Monetary policy is one of the least understood areas of finance, yet it’s something we’ve been hearing a lot about in the wake of the economic meltdown of 2008. In very general terms, monetary policy is what keeps the economy stable and prosperous.
So, how do the main components of monetary policy such as interest rates, lending and reserve requirements affect you, the consumer? In more ways than you may think–that’s why it’s important to be in the know.
What Is Monetary Policy?
Monetary policy refers to the policies central banks, such as the Federal Reserve, use to determine how much money is available. Interest rates are one of the main tools of monetary policy. The goals of monetary policy are either:
• Expansionary: Monetary policies that increase the total supply of money are said to be expansionary. Central banks use this strategy to combat unemployment through lower interest rates designed to increase business growth.
• Contractionary: When Federal Reserve monetary policy reduces the amount of money or slows the growth of available money it is contractionary. Such policies are used to control inflation.
Monetary Policy Vs. Fiscal Policy
Monetary policy and fiscal policy are not the same and often confused. Fiscal policy is a more general term referencing taxation, government expenditures and the borrowing associated with both. Fiscal policy can be thought of as the government’s business plan, while monetary policy is a targeted means of managing the value of money.
Tools of Monetary Policy
Central banks use different tools of monetary policy to control the value of money and create a stable and prosperous economy. These tools include:
• Interest Rates: Central banks determine the interest rate at which banks lend money to each other for short-term loans.
• Discount Window Lending: A central bank can open a window for loans at a discounted interest rate–a sort of “sale” on money for banks.
• Reserve Requirements: The Federal Reserve and other central banks determine how much in assets a bank must hold in the central bank’s reserve.
• Monetary Base: The primary role of central banks is to determine how much money is available at any given time. This is known as the monetary base–the sum total of all bills, coins and commercial bank reserves held in the central bank.
The Prime Rate
The main way that monetary policy affects you is interest rates. Central banks set interest rates for short-term loans that banks make to one another. This is known as the prime rate. While the prime rate doesn’t affect you directly, it does affect the broader economy.
Fluctuations in the prime rate “trickle down,” most notably in the form of mortgage rates. The prime rate affects just about every other kind of interest rate from car loans to credit cards.
Interest Rates and the Economy
When interest rates go down it makes the cost of borrowing money go down. Even a one or two percent fluctuation in interest rates can impact the economy enormously. When interest rates go down, businesses look to expand with increased spending. Employees of these businesses can then spend more money on durable goods.
If interest rates are low and the economy is robust, banks are more apt to loan money. Common stocks and bonds become more attractive investment options because of this growth, giving companies more capital to grow.
The Down Side of Low Interest Rates
Lowered interest rates aren’t without drawbacks. Low interest rates make the dollar less valuable against other currencies. This can be good for businesses that rely upon exports, as American exports will be cheaper when sold abroad. Consumers will have to pay more for imported goods, however.
Monetary policy can control inflation to a certain extent. In fact, finding the “sweet spot” where low interest rates and low inflation intersect is one of the goals of monetary policy. When the monetary policy increases demand enough, wages and prices will increase at greater rates. A monetary policy that keeps interest rates artificially low eventually leads to increased inflation without a corresponding increase in either production or employment.
There is often a long lag time between monetary policy changes and changes in the real economy. Further, the lag time varies unpredictably. Lags last anywhere between three months and two years or beyond. When inflation is involved the lag might be as long as three years or more.
The time lag causes a number of problems for central bankers. Rather than seeing immediate effects of monetary policy, central bankers must wait months or years to see how well current monetary policy is working.
Current Monetary Policy
Current monetary policy attempts to find a balance between growth and inflation. Particularly when the economy is in a contractionary period, this can be a difficult balance to come to. The tendency for the last two decades has been one of rock-bottom interest rates as an integral part of Federal Reserve monetary policy.