/speeches/2004/20041202/default.htm
Bies, Susan S. (2004, October 23). The Federal Reserve System and the economy (Federal Reserve Board Member speech). Retrieved January 23, 2006, from http://www.federalreserve.gov/boarddocs/speeches/2004/20041023/default.htm
The Federal Reserve System: Purposes and functions. (2005, June). Washington, DC: Board of Governors of the Federal Reserve System.
Mishkin, Frederic S. (2006). The economics of money, banking, and financial markets (7th ed.). New York: Pearson-Addison-Wesley.
91st Annual Report: 2004. (2005). Washington, DC: Board of Governors of the Federal Reserve System.
Treasury Bulletin. (2005, September). Washington, DC: U.S. Department of Treasury.
Edward Wei-Te Hsieh
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.
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.