Monetary policy refers to the government's manipulation of the money supply and the availability of credit in order to achieve policy aims. In the United States, this is handled by the Federal Reserve, and the goals are to promote maximum employment, keep prices stable and maintain moderate long-term interest rates.
The Federal Reserve has three main tools of economic policy:
- Open market operations: The Fed's buying and selling of government securities, such as those issued by the U.S. Treasury.
- The discount rate: What the Fed charges to depository organizations for short-term loans
- Reserve requirements: The Fed's required percentage of deposits that a bank must maintain, whether that amount is held in the bank's vaults or deposited at a Federal Reserve Bank.
Typically, the Federal Reserve controls monetary policy by controlling the short-term nominal interest rate and managing the reserve supply by buying and selling U.S. Treasury Securities. The securities purchases help the short-term interest rate hit the Federal Open Market Committee's target number.
Keeping Rates Low
Sometimes, monetary policy can spur growth by keeping interest low. For example, following the U.S. financial crisis of 2007-08, the Federal Reserve reduced the federal funds rate, which serves as the overnight interest rate for loans between banks, effectively to zero. That in turn lowered the cost of borrowing for consumers, and helped spur economic growth.
It also offers forward guidance regarding its expectations for how interest rates will move in the future. Offering insights into its future policy decisions increases transparency and can serve to spur investment by letting investors know how long they can expect rates to remain constant. It also raises the risk, however, that the market won't interpret the information in the desired way. For example, announcing that interest rates likely would remain low for an extended period could cause listeners to think that the government expected the economy to stay weak, and therefore inspire consumers and investors to cut back on their activity until the situation improves.
Monetary policy can take on a more activist role as events warrant. The 2007-08 crisis, for example, sparked a number of unconventional monetary policies in the United States. The Fed conducted emergency lending operations that went beyond the scope of previous precedents. It also conducted large-scale asset purchases issued by housing-related government-sponsored mortgage-backed securities -- and continued to do so for years.
In 2013, for example, the Fed was still purchasing $40 billion per month in mortgage-backed securities. These measures absorbed supply that otherwise would have contributed to the glut of housing securities on the market, reducing the supply and propping up home prices and stocks. Critics of that action note that purchasing the securities doesn't eliminate the toxic assets, but simply transfers them to the Fed's balance sheet with a negative effect on its own bottom line.
That crisis also saw the Fed allocate credit directly towards financial institutions. Among those loaned such funds included Morgan Stanley, Citigroup, Bank of America and Goldman Sachs. The intent was "to address the strains in financial markets, support the flow of credit to American families and firms, and foster economic recovery."
While the Federal Reserve's policies may have helped the United States through the economic crisis that began in 2007, Jeff Lacker, the President of the Federal Reserve Bank of Richmond, noted that its approach carried risks as well. For example, the choice to purchase mortgage-backed securities could invite pressure from other interest groups to do the same if it experiences price collapses and investor failure.
Examples of Negative Outcomes
Historically, some governments have responded to financial crises by greatly increasing the currency supply. This monetary policy can lead to hyperinflation. The classic example here is the Weimar Republic in Germany, which responded to the Allied demand for reparations following World War I and the subsequent occupation of the Ruhr valley by printing more money. That caused what was left of the post-war economy to collapse, and would set the stage for the Nazis rise to power and the Second World War. Closer to home, in the Civil War the Confederate States increased the amount of its currency in circulation to meet its financing needs, which caused hyperinflation and rising prices.
Ineffective monetary policies also can exacerbate a negative situation. For example, tightening the money supply helped exacerbate the negative effects of the Great Depression and contributed to a recession in 1937 that interrupted the recovery, according to The Economist.