What are Monetary Policies?
Monetary Policies are a set of tools used by a nation’s central bank to control the supply of money and promote economic growth. These policies are used to employ various strategies such as Quantitative Easing and Forward Guidance etc, to lower interest rates and encourage individuals to borrow and invest, all while increasing the money supply.
Monetary policies have a great impact on the economy and are quite interesting. In 2016, Japan set its interest rate to -0.1% in order to fight deflation and encourage loans, this was a very unconventional move by the Bank of Japan (BOJ) in the monetary policy history. Japan continued with this policy up until 2018, making it one of the few major economies to implement such a policy.
Key Takeaways
- Monetary Policies are used to control inflation, stabilize the nation’s financial system, and manage employment levels.
- The three monetary policy tools include Open Market Operation, Discount Rates, and Reserve Requirement.
- Monetary Policies are tools used by central banks to manage and control the money supply while also uplifting people to borrow and invest.
Understanding Monetary Policy
Understanding Monetary Policy requires us to know how a nation’s central bank makes money and applies interest rates that influence the economy.
The primary objective of these policies is to control inflation and stop recessions before they even happen. During the 2008 financial crisis in the U.S. the federal reserve lowered its interest rates to near zero and engaged in Quantitative Easing (QE) while purchasing $4 trillion in assets. This helped in economic recovery and prevented a deeper recession.
Monetary Policies also help manage the employment levels to promote financial security for each individual. The Federal Reserve in the United States targets a 2% inflation rate and aims to maximize better employment opportunities.
These policies aim to stabilize a nation’s financial state as well. In 1997, during the Asian Financial Crisis, the Thai baht completely collapsed which caused a widespread panic in the nation and led people to lose hope in the nation’s financial state. To control this situation, the Bank of Thailand implemented different policies, increased interest rates sharply, and restored investors’ confidence. This helped the nation to rebound from their financial state by the early 2000s.
Types of Monetary Policy Tools
The three main types of monetary policy tools are:
1. Open Market Operations:
In open market operation (OMO) the central bank buys or sells government securities to control the supply of money.
Buying government securities allows the central bank to put more money into the economy, while selling the securities withdraws money, affecting the interest rates and the overall liquidity.
2. Discount Rates:
Discount Rates are the interest rate at which a commercial bank can borrow money from the central bank to meet their liquidity needs. Lowering the discount rates encourages banks to borrow more money and give out loans, which helps in boosting economic activity while raising the discount rates helps control inflation.
An interesting aspect of discount rates is its psychological impact: when a central bank lowers the discount rates, it signals to the economy that it is committed to support the economy’s growth.
3. Reserve Requirement:
Reserve Requirement refers to the funds that a bank must hold in reserve against their deposits to show that they can meet monetary requirements and have a stabilized financial system.
To understand this better let’s consider the central bank sets a reserve requirement of 10%. This means that for every $100 deposit, the bank must hold $10 in reserve and can lend out $90.
During the Great Depression, the U.S. Federal Reserve raised the reserve requirement from 13% to 20% in 1936 – 1937. Reducing the money supply by $1.5 billion and worsening the economic downturn. It is important to note that the reserve requirement is applicable to all commercial banks and varies on the bank size and deposit types.
Types of Monetary Policy
There are two major types of monetary policies described below:
1. Expansionary Monetary Policy
These policies help the economy grow and move forward especially during the times of recession. Expansionary Monetary Policy are implemented by lowering interest rates, which make borrowing cheaper and encourage people to spend and invest more. Central Banks can use tools like OMO’s and Quantitative Easing to promote consumer spending and reduce employment levels.
2. Contractionary Monetary Policy
These policies are used to control inflations and stabilize the economy when it is overheating. Contractionary Monetary Policy reduces consumer spending and borrowing by increasing interest rates. Central Banks can sell government securities to slow down economic growth to prevent inflation from rising too quickly.
Q: What Triggers Changes in the Monetary Policy?
Changes in the monetary policy are often triggered by key economic indicators like inflation and employment rates, which signal central banks the need for adjustments. Fluctuation and economic events like COVID-19 can also lead the central banks to change policies accordingly.
In March 2020, during COVID-19, to help the nation regain its power the U.S. Federal Reserve cut the federal funds rate to 0% – 0.25% and began buying $120 billion in bonds monthly.
Q: What Is the Difference Between the Monetary Policies of First, Second, and Third World Countries?
First-World Countries prioritize stability and use advanced tools to ensure high credibility and transparency in their policies.
Second-World Countries strive to balance growth and inflation but often have limited tools and face political pressures that can affect central bank independence.
Third-World Countries focus on stabilizing economies with high inflation while promoting growth, having limited resources and significant informal markets that hinder policy effectiveness.
Q: How Are Monetary Policies Formulated?
Monetary policies are formulated through a careful process that looks at important economic data, such as inflation and employment rates. Central banks, like the Federal Reserve, meet regularly—like the Federal Open Market Committee (FOMC)—to review the current economic situation and decide on any needed changes to policy. This way, they can make informed choices that respond to what’s happening in the economy.
Bottom Line
Monetary Policy uses tools to help the economy during inflation and recession and help nations control and stabilize employment rates and financial states. The main monetary tools such as Open Market Operations, Discount Rates and Reserve Requirements help central banks in shaping policies accordingly. A nation’s monetary policies are often correlated to its economic conditions.