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Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
The Fed can use four tools to achieve its monetary policy goals:
the discount rate, reserve requirements, open market operations,
and interest on reserves. All four affect the amount of funds in
the banking system.
• The discount rate is the interest rate Reserve Banks charge commercial banks for short-term loans. Federal Reserve lending at the discount rate complements open market operations in achieving the target federal funds rate and serves as a backup source of liquidity for commercial banks. Lowering the discount rate is expansionary because the discount rate influences other interest rates. Lower rates encourage lending and spending by consumers and businesses. Likewise, raising the discount rate is contractionary because the discount rate influences other interest rates. Higher rates discourage lending and spending by consumers and businesses. Discount rate changes are made by Reserve Banks and the Board of Governors.
• Reserve requirements are the portions of deposits that banks must hold in cash, either in their vaults or on deposit at a Reserve Bank. A decrease in reserve requirements is expansionary because it increases the funds available in the banking system to lend to consumers and businesses. An increase in reserve requirements is contractionary because it reduces the funds available in the banking system to lend to consumers and businesses. The Board of Governors has sole authority over changes to reserve requirements. The Fed rarely changes reserve requirements.
• Open market operations, the buying and selling of U.S. government securities, has been a reliable tool. As we learned earlier, this tool is directed by the FOMC and carried out by the Federal Reserve Bank of New York.
• Interest on Reserves is the newest and most frequently used tool given to the Fed by Congress after the Financial Crisis of 2007-2009. Interest on reserves is paid on excess reserves held at Reserve Banks. Remember that the Fed requires banks to hold a percentage of their deposits on reserve. In addition to these reserves banks often hold extra funds on reserve. The current policy of paying interest on reserves allows the Fed to use interest as a monetary policy tool to influence bank lending. For example, if the FOMC wanted to create a greater incentive for banks to lend their excess reserves, it could lower the interest rate it pays on excess reserves. Banks are more likely to lend money rather than hold it in reserve (so they can make more money) creating expansionary policy. In turn, if the FOMC wanted to create an incentive for banks to hold more excess reserves and decrease lending, the FOMC could increase the interest rate paid on reserves, which is contractionary policy.
As the objective of monetary policy varies from country to country and from time to time, a brief description of the same has been as following:
(i) Neutrality of money
(ii) Stability of exchange rates
(iii) Price stability
(iv) Full Employment
(v) Economic Growth
(vi) Equilibrium in the Balance of Payments.
1. Neutrality of Money:
Economists like Wicksteed, Hayek and Robertson are the chief exponents of neutral money. They hold the view that monetary authority should aim at neutrality of money in the economy. Any monetary change is the root cause of all economic fluctuations. According to neutralists, the monetary change causes distortion and disturbances in the proper operation of the economic system of the country.
2. Exchange Stability:
Exchange stability was the traditional objective of monetary authority. This was the main objective under Gold Standard among different countries. When there was disequilibrium in the balance of payments of the country, it was automatically corrected by movements. It was popularly known, “Expand Currency and Credit when gold is coming in; contract currency and credit when gold is going out.” This system will correct the disequilibrium in the balance of payments and exchange stability will be maintained
3. Price Stability:
The objective of price stability has been highlighted during the twenties and thirties of the present century. In fact, economists like Crustar Cassels and Keynes suggested price stabilization as a main objective of monetary policy. Price stability is considered the most genuine objective of monetary policy. Stable prices repose public confidence because cyclical fluctuations are totally eliminated.
4. Full Employment:
During world depression, the problem of unemployment had increased rapidly. It was regarded as socially dangerous, economically wasteful and morally deplorable. Thus, full employment assumed as the main goal of monetary policy. In recent times, it is argued that the achievement of full employment automatically includes prices and exchange stability.
5. Economic Growth:
In recent years, economic growth is the basic issue to be discussed among economists and statesmen throughout the world. Prof. Meier defined “Economic growth as the process whereby the real per capita income of a country increases over a long period of time.” It implies an increase in the total physical or real output, production of goods for the satisfaction of human wants.
In other words, it means utilization of all the productive natural, human and capital resources in such a manner as to ensure a sustained increase in national and per capita income over time.
6. Equilibrium in the Balance of Payments:
Equilibrium in the balance of payments is another objective of monetary policy which emerged significant in the post war years. This is simply due to the problem of international liquidity on account of the growth of world trade at a more faster speed than the world liquidity.
It was felt that increasing of deficit in the balance of payments reduces, the ability of an economy to achieve other objectives. As a result, many less developed countries have to curtail their imports which adversely effects development activities. Therefore, monetary authority makes efforts that equilibrium should be maintained in the balance of payments.
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