Shawn has a masters of public administration, JD, and a BA in political science.
Monetary policy is implemented to control the rate of change in the general price level in an economy. In this lesson, you'll learn how monetary policy can help stabilize prices. You'll also have a chance to take a short quiz.
Price Stability and Monetary Equilibrium
Price stability in an economy means that the general price level in an economy does not change much over time. In other words, prices neither go up or down; there is no significant degree of inflation or deflation. The term monetary policy refers to the decisions that a government makes concerning interest rates and the supply of money in an economy. Monetary policy can be used to try to keep prices stable. In the United States, the Federal Reserve, which serves as the United States' central bank, sets the monetary policy.
The general goal of monetary policy is to help the economy reach or maintain monetary equilibrium. An economy is at monetary equilibrium when the quantity of money demanded equals the quantity of money supplied. The price level where the supply of money equals demand for it is the equilibrium price, which tends to be stable unless some outside factor changes demand or supply. In other words, prices will be stable when people have no more money or no less money than they need to make the purchases they want to make.
Open-Market Operations and Price
The Federal Reserve can attempt to control inflation or deflation by engaging in open-market operations. In open-market operations, the Federal Reserve buys or sells government securities on the open market to change the rate of growth in the country's money supply. A change in the country's money supply affects the general price level in an economy, as we will soon see.
If the government wants to slow down the rate prices are increasing, it will decrease the supply of money in the economy by selling government securities. When a government sells securities (such as Treasury bonds), it is taking money out of the economy and replacing it with government securities. If there is less money in the economy, interest rates will tend to increase, as borrowers have to compete for loanable funds. Some borrowers will decide not to borrow money if interest rates hit a certain level, which results in a decrease in demand. As demand decreases, sellers will produce less and will not increase prices as they attempt to induce customers to buy their products. Eventually the supply of money will equal the demand for it and prices will stabilize.
The Federal Reserve can also try to stop decreasing prices by use of open-market transactions. Instead of selling government securities, it will buy them back, trading money for securities. This will increase the money supply and tend to reduce interest rates as lenders compete for borrowers. Demand will increase because of the increased availability of money, which will induce sellers to increase production and increase their prices to gain more profit from the demand. Eventually, the demand for money will equal the supply of it, and the general price level will stabilize.
Discount Rate and Price
As we've already discussed, monetary policy can be used to increase or decrease the supply of money. As the supply of money goes down, interest rates will go up; and as the supply of money goes up, interest rates will go down. In this manner, the Federal Reserve is able to indirectly affect interest rates. However, the Federal Reserve does have a more direct, albeit less effective, means to affect interest rates that can also affect the price level.
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The Federal Reserve has the power to directly lower or raise the discount rate. The discount rate is the rate at which the Federal Reserve loans money to banks if they can't cover their minimum required reserves, which is the minimum amount of deposits a bank is required to have on hand to cover withdrawal demands. If the Federal Reserve wants to encourage lending, and thereby increase the supply of money, it will keep the discount rate lower. As we already know, an increase in the money supply tends to cause inflation (an increase in the price level). On the other hand, if it wants to discourage lending, it may raise the discount rate. Less lending means less money in the economy, which means less inflation.
However, a change in the discount rate is not all that effective in creating price stability compared to open-market operations. This is because banks tend not to seek money from the 'discount window' unless they absolutely must, because they don't want to give the Federal Reserve an idea that they may be struggling. Instead, banks tend to get loans from other banks.
The Federal Reserve has regulatory authority over banks. In fact, the Federal Reserve determines the minimum amount of reserves a bank under its jurisdiction must maintain. As we noted earlier, a minimum reserve requirement is the minimum value of its deposits that a bank must keep on hand in order to honor withdrawal demands. A bank will usually lend out the rest of its deposits, which is how they make money. If the Federal Reserve wants to decrease the supply of money in the economy, it will increase the required reserve level, which tends to increase interest rates and slow inflation. If it wants to increase the money supply, it may lower the minimum reserve requirement, which can keep prices from falling.
Price stability is one of the primary goals of monetary policy. Price stability is a state of price equilibrium where prices do not go up or go down by any significant degree. An economy can reach price stability when the supply of money in an economy equals the demand for it. Increases in money supply tend to decrease interest rates and help to control deflation by providing upward pressure on prices. Decreases in money supply tend to increase interest rates and help to control inflation by keeping prices down, by causing demand to decline. The Federal Reserve implements monetary policy by engaging in open-market operations, changing the discount rate, and changing the minimum reserve requirement.
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