In the SparkNote on money and interest rates we learned about the money supply. This is the starting point for understanding monetary policy. Initially we defined the money supply as the total amount of currency held by the public. While this definition is correct, it is incomplete. In the Sparknote on Banking we learned that through a fractional reserve banking system, the money supply increases. Thus, the money supply is better defined as the total amount of currency plus deposits held by the public. This accounts for all mony available as currency or demand deposits.
Simply stated, monetary policy is carried out by the Fed to change the money supply. When the Fed increases the money supply, the policy is called expansionary. When the Fed decreases the money supply, the policy is called contractionary. These policies, like fiscal policy, can be used to control the economy. Under expansionary monetary policy the economy expands and output increases. Under contractionary monetary policy the economy shrinks and output decreases. Let's investigate how the Fed affects the money supply.
There are three basic ways that the Fed can affect the money supply. The first is through open market operations. The second is by changing the reserve requirement. The third is through changing the federal funds interest rate. Each of these actions in some way affects the total amount of currency or deposits available to the public.
Open market operations are the sale and purchase of government bonds issued and regulated by the Fed. When the Fed sells government bonds, the public exchanges currency for bonds, resulting in a shrinking of the money supply. When the Fed purchases government bonds, the Fed exchanges currency for bonds, thus resulting in an increase in the money supply. Open market operations are the most common tool that the Fed uses to affect the money supply. In fact, almost every weekday government bonds are bought and sold in New York City.
The second way that the Fed can influence the money supply is through changing the reserve requirements. We learned in the SparkNote on the purpose of banks that the money multiplier shows how much an initial deposit increases the money supply after loans are made and redeposited. Recall that the money multiplier is one over the reserve requirement. Thus, if the reserve requirement is decreased, banks are required to hold fewer reserves and can then make more loans. Th is in turn repeats the cycle of loan to deposit, resulting in a greater increase in the money supply. For a given initial deposit, a smaller reserve requirement will result in a larger money multiplier, and thus in a larger change in the money supply.
The third way that the Fed can influence the money supply is through changing the federal funds interest rate. As we know, banks make deposits, withdrawals, and loans from banks' banks that are usually branches of the Fed. When a bank makes many loans, its reserves are near their absolute required minimum. If a customer makes a withdrawal, banks must either recall a loan or take out a loan to pay the withdrawal while still maintaining the necessary reserves. If the Fed increases the federal funds interest rate, banks will be less likely to borrow money from the Fed and will thus be more weary of making loans to ensure that they have the necessary reserve requirements. Thus, if the federal funds interest rate is higher, banks make fewer loans, the money multiplier is not fully utilized to its end, and the change in the money supply for a given initial deposit is smaller.
The Fed has two basic types of monetary policy. Expansionary monetary policy increases the money supply while contractionary monetary policy decreases the money supply. Expansionary monetary policy includes purchasing government bonds, decreasing the reserve requirement, and decreasing the federal funds interest rate. Contractionary monetary policy includes selling government bonds, increasing the reserve requirement, and increasing the federal funds interest rate. Recall that the point of monetary policy is to allow the Fed to control the economy, and in particular output and inflation, through the interest rate. Monetary policy and fiscal policy are like the reigns held by the Fed as it steers the big, wild horse known as the economy.
The interest rate changes when the fed changes monetary policy. In general, when the Fed uses expansionary monetary policy, thus expanding the money supply, the interest rate falls. The reason for this change can be conceptualized in two ways. First, given a constant demand for money, when money is widely available in the economy due to expansionary monetary policy, the interest rate falls as people are eager to make loans and hesitant to take loans. If there is much money in the economy and constant demand for money, then the price of holding money--the interest rate--must be low. Second, when the Fed injects money into the economy by purchasing bonds from the public, decreasing the reserve requirement, or decreasing the federal funds interest rate, the demand and price for loans falls. Since the interest rate is the equilibrating factor in the market for loanable funds, a fall in the demand for loans results in a fall in the interest rate. This works in conjunction with a direct decrease in the interest rate effected by the Fed.
We can apply the reverse of the above logic to the effects of contractionary monetary policy on interest rates. Given a constant demand for money, when money is relatively scarce due to contractionary monetary policy, the interest rate rises as people are hesitant to make loans and eager to take loans. Alternatively, when the Fed takes money from the economy by selling bonds to the public, increasing the reserve requirement, or increasing the federal funds interest rate, the demand for loans rises as money becomes harder, or more expensive, to obtain. Since the interest rate is the equilibrating factor in the market for loanable funds, a rise in the demand for loans results in a rise in the interest rate. Similarly, in order to induce the public to give up their cash in exchange for bonds, the government must offer an interest rate that is more attractive than the competing rates, corrected for risk. When the government does this, the overall interest rate in the economy also increases. Again, some Fed contractionary monetary policy--like increasing the reserve requirement and increasing the federal funds interest rate--directly affects the interest rate.