Monetary policy refers to the actions that a government takes, whether through a central bank or other financial conduit, that increases the money supply in the economy. There are four principal means by which a central bank can affect monetary policy change: expanding its monetary base, lessening its reserve requirements, allowing greater access to the discount window and lowering its interest rate.
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Objectives of Monetary Base Expansion
The ultimate aim of monetary base expansion is to stimulate a torpid economy. The stimulation is achieved by putting new money into the system through any of the four ways enumerated below. The idea is to encourage lending and the flow of credit so that business will have the necessary access to capital to grow.
To increase the amount of money circulating in the economy (i.e., the monetary base) the government will buy government bonds in exchange for hard currency, or tangible effective capital. Often referred to as quantitative easing, this is one of the most useful ways of adding money to an economy and stimulating growth.
The Federal Reserve of the United States, like many other central banks in the world, requires that banks hold a certain amount of liquid cash in reserve that isn't available for lending to the public. When the Federal Reserve lowers its reserve requirements, it means that banks can access this reserve capital and make it available for lending to the public.
Banks in the U.S. can borrow directly from the Federal Reserve at a "discount" or lower rate than would be ordinarily available if the banks were to borrow from each other. This provides access to liquidity at a cheaper price and adds to the monetary base of an economy. By expanding the number of financial institutions who have access to the discount window, the government effectively makes cheaper money available to more institutions, and thus creates a greater money supply in the economy.
The monetary authorities of any given country can set an interest rate at which banks can borrow from each other. By actively lowering this rate through open-market operations, a central bank makes liquidity cheaper and more accessible to the public, thus growing the money supply. It has the secondary impact of lowering rates on other interest-rate-sensitive vehicles, such as mortgages and car loans.
Government officials must be cognizant of two important facts relating to monetary policy. First, any new policy will generally take at least six months and as many as 12 months before there is a meaningful impact on the economy. Second, any expansionary policy carries with it the threat of future inflation as a result of the buoyed money supply.
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