Monetary policy refers to actions of the government, through the country’s monetary authority, to regulate the economy by influencing the supply of money and credit, and the prevailing interest rates. The Federal Reserve is the monetary authority of the U.S.A. Therefore, it is in charge of formulation and implementation of monetary policy in the U.S.A. Monetary policy seeks to achieve the five macroeconomics goals; full employment, economic growth, favourable balance of payment, price stability and income redistribution. In the U.S.A, monetary policy has been effective in regulating the economy and in pursuit of the chief macro-economic goals of any government.
There are various tools employed in implementing monetary policy including; Open Market Operations (OMO), reserve requirement, discount rate and moral persuasion. Open Market Operations refer to selling and purchasing of government securities in order to influence supply of money and market interest rates. Reserve requirement refers to the portion of bank deposits that needs to be held by banks either in their vaults or with the Federal Reserve. Discount Rate refers to the interest rate at which the Federal Reserve lends to commercial banks. Moral persuasion refers to actions by the Federal Reserve to appeal to commercial banks to behave in a certain manner for the good of the country. The monetary policy employed depends on what the government seeks to correct or achieve.
Monetary policy is often classified into two; expansionary monetary policy and contractionary monetary policy. An expansionary monetary policy seeks to increase money and credit supply. It also seeks to lower the prevailing interest rate in order to increase the demand for credit. Generally, an expansionary monetary policy seeks to spur economic growth and lower unemployment rates. A contractionary monetary policy seeks to reduce money and credit supply and increase interest rate which consequently reduces demand for credit. A contractionary monetary policy seeks to reduce inflation rates and achieve a favourable balance of payment.
A government pursuing an expansionary monetary policy will purchase government securities, reduce reserve requirements and lower discount rates. Purchasing government securities and reducing reserve requirements increases money and credit supply available to the public. Purchase government securities by the Federal Reserve increases demand for government securities. This creates an upward pressure on bond prices and reducing yield. Lowering discount rate reduces the rate at which commercial banks lending rate which increases demand for credit. This increases consumer demand. Increase in consumer demand coupled with the availability of cheap credit encourages businesses to expand production and employ more people. Expanding production and increased investment creates economic growth while increased employment by businesses reduces the unemployment rate. However, an expansionary monetary policy is likely to increase inflation due to increased consumer demand. Increased demand is also likely to results in unfavourable balance of payment if the increased consumer demand is directed towards imported goods.
A government pursuing a contractionary monetary policy will sell government securities, increase reserve requirements and raise discount rates. Selling government securities and increasing reserve requirements reduces money and credit supply available to the public. Sell of government securities by the Federal Reserve increases supply for government securities. This creates a downward pressure on bond prices and increasing bond yield. Raising the discount rate reduces the rate at which commercial banks’ lending rate consequently reducing demand for credit. A reduction in consumer demand will reduce inflation rates. It may also improve the balance of payment position by reducing demand for imported goods. However, a contractionary monetary policy is likely to have an adverse effect on economic growth and increase unemployment. This reduces consumer demand. Reduction in consumer demand coupled with high cost of credit discourages businesses from expand production and employ more people. Businesses will be forced to reduce production and lay off workers resulting in unemployment and a decline in economic growth.
The financial crisis of 2007-2008 adversely affected the U.S.A economy. The government took several measures to mitigate the negative consequences of the financial crisis and get the American economy back on track. Monetary policy was one of the tools that were employed in attempts to restore the economy. The Federal Open Market Committee lowered the discount rate to an all-time low and maintained it at a range of 0 to 0.25 per cent. The American economy recovered albeit slowly. There is a still high level of unemployment in America today. To this end, the Federal Reserve is still employing expansionary monetary policy. The latest press release by the Federal Reserve indicates the Federal Reserve redeemed short term government securities worth $ 667 billion and used the proceeds to purchase long term government securities in an effort to reduce long term interest rates so as to facilitate economic growth.
In conclusion, monetary policy is one of the effective ways of achieving the five major macro-economic goals. However, pursuit of the macroeconomic goals often requires conflicting monetary policy making it difficult to pursue all the macroeconomic goals together. Therefore, the government needs to decide the most pressing macroeconomic goals that should be pursued depending on the prevailing economic situation.
References
Arnold, R. A. (2008). Economics. New York: Cengage Learning.
Federal Reserve. (2013, May 1). Maturity Extension Program and Reinvestment Policy. Retrieved May 26, 2013, from Federal Reserve: http://www.federalreserve.gov/monetarypolicy/maturityextensionprogram.htm
Labonte, M. (2013, February 13). Monetary Policy and the Federal Reserve:Current Policy and Conditions. Retrieved May 26, 2013, from http://www.fas.org: http://www.fas.org/sgp/crs/misc/RL30354.pdf
