What is Monetary Policy? - Definition, Role & Effects

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  • 0:00 Definition Of Monetary Policy
  • 0:17 Conceptual Framework…
  • 2:05 The Fed's Monetary…
  • 3:48 The Fed And Interest Rates
  • 5:07 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

National governments have a couple of tools they can use to steer an economy. Monetary policy is one of those tools. In this lesson, you'll learn what monetary policy is and discover its role and its effects. A short quiz follows the lesson.

Definition of Monetary Policy

Monetary policy consists of the decisions made by a government concerning the money supply and interest rates. In the United States, the Federal Reserve (the Fed) determines and implements monetary policy.

Conceptual Framework of Monetary Policy

In order to understand monetary policy, you must first understand the relationship between money supply and banking in market economies. After we have examined how banking is related to money supply of a country, we can then look at how the Federal Reserve can affect the money supply through its policies.

Banks make most of their profits from lending, so they want to make as many loans as possible. However, in order to provide depositors with confidence that their money will be available for withdrawals, the Fed requires a bank to set aside a certain percent of each deposit as a reserve that cannot be lent out. For example, if a bank is required to keep 10% of its deposits as reserves, it will have to keep $1,000,0000 in reserves if it holds $10,000,000 in deposits. It can lend out the other $9,000,000.

Every time a bank loans out money, it's actually increasing the money supply. Imagine that you deposit $20,000 into a bank account, and the bank has a 10% reserve requirement. The next day, the bank loans out $18,000 to a business for a capital asset purchase. By loaning the money, the bank has effectively increased the money supply from $20,000 to $38,000.

How? You still have $20,000 in the bank, but only on paper. However, you can draw on that $20,000 pretty much anytime you want, and it will be available because people don't need or use money at the same time. Thus, there are sufficient reserves to handle the normal volume of withdrawals. But we mustn't forget about our borrower - he has just been given $18,000 to spend on new equipment. That $18,000 will be given to a manufacturer who will deposit it in a bank. The bank, in turn, will set aside its reserve requirement and lend out the rest - thereby growing the money supply even more.

The Fed's Monetary Policy Tools

The Fed can affect the supply of money in the economy by changing the amount of money that banks must hold in reserves. It can use three different tools to do this:

Change Reserve Requirements

The Fed has regulatory authority over banks, which means it can require banks to change their reserve requirements. If the Fed wants to reduce the money supply, it can raise the reserve requirements, which means there will be less money available for banks to lend because they have to keep more in reserves. On the other hand, if the Fed wants to expand the money supply, it can lower reserve requirements, which means there will be more money available for banks to lend.

Change the Discount Rate

The Fed can also change the discount rate, which is the interest rate that it gives to banks when they borrow money from the Fed in the short-term to meet minimum reserve requirements. If the Fed charges a high interest rate, banks will be less likely to borrow money from the Fed. On the other hand, if the Fed charges a low interest rate, then banks may be willing to borrow, which means that they may make more loans.

Open-Market Operations

The third tool available to the Fed is open-market operations, which is where the Fed buys or sells government securities, such as Treasury bills, Treasury notes, and Treasury bonds, on the open market. If the Fed buys, it is increasing the supply of money in the economy because it is trading dollars for the securities. On the other hand, if the Fed sells, it is decreasing the supply of money because it is sucking up dollars from the economy and giving out federal securities. Open-market operations is the tool used the most in recent years.

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