In the U.S., the Federal Reserve maintains control over our money supply, issuing currency as needed and making decisions that support the stability of our economy. These policies and decisions are called monetary policy and they ensure that unemployment levels are low, the gross domestic product (GDP) maintains stability, prices remain stable, foreign exchange rates are relatively predictable and select sectors are growing properly. The actions of the Federal Reserve are intended to create the kind of stability that empowers our nation to thrive and prevents crashes that result in bank runs and other economically disastrous dynamics.
Define Monetary Policy
Small business owners often deal with banks on a regular basis, and while you may not be familiar with monetary policy, you've probably noticed that at certain times your interest rates go up or down and your taxes increase or decrease. You might also notice that you have access to more or less credit at certain times, even though your business' credit standing has remained stable. Your ability to employ new people changes with these factors as well as your ability to offer new products.
These changes in your experience of business are due to monetary policies decided upon by the Federal Reserve of the United States. In order to release more money into the economy or reign it in, they write up policies and put them into action. Some monetary policy examples include buying or selling government securities through open market operations, changing the discount rate offered to member banks or altering the reserve requirement of how much money banks must have on hand that's not already spoken for through loans.
Functions of the Federal Reserve
In 1913, the Federal Reserve System(the "Fed"), was created by an act of Congress in order to create an environment of greater economic stability in the United States and grant the public more confidence about keeping their money deposited in banks. Since then, the Fed has been responsible for issuing currency, supervising and regulating the financial industry, maintaining payment systems and defining monetary policy while also carrying it out. While the Fed was created through an act of Congress, it's separate from our U.S. government.
In order to conduct their operations, the Federal Reserve System includes 12 regions with a reserve bank in each one. These reserve banks are in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis and San Francisco. In addition, the regions maintain 24 branch offices that help conduct regular business. The federal reserve also makes use of a Board of Governors and Federal Open Market Committee in order to conduct monetary policy and watch over the economy of our nation.
How Monetary Policy Works
Making monetary policy is probably a bit different from creating new policies for your business, though you likely relate to the idea of wanting your policies to result in greater profits and stability. Some of the goals of monetary policy are to:
- Promote a high employment rate.
- Promote a low unemployment rate.
- Maintain stable pricing throughout the economy.
- Limit inflation.
- Encourage stable exchange rates with other currencies.
- Influence stable and reasonable interest rates.
- Encourage healthy economic growth.
In order to achieve these aims, the Federal Reserve System makes use of several tools that help to ensure major economic decisions are a collaborative effort instead of the work of one or two people. These tools include:
- Regional Federal Reserve banks as well as branch offices that represent all 12 regions in the United States. Outside of the continental United States, the San Francisco region serves Hawaii, Guam, American Samoa and the Northern Mariana Islands. The Seattle region serves Alaska, and the Richmond region serves the District of Columbia. New York Serves Puerto Rico and the U.S. Virgin Islands.
- The Board of Governors, which is made up of seven people who serve 14-year terms. They're appointed by the United States President and confirmed by Congress. Even though the Fed is separate from our government, it's still accountable to it.
- The Federal Open Market Committee, which includes all seven board governors as well as five of the regional bank presidents. Even though only five of the presidents are included, all 12 are present for the meetings, which occur eight times per year. The president seats on the committee rotate to ensure every region is represented over time.
The Monetary Policy Report
In order to maintain transparency and accountability about its monetary policy actions, the Federal Reserve issues a semiannual monetary policy report. This report includes three major sections:
- Recent Economic and Financial Developments: This section includes data and graphs representing employment and unemployment trends, employment compensation, business-sector output by hour, price inflation, oil and energy prices, changes in gross domestic product (GDP) and gross domestic income (GDI), consumer spending patterns, personal savings rates, housing trends, debt trends and more. For instance, if unemployment rose while consumer spending dramatically decreased, this section of the monetary policy report would detail that in words and through graphs.
- Monetary Policy: Some monetary policy examples detailed in this section of the report include increases and decreases in the federal funds rate, reductions or increases in the Federal Reserve balance sheet like payments on SOMA securities and changes in the required reserve rate for banks. The monetary policy section also contains lengthy explanations, an area to define monetary terms for the layperson and details of monetary policy changes in plain English so that business owners and the general public can understand what's going on in the economy and why.
- Summary of Economic Projections: The final section combines information from the first two sections in order to give monetary policy examples and changes that could become necessary within the next two years. Here, the report details the general trends of the economy and whether the Fed expects to implement changes to the federal reserve rate or funds rate as well as what open market operations they expect to engage in. For instance, if they're predicting necessary increases in the federal reserve rate, the report will show why using graphs, numbers and written explanations.
Open Market Operations
Open market operations (OMO) are when the Federal Reserve buys or sells government securities in order to arrive at a monetary definition of the desired currency circulation levels in the economy. When the Fed purchases securities, that increases the amount of money circulating in the economy to give it a bit of a bump up. This typically leads to things like lower unemployment rates and higher consumer spending.
When the Fed sells securities, that decreases the amount of money circulating in the economy to reign things in a bit. Most business owners are likely to find this frightening, but without this restraint on the economy, inflation could increase at an unhealthy rate. Contrary to how we feel when there's less money circulating in our economy, it actually increases long-term stability in the business sector, which is good news for business owners.
The Federal Open Market Committee is the body that decides when and how open market operations will happen. They set a target federal funds rate and then decide how to buy or sell government securities accordingly. While this committee is separate from our U.S. government, they're accountable to it and their open market activities greatly impact all levels of government and the public.
The Discount Rate
Just like you go to the bank to get a loan when you need to expand your business, commercial banks receive loans from the Federal Reserve in order to be able to meet reserve requirements at the end of a business day or period. Similarly to how loans from the bank are probably a last resort resource for sustaining or growing your business, commercial banks prefer to get loans from one another before taking out a loan from the Federal Reserve. When they do take a loan out from the Fed, the interest rate charged on that loan is referred to as the discount rate.
The Fed carefully decides on the wisest discount rate and that largely depends on how much money is sitting in their reserves. If they want to release more money into the economy, then they lower the discount rate, but if they want to decrease the money in the economy to rein in inflation, they increase the discount rate. This makes loans more or less expensive to member commercial banks and, in turn, influences how much money is available to give someone like you a business loan.
Changing the Reserve Requirements
When the Fed's monetary definition of economic stability prescribes expanding or contracting the amount of money circulating freely in the economy, their monetary policy changes accordingly. When the Fed wants to slow down financial growth, they'll raise the reserve requirement, which then causes an increase in loans issued from the Fed at a higher discount rate.
When the Fed wants to increase economic growth, they'll lower the reserve requirements so that commercial banks can issue more loans to business owners like you. Business owners use those funds to grow their businesses and pay employees, which results in more money circulating in the marketplace.
Expansionary Monetary Policy
The Federal Reserve sometimes needs to increase the amount of money injected into the economy in order to increase consumer spending and aid in a healthy level of economic growth. There are three steps the Fed typically takes in order to enact expansionary monetary policy:
- Decreases the federal funds rate: When the Federal Reserve decreases the federal funds rate, this also decreases the cost of borrowing for commercial banks, which creates more money available for lending to business owners and individuals, who then push this currency into circulation in the economy.
- Purchases government securities: When the Fed purchases securities, this creates more money in the banks that held the bonds, which also increases the amount that those banks can lend to businesses and individuals. This expands the economy through creating money people can use to pay employees, buy necessities or otherwise spend in the marketplace.
- Reduces reserve requirements: When the Federal Reserve reduces the reserve requirements for commercial banks, this also frees up money they can use to lend businesses and consumers, again causing more money to circulate in the marketplace.
Contractionary Monetary Policy
When the money supply increases too quickly, sometimes this causes prices to rise too rapidly and decreases how much your money can buy. In order to reign in this inflation, the Federal Reserve enacts contractionary monetary policy, which includes:
Increasing the federal funds rate: When the Fed increases the federal funds rate, it becomes more expensive for member commercial banks to fund their operations through Fed loans. So, they issue fewer loans or reduced loan amounts to businesses and consumers, and usually at a higher interest rate. This discourages businesses and individuals from seeking loans, thereby reducing the money circulating in the marketplace.
Selling government securities: When the Federal Reserve increases the federal funds rate, they tend to also sell government securities, which reduces the money available at the banks holding the bonds, so they're less likely to issue business and consumer loans.
Increasing the reserve rate: At the same time as increasing the federal funds rate and selling government securities, the Fed often increases the reserve rate in order to keep more money on hand in member commercial banks. This decreases loans and the amount of currency circulating in the economy.
- Investopedia: Monetary Policy
- Federal Reserve Education: Monetary Policy Basics
- Board of Governors of the Federal Reserve System: Monetary Policy Report: February 2019
- Investopedia: What are Some Examples of Expansionary Monetary Policy?
- Business Jargons: Types of Monetary Policy
- The Board of Governors of the Federal Reserve: Open Market Operations
- Investopedia: Open Market Operations
- Board of Governors of the Federal Reserve System: Discount Rate
- Investopedia: Federal Discount Rate
- Board of Governors of the Federal Reserve System: Reserve Requirements
- Investopedia: Reserve Requirements
- Economics Help: Expansionary Monetary Policy
- CFI: What is a Contractionary Monetary Policy?