Monetary policy is a tool that central banks use to manage the economy in times of uncertainty. Monetary policy is the mechanism through which the central bank decides how much money is injected into the economy to support growth and keep inflation in check. The Federal Reserve (Fed) is the only major central bank that publicly discloses its plans for monetary policy. Here are ways monetary policy has enabled the financial sector to grow.
- Inflation targets
An increase in the Fed’s target interest rate can be used as an automatic stabilizer by inducing capital spending and thus boosting economic activity. This type of stabilizing effect is often referred to as “monetarist stabilization” because it focuses on maintaining price stability without any direct action by policymakers. By setting short-term interest rates close to zero, the Fed makes borrowing for investment more attractive than saving for consumption. It also helps firms make long-term investments at low and stable prices.
- Open market operations
A reduction in reserve requirements can boost bank lending. Lowering these requirements means commercial banks do not have to sell their assets or other securities to meet reserve requirements. When credit expands, businesses will borrow from commercial banks, lending back out again. Since businesses cannot always depend on receiving loans for projects and they often prefer higher risk but potentially high reward projects to lower risk and less rewarding ones, this creates a self-reinforcing cycle where more expansion begets more expansion – even though there are more borrowers, lenders, and entrepreneurs making new products and services.
- Quantitative easing
QE1 was implemented by the Fed in 2008 when the federal government spent $85 billion buying up mortgage-backed securities and agency debt instruments held by banks. The Fed announced QE2 in 2009 with another $1 trillion program. Under both programs, the Fed bought Treasury bills directly from financial institutions, thereby lowering demand for cash and increasing the supply of liquidity within the banking system. These actions helped stabilize markets during and after the housing crisis by reducing the volatility of interest rates and stock indices.
- Discount window operation
When the Fed cuts the discount rate below 0%, this encourages banks to extend cheap loans to local businesses and consumers while ensuring that these loans are repaid. Lowered rates help make borrowing easier and encourage increased consumer spending.
- Asset purchases
The Fed buys bonds and other types of securities such as stocks, corporate debt, and real estate in exchange for withdrawing reserves from the banking system. When the Fed buys assets, it takes reserves out of the banking system and injects them into the economy to stimulate aggregate demand. This process increases the supply of savings and decreases the rate of return on asset purchases.
