monetary policy, how it affects our economy, and what it’s used for
hey honey bunnies! today i’m gonna do my best to explain the concept of monetary policy, how it affects our economy, and what it’s used for. it’s really prevalent in current economic news regarding the federal reserve, so hopefully, you can understand more of why it’s so currently relevant!
open market operations (to its barest bones of buying and selling bonds) works like this. first off, bonds pay a fixed annual interest payment. in simple terms, bonds are issued out to people by governments because they need to borrow large amounts of money. say the government wanted to buy a huge rocketship but didn’t have the money to pay for it; they would issue out bonds to people so people pay for the bonds and then later on they are promised to receive more money when they sell those bonds.
the third tool of monetary policy is the required reserve ratio. basically, back when economic crises used to happen, people would show up in large numbers to the banks like “literally give me all my money back i need it now” and banks would be like “babes we literally do not have any on hand” which just left the state of our society in confusion and utter brokeness. because of these past experiences, the fed implemented a required reserve ratio, which means that a fixed percentage of the money consumers put into the bank must be kept on hand at the bank so at least some of their money will be available. for example, if the reserve ratio rate is 10% and you go to the bank right now and put in $100, then the bank is forced to keep $10 from your money there at the bank.
in terms of our current pandemic state, as of recently the fed has announced that they are going to raise interest rates to combat the inflation occurring in our economy. as explained previously, increasing interest rates increases the amount of money being paid to banks, which decreases the amount of money people have in their pockets. by increasing the interest rates, the fed hopes to lower inflation (price levels) by decreasing the purchasing power of the consumers who buy the products in our economy. if people have less disposable income, then they cannot pay the high prices that arrived with inflation, so companies will have to decrease their prices. at least, that is the hoped course of action that the fed is hoping occurs with this interest rate hike.
monetary policy is a set of tools that a nation’s central bank has to balance economic growth by controlling the overall supply of money that is available to the nation. as i talked about in the inflation article, inflation and deflation can lower and raise prices, and monetary policy is used to stabilize the economy by having it stay at a place where the prices aren’t too high or too low.
when bonds are sold, it is a tool of contractionary monetary policy because people give their money to the government to obtain the bonds, and the government can now eliminate the money it received and lower the money supply. contraction means “the process of becoming smaller,” so associate contractionary with a smaller supply of money in our economy. vice versa, buying bonds is a tool of expansionary monetary policy, where the government gives people money in exchange for their bonds, and supplies more money into our economy. expansionary=expanding or increasing our money supply.
when the fed lowers the RRR (required reserve rate) it is used as a tool of expansionary monetary policy because of a thing called the monetary multiplier. the monetary multiplier is equal to 1 / the required reserve ratio, and whatever number that is is multiplied into the original money consumers put into the bank to find out how much money that original deposit can grow into. when the RRR is closer to 0, the multiplier becomes larger. if we go back to the $100 example, say there are two different RRR’s, 10% and 20%. if the RRR is 10%, not only does the bank have $90 dollars (which excludes the required reserve of $10) to loan out to other people, but the multiplier is 10, which means the $100 can turn into $1000. at 20%, the bank can only loan out $80 and the $100 will only turn into $500. therefore, when the RRR is lower, more money can be loaned out and created, which increases the money supply to help expansionary monetary policy, and the opposite occurs for contractionary policy.
you can use this graph to understand how monetary policy affects our interest rates along with our GDP. when the supply line goes to the right, it intersects with a lower interest rate, showing how increase in money supply decreases the nominal interest rate, and when the supply line shifts to the left, the interest rate increases. in our entire economy, when interest rates are lower, more people are willing to invest in loans because of the cheaper price, and that contributes more money to our gross domestic product (since investment is one of the four elements of GDP). because higher GDP often is a sign of economic growth and low unemployment, expansionary monetary policy increasing the money supply promotes economic growth in our overall economy, and the opposite applies for contractionary monetary policy.
there are three tools of monetary policy: open market operations, the discount rate, and reserve requirements. open market operations refer to the buying and selling of short-term Treasuries and other government securities like bonds. the discount rate refers to the interest rate set by the federal reserve for other banks borrowing money from the federal reserve. reserve requirements refer to the changing of the reserve requirement ratio, which is the ratio of money banks are required to keep of liabilities (mostly deposits from people) in order to not have money withdrawal issues during times of crisis.
the next tool of monetary policy as stated before is the discount rate. the discount rate refers to the interest rate set by the federal reserve for other banks borrowing money from the federal reserve. when the federal reserve increases discount rates, banks are less inclined to borrow money from the federal reserve because of the higher interest they will be forced to pay for that borrowing. they instead borrow from other banks and their lack of borrowing new money from the fed causes the money supply to decrease in our economy (contractionary monetary policy). the opposite occurs for expansionary monetary policy.
a money supply and money demand graph looks like this: (on the left)
the D line is the money demand and the S line is the money supply. the money supply line is vertical because the federal reserve sets the quantity of money in circulation, so external factors like interest rates will not change that number. the money demand is downsloping because as the quantity of money increases, people have less need to borrow money because they have more money, so banks reduce their interest rates on loans to attract people to take out loans. as the quantity of money in the economy decreases, the opposite happens because people are required to take out loans since they have less money available, so banks can charge higher interest rates. ultimately, quantity of money and the nominal interest rate are inversely related.
thank you so much for reading honey bunnies!! i know monetary policy is kind of a hard to understand topic, so i hope this explained it in a simpler way that made it go from understanding calc to understanding algebra I: still a difficult concept to understand, but not nearly as difficult as it could’ve been.
let me know if you have any questions, and i hope you guys have an expansionary day ;)