12.6. Monetary Policy
There is a direct relationship between the money supply and the level of business activity. When the money supply is increased, consumer spending and business spending tend to increase with it. It follows that in times of recession, an increase in the money supply will help bring about economic recovery. When the economy is expanding and prices are rising, a reduction in the money supply will reduce demand and lower prices.
The Federal Reserve's responsibility is to regulate the supply of money to reduce the effects of recession or rapid expansion. Supporters of monetary policy as the best way to ensure price stability and control inflation over the long run are called monetarists. Monetary policy is the responsibility of the Federal Reserve System.
The Fed and the money supply. The Federal Reserve System has several tools it can use to regulate the money supply. The most important of these are listed below.
• Open market operations. Open market operations refers to the purchase and sale of government securities (such as Treasury bills and bonds) by the Fed's Open Market Committee. When the Open Market Committee directs the Federal Reserve to buy government securities from banks and other investors, it puts money into the economy. The money is deposited by the sellers in their checking accounts. For their part, the banks will try to lend as much as they can of the new deposits, thereby adding to the money supply. As these new loans move through the banking system, the total money supply will be increased still further by the deposit multiplier (see Chapter 11).
When the Open Market Committee sells government securities, it takes money out of the economy. Bank reserves are reduced, as those who purchased the securities pay the government by writing checks. The reduction in reserves also reduces the ability of banks to lend money, which slows the growth of the money supply.
• The discount rate. Just as business firms look to their banks when they need to borrow, banks look to their Federal Reserve bank when they are in need of funds. Like other borrowers, the banks are charged interest on their loans from the Fed. The interest rate on loans to banks and other financial institutions is called the discount rate.
When the Board of Governors raises the discount rate, the banks will increase the interest rates
that they charge their customers. Similarly, when the discount rate is reduced, banks drop their loan rates. Higher interest rates tend to discourage borrowing, while lower rates have the opposite effect. When loans are increased, the money supply grows. When loans decline, the money supply falls.
• Reserve ratios. As you learned in the previous chapter, banks are required to keep a percentage of their deposits—the reserve ratio—in reserve. A portion of their reserves is deposited at their district Federal Reserve bank. The balance of their deposits is available for loans to their customers.
When the Board of Governors increases the reserve ratio, it reduces the ability of the banks to lend money. When the reserve ratio is decreased, the commercial banks are free to lend a larger portion of their deposits which in turn will increase the money supply.
The Limitations of Monetary Policy. Monetary policy is least effective at the extreme ends of the business cycle. During periods of expansion, when optimism among buyers and sellers is running high and prices are rising, the Fed may try to hold down spending (and prices) by increasing interest rates. Because the business outlook is so bright, many firms continue to borrow despite the high cost of loans. They expect that their interest expenses will be more than offset by higher prices and greater sales. In fact, because the higher interest rates increase the cost of doing business, they can even add to the inflationary pressure.
Recent changes in the U.S. economy have also limited the effect of monetary policy. Up until the 1980s, for example, the interest rate that banks could pay their depositors was limited by law. In those days, the Fed could reduce the money supply by increasing the interest paid on government securities. As interest rates rose above that paid by banks, money flowed out of deposits and into Treasury securities. This, in turn, reduced bank reserves and the money supply. Today, however, this is less likely to happen, since banks are free to raise interest rates, and the public has a wider variety of places to invest its savings.
Similarly, the integration of the U.S. economy into the global economy has weakened the Fed's ability to control interest rates. Interest rates are affected by the monetary policies of central banks around the world.