Monetary Policy Primer
April 06, 2015
We’ll define monetary policy as the actions of a nation’s central bank aimed at controlling the expansion or contraction of the money supply. In the United States, the central bank is the Federal Reserve. First, let’s take a look at the “Fed,” as it is often known, and what it does.
How the Fed Works
The Federal Reserve is the central bank of the United States. It is technically nonpartisan and independent of the three governmental branches. The head of the Federal Reserve is given the title of Chairman or woman of the Federal Reserve. He or she is nominated by the President of the United States and confirmed by the Senate. The current Chair is Janet Yellen. Below her is a board of governors who represent the twelve Fed branches throughout the country.
The Fed employs economists who analyze economic data from all over the world to track the purchasing power of the dollar and U.S. consumption levels. Based on the analysis, the Fed decides how it should intervene in the markets to maintain stability and sustainable economic growth. The Fed has a few roles and tools at its disposal in this regard.
Federal Reserve Functions
The Government’s Bank
While United States dollars are technically printed by the US Treasury, the Treasury keeps a sort of checking account at the Fed. This works exactly as you would expect: government revenues go into the account, and the government can draw from the account to finance its payments. When the government spends more than it takes in, it pays for the debt by issuing US government securities such as Treasury bonds, bills, and notes, with the Fed acting as the financial intermediary. Additionally, when Treasury prints out new federal currency, it effectively sells the currency to the Fed at cost, and the Fed then distributes the money into the money supply through various means.
The Banker’s Bank
The Fed also serves as “the banker’s bank” in the US economy. All licensed commercial banks are required to have accounts at the Fed where they keep a certain amount of cash reserves in case a crisis hits the economy (these are called federal funds and are the bank’s namesake “federal reserves.”) The Fed can mandate just how much banks are required to store at the Fed by raising and lowering the reserve ratio – the ratio of bank reserves at the Fed to bank loans.
The Lender of Last Resort
One of the Fed’s most important jobs is to facilitate emergency lending, especially in an economic crisis. It has two main ways of doing this. The first is by facilitating lending between private banks’ federal funds. The Fed can set the Federal Funds Rate, the rate at which banks loan their federal funds to each other. Next, the Fed serves as the nation’s “lender of last resort”: when a bank or other financial institution is in danger of collapse and thus has no access to credit, and the Fed determines that its collapse could have serious economic consequences, the Fed can step in and offer generous loan terms backed by the government. This was one of the Fed’s primary roles during the recent financial crisis.
The Fed, along with the Department of the Treasury and the US Securities and Exchange Commission, is one of the government’s main regulators of financial institutions. Explaining how and why financial markets are regulated would require an entirely separate article, but you can get a basic overview of what the Fed does here.
The Fed is not just charged with ensuring stability in the banking sector. It is also the principal institution conducting monetary policy in the United States. In the Federal Reserve Act, Congress charged the Fed with three main objectives: maximum employment, stable prices, and moderate long-term interest rates. The goal of maintaining maximum employment with stable prices is often referred to as the Fed’s dual mandate.
First, it is important to understand what the money supply is. The money supply is how much liquid money (spendable money) is in the economy at a given time. A larger money supply means more people are spending money rather than saving it, and therefore consumption increases, more people are employed, and businesses are expanding. A contracted money supply creates incentives for people to save rather than consume, consumption goes down, and unemployment goes up.
To understand monetary policy, one must understand that GDP in an industrialized economy generally increases over time. In the United States, that growth is usually around 4% a year. We call this generally increasing trend the potential GDP, represented by the blue line in the figure below and formulated by taking into account technological advances, population growth, and educational investment. Around the upward sloping Potential GDP trend is the Actual GDP line, which measures annual GDP, demonstrating the business cycle, which can be described as periods of increased output (expansion) and decreased output (recession). It is represented by the red line. Periods of recession and expansion will always be part of any capitalist economy. It is the role of policy makers at the Fed to use monetary policy to keep actual GDP close to the potential line by expanding the money supply during periods of recession to encourage spending and increased output, and by contracting the money supply during periods of expansions to curb overproduction, or bubbles.
The graph below demonstrates the potential and actual GDP of the United States from 1950 to today, and the projected potential GDP until 2020. The abnormal deviation of the actual from the potential GDP in 2009 demonstrated the Great Recession.
Tools of Monetary Policy
To understand the Fed’s policy tools, it’s important to first have a grasp of the economic theory underlying them. Here’s a hypothetical:
Let’s say your income is $40,000, and after you spend $20,000 on consumption such as food and housing, you have $20,000 left over. You have two options: you could put that money into a savings account and earn a return approximately equal to the interest rate set by the Fed, or you could invest it – in bonds, in the stock market, or in another financial product, where your money is less liquid, and less certain to receive a return, but will on average accrue a higher return.
Which is better? Well, in booming economic times, it may be better to save the money. The Fed worries about overinvestment in certain assets that may collapse (think of the stock market during the Great Depression or the housing market during the recent financial crisis). Saving now also means having more liquid capital, and it provides a safer storage mechanism for your money than a volatile financial market. But if the economy is in poor shape, it is certainly better to invest. More investment means more capital for businesses, which can spur more hiring or innovation.
We can also apply this hypothetical to corporations. Let’s say you are the CFO of a company that has made a $50 million profit. You can either save this money as profit, return part of it to your investors as dividends, or reinvest it into your business in the form of hiring new workers, buying new equipment, or investing in other forms of capital. You may think that in all cases, it is better from an economic perspective to hire more workers. But that isn’t always the case. Economists believe that if unemployment gets too low, that workers will simply have too much bargaining power when negotiating employment contracts, since there are more jobs available than labor. They will demand higher wages, which will lead companies to raise prices in order to make enough money to pay their employees. When consumers face higher prices, they’ll demand higher wages to compensate, which will lead to what’s known as an upward spiral of prices and wages. This will lead to rampant monetary inflation.
Economists call the lowest unemployment rate before the upward spiral takes place the natural rate of unemployment. You may ask what this rate is, and unfortunately like potential GDP earlier it is a somewhat nebulous concept with no definitive answer. That said, the Fed has attempted to calculate it and it usually falls between five and six percent.
As a result, when reading through the Fed’s policy tools below, consider them to be primarily aimed at achieving the appropriate ratio of savings and investment that allows the Fed to fulfill its dual mandate described above. Here are the Fed’s principal tools:
Changing the Reserve Ratio
The Fed adjusts this rate according to the conditions of the economy at the time: if there is a financial crisis and the system needs more stability, the Fed will require higher reserve levels. If the economy is being hampered by a lack of access to credit that is stifling private investment, the Fed will lower the requirement so that banks can give out more loans. The Fed can also increase and decrease the rates at which banks can borrow from the Fed, called the discount rate.
One way the Fed can control the money supply is by setting target interest rates, which will trickle down set the interest rates on CDs, mortgages, auto loans, etc. The Fed does this by setting the federal funds rate described earlier. The FFR, which as you will recall is the rate at which banks lend to each other, then becomes the default interest rate banks deliver to consumers. It also sets the rate at which banks loan to businesses (with a few percentage points added on, of course, so that the bank can make a profit).
Logically, if interest rates are higher, people will want to save their money because they will get a higher return on it without the risk of investing in an asset. Also, individuals and businesses will be less likely to take loans because of high interest repayment rates. Conversely, if interest rates are low, people will spend and invest rather than save, and will be more likely and able to take out loans. Thus, when the economy is doing poorly, the Fed will want to ramp up investment and access to capital to spur new businesses, and it will do this in part by cutting the interest rate to disincentivize saving. If the economy is booming, the Fed will be cautious of over-investing in financial assets in case they crater (think the stock market during the Great Depression, or the housing market during the financial crisis), and thus will make saving more attractive by raising interest rates.
(Figure above) The point MS1, I1 can represent a point in time when interest rates are low, the economy is booming, and the Fed feels that it is time to reduce consumption because they fear a bubble. It uses its tools to raise interest rates, which encourages people to save and not spend money, contracting money supply. Md is reduced and the GDP decreases toward the trend (not shown above).
Open Market Operations
When the Fed wants to intervene in the markets by directly shifting the money supply, it has several tools at its disposal. We call these actions the Fed takes open market operations.
First, the Fed can buy US government securities (distributed by the U.S. Treasury as a form of savings for the investor) from the public in exchange for dollars (which the Fed distributes). This injects money into the economy. Think of the bonds as a way in which consumers and businesses save rather than spend, and the dollars are how they spend. When the Fed wants to encourage investment and spending, it will aggressively purchase bonds in order to flush money towards the bondholders. This will increase the money supply and increase GDP. Conversely, the Fed can sell bonds, which encourages saving and reduces the money supply.
The newest form of monetary policy is the Fed’s quantitative policy programs, often called quantitative easing (QE). In this program, the Fed enters the financial market directly and purchases financial products, mainly bonds. The idea is that when corporations or other entities sell bonds or mortgage-backed securities, for example, they often do so to raise liquid capital to finance new investments. When the Fed purchases these products, they are injecting money directly into banks and businesses, hoping that money will be put to productive investments such as hiring more workers.
Is this the most efficient way to spur the economy? What is stopping corporations from simply pocketing the money rather than hiring workers? Isn’t there dead weight loss (when potentially productive money is not used for investment or consumption) for the economy when not all of the money from the Fed is put to productive use?
The answer is yes, there very well could be. But remember that these Fed tools are used in conjunction with interest-rate setting policies that disincentivize saving and encourage investment. Also, QE has been sparingly used by the Fed, first during the 1990’s savings and loan crisis and more recently during the late 2000’s financial crisis. That said, some have argued that it would be more economically efficient for the Fed to simply give money to consumers directly.
The Dual Mandate and Inflation
The last major dimension of Fed policy to consider is its dual mandate mentioned above: full employment and stable prices (i.e., controlled inflation). The issue is that in the short run, the Fed arguably faces a tradeoff between these two goals.
The intuition here is simple. To achieve maximum employment, the Fed must inject money into the economy to provide businesses with liquid capital. But when the money supply expands, money becomes less valuable and prices increase. We call this tradeoff the Phillips curve:
That said, the Phillips curve only holds in the short run. The intuition behind this makes sense as well. In the long run, if high inflation is expected, workers bargaining for contracts will demand steadily increasing wages each year (in order to keep purchasing power constant), which will suck more of corporations revenues, leaving them with less money to hire new workers.
The Fed thus faces a time-inconsistency problem: In the short run, it wants employees to believe that inflation will not be a major issue so that their wage contracts do not automatically increase. But after wage contracts are signed, it wants to increase the money supply (causing inflation) to spur new hiring.
As a result, the Fed compromises on these points. It sets an annual target rate of inflation (currently around 2%) and promises to expand or contract the money supply as needed to hit that mark (while at the same time preserving the option of more aggressive short-term stimulus during a down economy). Thus, the Fed gives itself the leniency to engage in monetary stimulus in the short run, especially during crises, but maintains long-term commitments to price stability.
Exchange Rate Policy
Central banks such as the Fed also maintain a monopoly over the currency supply in their home countries. They can use this control over the money supply to influence international currency exchange rates.
What is currency manipulation?
There are two main features of currency to consider: its inflation rate (or purchasing power within its own country) and its exchange rate (or its value relative to other currencies). Central banks which control monetary policy can affect either of these rates.
Currency manipulation, and specifically currency devaluation, occurs when central banks systematically and artificially devalue their own currency relative to other countries’ currencies. How can a central bank devalue currency? Well, at its most basic level the relative price of a currency is determined by its value in the international currency market. And just as with any other market, its price is determined by supply of, and demand for, the currency. Since central banks control their currency supply (as well as influence demand by buying and selling currencies), they can directly affect the relative value, or exchange rate, of their own currency. Currency manipulation, however, occurs when central banks use their monetary policy powers to affect the value of other currencies. They do this principally by engaging in direct purchases of foreign currency assets and stockpiling foreign currencies (such as the US dollar). Through traditional mechanics of supply and demand, central banks can juice up demand for (and thus the price and exchange rate value of) foreign currencies, consequently devaluing their own in a relative sense.
Why would central banks want to devalue their currency?
Let’s consider a hypothetical example in which one dollar is worth exactly one euro. Company A in the US produces good X at a cost of one dollar, and sells it for two dollars.. Company B in France produces its own version of good X at a cost of one euro, and sells it for two euros. A consumer in France is indifferent between buying from Company A or Company B, because they cost the same thing.
Now, the Federal Reserve alters the exchange rate so that one dollar is now worth only .5 euros. This doesn’t change the cost structure for either company, since they are producing within their own country. Company A continues to sell good X for two dollars, and Company B sells it for two euros.
But now our French consumer is no longer indifferent. If he or she can exchange their two euros for four dollars at the current exchange rate, they can now afford to buy two units of good X from Company A – but only one unit from Company B! The relationship between exchange rate value and other economic variables such as production levels is commonly described by what’s known as the Mundell-Fleming model.
Thus, currency devaluation makes the exports from the country with the devalued currency artificially cheaper than they would be otherwise, and imports artificially more expensive.
The implications of this for international trade are obvious: countries can massively increase both domestic and international demand for their produced goods just be devaluing their currencies. This has dangerous consequences for international trade, as it rewards countries who engage in this unfair manipulation and encourages a “race to the bottom” whereby all countries compete to devalue their currency the most to increase their GDP.
How do countries fight this?
To combat this kind of competitive devaluation, countries have negotiated numerous multilateral agreements to do things such as fix the currency exchange rate by pegging it to a certain value. The most famous of these monetary systems is known as the Bretton Woods System, whereby countries pegged their currencies to the value of the American dollar, which itself was pegged to the price of gold. This system was abandoned in the early 1970’s.
These fixed peg systems, however, nearly always fail, because they reduce nations’ monetary policy autonomy. Recall that nations’ central banks expand or contract the money supply as needed to stimulate or rein in economic growth. And we have already established that as in any market, the market for a given currency is determined by supply and demand, which produce the currency exchange rate. (See the Mundell-Fleming model article linked above for a better description of how this works.)
However, countries grow and economies change at different rates. Thus, different central banks in different countries face divergent incentives at any given time: some will want to expand the money supply, some will want to contract, according to economic conditions. A fixed peg, however, mandates that central banks maintain a certain supply of money that will produce the desired exchange rate. As a result, maintaining a fixed peg restricts central banks’ ability to manage the economy – an unacceptable outcome for many countries.
Many developed countries, instead, have moved to what is known as a floating exchange rate, where the exchange rate is determined by the international currency market, but the central bank retains its ability to impact the money supply – even if its actions affect the currency price.
Theories of Monetary Policy
However, not every economist agrees that this is how the Fed should conduct monetary policy. Here are some competing theories of monetary policy.
Largely associated with economist Milton Friedman, monetarism argues that monetary policy should target the money supply’s growth rate above all else. According to monetarists, the money supply is the main influencer of GDP in the short run and the price level in the long run.
To understand why, let’s look at the Quantity Theory of Money, which states that the money supply times the velocity equals the nominal GDP times the price level. Also called the Equation of Exchange, it can be written as MV = PY. The velocity of money can be conceptualized as how fast a single dollar moves in the economy through transactions. The velocity variable is where this equation creates a schism in thought between economists. Monetarists believe that velocity is generally stable, and with predictable price level changes in the short run (inflation), Y, or nominal GDP, is thus simply proportional to M, the money supply. However, in the long run, price level should predictably follow the changes in the money supply, and real GDP should not be affected by this policy. On the other hand, in the short run, prices and wages are sticky, or take time to adjust, and cannot move as fast as the central bank can manipulate the money supply, so there are temporary effects on real GDP when needed.
Friedman argued for a monetary rule, which would require the Fed to target the money supply rate of growth to the growth rate of real GDP, leaving long term price level unchanged. In this view, the central bank acts like a machine, taking in inputs from the economy and adjusting the money supply according to fixed rules without discretion. This rule would leave interest rates free to move as there is no directive to manipulate interest rates, only the money supply.
Market monetarists believe that monetary policy should target nominal GDP or nominal national income.
One of the differences between market monetarism and Friedman’s monetarism is the interpretation of velocity. Market monetarists believe that velocity is volatile, and that simply targeting the money supply is not enough since the volatility of velocity can counteract any policy actions. Instead of looking at money supply or interest rates to determine monetary policy, they look to the demand for money (also called liquidity preference). With that information, the Fed should act to hit a nominal income target (nominal meaning income before adjusting for inflation). Doing so would allow monetary policy to move independently of the volatility of money and let interest rates fluctuate with the market. In addition, inflation would be included in the nominal GDP, so it should not grow faster than desired.
In practice, the idea is that the central bank would declare a certain annual nominal GDP rate of growth, say 5%, and monetary policy would be adjusted to hit this goal. On average, the real GDP would then grow at 3% with an inflation rate of 2%. This process of sticking to a certain percent year after year is called rate targeting. Many market monetarists argue instead for level targeting. This methodology means that if the growth rate falls short one period, then the target must increase in the next period to bring the economy back to the long term goal. Level targeting is intended to fix the potential drift away from the long term goal that rate targeting allows when a deviation from the target in one year can compound over time (since we are dealing with percent growth). In simpler terms, if real (after adjusting for inflation) economic growth comes in lower than expected, the Fed should aggressively pump more money into the system until nominal growth hits the target level. Proponents of this theory argue that the economic benefits of more money that can be put to productive uses outweigh the potential costs of inflation.
Because the Fed would be committing to this growth rate, there would have to be a price for the failure of the economy to live up to this nominal GDP target level. This price would then reflect the magnitude of a policy change needed to bring the economy back to target. One way is to publish the central bank’s forecasts, but another methodology would be to have a futures market that would allow the Fed to adjust policy until the market thinks the target will be met. If each individual believes the nominal growth rate will be 5%, then they will act like it will be, making it happen in reality. This expectation is a major advantage of the nominal income target.
In the real world, there aren’t any central banks that apply market monetarism principles, and when the U.S. Federal Reserve did express the potential to do so, it stated that the cost of switching policy actions would outweigh the benefits.
Rules versus Discretion
The Fed is currently largely discretionary in that decision-makers are using their experience and judgement when determining what to do in certain economic situations. Yes, they target a two percent inflation rate and an unemployment rate between five and six percent, but the central bankers at the Fed have a lot of leniency within these targets to adjust monetary policy.
John B. Taylor argued for harder rules that the central bank would have to follow and operate on. When there are rules in place, then the public knows how the central bank will react to certain situations, and can act accordingly to get there.
The Taylor Rule defines how much the central bank should change nominal interest rates in response to economic indicators. Here is a more detailed mathematical explanation of the Taylor Rule. The Taylor principle claims that the central bank should increase the nominal interest rate more than the inflation rate. John B. Taylor’s goal was to eliminate decision-maker’s time inconsistency, which means that actions made by people can change over time even under the same circumstances. Monetarists are in favor of rules-based monetary policy (just match money supply growth rate to real GDP growth rate).
Ben Bernanke explaining the Fed’s monetary policy:
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