What is Monetary Policy?

This is a very brief overview of how Monetary Policy is carried out in the U.S. Monetary Policy can affect the decisions of consumers to buy or sell houses, cars, take out loans, start businesses, apply for credit cards, open bank accounts and so on. The Federal Reserve is responsible for setting monetary policy in the United States.  Ideally, the Federal Reserve aims to control inflation, employment and output through a small arsenal of tools at its disposal.  The Federal Reserve achieves its goals by manipulating demand - the tendency of consumers and businesses to spend on goods or services.

The tools used by the Federal Reserve are as follows:

Bank Reserves –The amount banks are required to keep in order to meet outflows or withdrawals. The Fed can raise or lower the requirement depending upon whether it wants to stimulate inter-bank lending.

Fed Funds Rate – The interest rate at which banks lend money to each other to meet the bank reserves requirement. A higher rate would be set if the supply of reserves available to lend is less than the demand for those reserves. The converse is also true. If the supply of reserves is greater than the demand, the rate is lowered.

Open Market Operations – The Federal Reserve Bank of New York will either buy or sell government bonds on the open market. When the fed purchases government bonds from a bank, the resulting transaction increases the reserve supply of that bank. The bank is then able to lend the surplus reserves to other banks and the fed funds rate drops.

Discount Rate – The interest rate at which a bank can go directly to the Federal Reserve to borrow funds. The Fed typically keeps this rate higher than the Fed funds rate in order to make sure that banks borrow from each other.

It is difficult for the Federal Reserve to utilize these tools effectively because of the operational lag between exercising new policy and seeing its effects.  The Fed does not know exactly when a change in policy will cause a desired effect. The Fed also cannot afford to wait to see the effects of a policy change and must anticipate what changes it needs to make before the economy has an actual shift. Economic indicators are used to gauge the direction of the economy and take pre-emptive measures.

Article by: Joan Villazon, CFO
Consumer Debt Solutions, Inc.
http://www.consumerdebtsolutions.net