International Financial Markets and Institutions

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Monetary policy is a tool employed by a countries central bank in order to control the economy. In America the institution responsible for conducting monetary policy is the Federal Reserve. Since the Global Financial Crisis of 2008, the Reserve has used monetary policy to help stabilize the economy. Monetary policy governs the money supply in an economy and hence controls the interest, growth and inflation rates. The major goals of monetary policy are sustainable growth, low unemployment and price stability.

In terms of monetary policy, money supply refers to the amount of liquid money available to circulate an economy. If the Federal Reserve increased money supply, the interest rate would decrease. This is known as an expansionary policy. A contractionary policy involves taking money out of circulation hence increasing money scarcity and the interest rate; it costs more to borrow and decreases economic activity.

There are three major tools of monetary policy that can be utilized. The first is the reserve requirement. This is a set percentage of a banks total deposits that must be kept on reserve at the reserve bank.  If the Federal Reserve wanted to increase money supply in an expansionary policy they would lower the reserve requirement. By doing so commercial banks have more money to lend to the public, increasing economic activity and decreasing the interest rate. To decrease supply and stabilize growth, the Federal Reserve would increase the reserve requirement, taking money out of the system. The second tool is Open Market Operations. This is the most regularly used tool used by the US; it involves buying or selling bonds from houses to increase or decrease money supply. By buying bonds for liquid money the supply of money is increased and the Interest rate is decreased. This is expansionary and provides economic stimulus. By selling bonds to commercial banks for liquid money, there is less money in circulation and interest rates increase creating a contractionary effect.  The third tool is known as the Discount rate. The Federal bank is also known as the lender of last resort. If a commercial bank needs to meet its reserve requirement and has no other option it will borrow money from the reserve to fill its quota. The Reserve charges an interest rate known as the discount rate. It is only applicable to central commercial banks and so provides a benchmark for all other interest rates in the economy. By increasing the discount rate, it becomes more expensive for banks to borrow from the Reserve and hence more expensive for households to borrow from the commercial banks. The money circulating the economy therefore decreases. On the other hand if the Federal Reserve sees fit to implement an expansionary policy it would lower the discount rate.