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monetary policy

Page history last edited by Brian D Butler 12 years, 11 months ago


Purpose of Monetary Policy:


The purpose of Monetary policy is to either accelerate / decelerate the economy...either to cut unemployment (spur growth),...or to control inflation.

The money supply is controlled by the Federal Reserve (central bank):


"The Federal Reserve Board affects the federal funds rate by using open market operations, which is the purchase and sale of Treasury securities. If it wants to inject money into the economy, then it buys bonds, which also lowers interest rates. If it wants to lower the money supply, it sells bonds, which raises interest rates."


Related Pages from GloboTrends:




Table of Contents:




Monetary Policy


The Monetary policy is one way in which a government can spur growth (and jobs) in a country.  The other way is fiscal policy.  While the goals of the two systems might be similar, the mechanism and the results are quite different.  Many economists spend their entire lifetimes debating the optimum way to accomplish growth & employment, without causing inflation or high interest rates.


If the government is trying to stimulate the economy (get new jobs):

The key differences between the two are as follows: 

  1. Monetary policy: 
    • What: federal funds rate, discount rate
    • Who:  Central Bank (the Federal Reserve)
    • How:  increase / decrease money supply (to raise / lower interest rates, which will encourage investment or savings)
    • Where does the money come from: print new money, which enters the system when the Fed buys Treasury bonds from the market (see details about FOMC - how this proces works)
    • Effects:  interest rates down, currency depreciates
  2. Fiscal Policy:
    • What:  government spending
    • Who:  treasury department (its not the central bank, so they can not print more money)
    • How: spend money (new roads, buildings, projects, etc)
    • Where does the money come from:  either (a) raise taxes, or (b) borrow money by issuing new bonds
    • Effects:  interest rates go up, currency appreciates


Federal Balance Sheet:


Data from federal Reserve:

Related KookyPlan pages:



Velocity of Money


Discussion from Source:  MacroMan blog October 2009


"the financial crisis has brought about a precipitous decline in the velocity of money- i.e., how much economic activity is generated per unit of money supply. Bloomberg helpfully calculates a velocity indicator; as you can see, while recent fall has been steep, velocity never really recovered from the heady day's of the 90's productivity boom (and..err....internet bubble.)


Given the damage inflicted on Main Street by this recession, the Fed will almost certainly want to see what looks to be a sustained uptick in the "economic" velocity of money before meaningfully tightening the taps; after all, we know that Big Ben is a student of the Depression and of the policy mistakes that occured in the 30's.  So what's the problem? Well, the challenge for the Federales is that there are some areas where velocity has picked up- namely, financial markets. Macro Man constructed a rough and ready "financial velocity" index, which is the ratio of an index of financial markets (the SPX, 10 year Treasury futures, EUR/USD, gold, and oil, all equally weighted) to M2. As you can see, after a calamitous decline in the teeth of the crisis, over the last couple of quarters financial velocity has picked up nicely.

So herein lies the problem; vast bulk of the veritable Everest of Fed liquidity provisions seems to have found its way onto Wall Street, not Main Street. Not that you didn't know this, of course; however, it seems close to inevitable that there will be a significant backlash against, ahem, "well-connected" banks that have benefited disproportionately from the Fed's largesse.

Now, the Fed might say that "that's a problem for the Administration, not for us." OK, fine. But the question stil remains; does the Fed shape policy to goose economic velocity higher (in which case lower for longer will be the outcome), or does it at long last address asset prices ('twould be troubling to see financial velocity start exceeding the 2002-2006 trend.)    There really isn't an obvious answer. It seems clear, however, that the government (and not just in the US, mind you) will wish to align the fortunes of Wall Street and Main Street more closely. Indeed, during the first six years or so of the Noughties, economic and financial velocity were relatively well-correlated...

...only to diverge sharply since 2007.

Re-aligning the two would appear to be a task well outside the scope of monetary policy; small wonder, then, that pockets of policymakers the world over are expressing considerable zeal for financial regulation.   And where does that leave the Fed? Fervently praying that economic velocity picks up so that their job becomes a bit easier!    Source:  MacroMan blog October 2009



Simple equation:



MV=PQ. This is an important equation; this is right up there with E=MC2. M (money or the supply of money) times V (velocity, which is how fast the money goes through the system -- if you have seven kids it goes faster than if you have one) is equal to P (the price of money in terms of inflation or deflation) times Q (which roughly stands for the quantity of production, or GDP)


So what happens is, if we increase the supply of money and velocity stays the same, if GDP does not grow, it means we'll have inflation, because this equation must balance. But if you reduce velocity (which is happening today), and if you don't increase the supply of money, you are going to see deflation. Now, we are watching, for reasons we'll get into in a minute, the velocity of money slow. People are getting nervous, they are not borrowing as much, either because they can't or because the "animal spirits" that Keynes talked about are not quite there.


Side point: what happens if the $300 billion they put in the system comes back to the Fed's books because banks don't put it into the LIBOR market because they are worried about credit risks? If that happens, it does absolutely nothing for the money supply. Okay? It's like, goes here, goes back there -- it doesn't help us. If the Fed creates money which is simply deposited back with the Fed, then there is effectively no money creation. We are still faced with deflation. The Fed has got to somehow get it into the financial system. They've got to figure out how to create some movement.  Source to read more:  John Mauldin's weekly newsletter:   April 17, 2009



US money supply (2008)




Graph: St. Louis Adjusted Monetary Base




Question:"what happens when the Fed increases the money supply?" (lowers interest rates)

  1. Currency will depreciate (this happens first, within one day)...then later it should appreciate (according to economic theory), but that depends on many factors, and is very hard to predict.
  2. inflation will increase (this happens second, over lots of time).



How does it happen?

  1. The central bank (actually, the Treasury) prints more money
  2. From the treasury department, trucks of money go up 95 to the Fed in New York City
  3. The Fed in NYC uses the new money to buy Treasury Bonds from the open market (from whoever in the market that is selling...usually big banks)
  4. They sell because the Fed offers a slightly higher price...gives them incentive to sell
  5. FOMC = federal open market committee
  6. People sell bonds to Fed, who gives them new money in exchange...which increases the money supply


What effect does this have on FX rates?

  1. Currency will depreciate (devalue) immediately

  2. The immediate effect is that the yield on the treasury bond will go down
  3. This is because the Fed offered a higher price, but because the ending price on the bond is fixed, that means that the yield goes down
  4. the dollar will devalue (depreciation) immediately.
  5. Because the return on USD goes down as the yield on treasury bonds goes down (they are highly correlated)


What effect does this have on inflation?

  1.  over time, there will be more inflation as the money supply increases.
  2. because there will be more money chasing the same amount of goods, so by supply & demand, the level of prices should go up as sellers are able to charge more for their products.
  3. more money in the system chasing the same number of goods is good for sellers, so they can charge more.
  4. Also, there is an investment effect...more money leads to lower interest rates, which encourages business investment, which leads to more production.  If the economy overheats, there could be inflation as a result.
  5. Time - this process takes a long time, and is confusing because lots of different variables comes into play.  This is different than the FX effect which happens immediately. 


BACK in 2002 Ben Bernanke, then still a Federal Reserve governor, declared that “under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” That does not mean it is easy. source: economist.com


Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon.” But the role of the money supply in creating inflation is less obvious than monetarism suggests.  The quantity theory of money holds that the money supply, multiplied by the rate at which it circulates (called velocity), equals nominal income. Nominal income in turn is the product of real output and prices. But does money supply directly boost nominal income, or does nominal income affect velocity and the demand for money? The mechanism is murky.   read more from economist.com




How the Fed controls the money supply:


see our discussion on  FOMC for more details...


external link:  http://www.econlib.org/library/Enc/MoneySupply.html



What is monetary policy?

The term monetary policy refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit as a means of helping to promote national economic goals.



How does the Federal Reserve implement monetary policy?

The Federal Reserve implements monetary policy using three major tools:

  • Open market operations. The buying and selling of U.S. Treasury and federal agency securities in the open market
  • Discount window lending. Lending to depository institutions directly from their Federal Reserve Bank’s lending facility (the discount window), at rates set by the Reserve Banks and approved by the Board of Governors
  • Reserve requirements. Requirements regarding the amount of funds that depository institutions must hold in reserve against deposits made by their customers.


read more from the Feds website:  http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm




What is the federal funds rate, and why does the FOMC raise or lower the target rate?


The federal funds rate is the rate charged by one depository institution on an overnight sale of immediately available funds (balances at the Federal Reserve) to another depository institution; the rate may vary from depository institution to depository institution and from day to day. The target federal funds rate is set by the Federal Open Market Committee (FOMC). By setting a target federal funds rate and using the tools of monetary policy--open market operations, discount window lending, and reserve requirements--to achieve that target rate, the Federal Reserve and the FOMC seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," as required by the Federal Reserve Act.





What is the discount rate?


The discount rate is the interest rate that an eligible depository institution is charged to borrow funds, typically for a short period, directly from a Federal Reserve Bank. By law, the board of directors of each Reserve Bank sets the discount rate independently every fourteen days subject to the approval of the Board of Governors. Originally, each Reserve Bank set its discount rate to reflect the banking and credit conditions in its own District. Over the years, the transition from regional credit markets to a national credit market has gradually produced a national discount rate. As a result, the Federal Reserve maintains a uniform structure of discount rates across all Reserve Banks.

For more information on the discount rate, see The Federal Reserve System: Purposes and Functions.




read more:  http://www.federalreserve.gov/generalinfo/faq/faqmpo.htm




History of US monetary & FX policy (in Brief)


During the early part of the 1980s, the United States pursued a combination of loose fiscal policy and tight monetary policy, which caused the dollar to appreciate and produced trade and current account deficits that set new records. Rather than altering domestic macroeconomic policy, the first Ronald Reagan administration actively encouraged capital inflows to finance the fiscal and current account deficits. These policies flooded the United States with imports and put pressure on traded-goods producers that was unprecedented in the postwar period. When these producers complained to the Treasury, they were told that Treasury would not attempt to cap the value of the dollar for their benefit. These groups then complained to Congress, which responded by passing the 1988 Act. Proponents intended this legislation to improve congressional oversight and Treasury's accountability on exchange rate policy.


Exchange rates have again become a particularly important issue for Congress in recent years. The issue's return to political prominence has this time been driven largely by objections to China's exchange rate policy. Competition from China has put pressure on US producers, who have complained to Congress that the renminbi is substantially undervalued. Meanwhile, Treasury has refused to cite China in its reports to Congress as a country that "manipulates" its currency, despite unprecedented amounts of foreign exchange intervention by Chinese authorities to restrain the renminbi's appreciation.


Frustrated by what they perceive to be the modest results of these discussions, several members of Congress have proposed legislation that, if adopted, would reform the process by which Treasury identifies and responds to currency manipulation and could impose trade restrictions to compensate for the resulting undervaluation. The stakes are high because such provisions would also apply to countries beyond China whose economic strategies have also included substantial undervaluation of their currencies.


read more:  >> Preview book




Does the Federal Reserve control or set the prime rate?


No, banks set their own rates based on the demand for various kinds of loans, the cost of money to the banks, and the administrative costs of making loans.





Circular Trading:  (triangular trading)

The Federal Reserve Bank, the US Treasury and the large US commercial banks are in a process that is commonly defined as “circular trading” in most emerging market stock exchanges.Unless China’s policy makers understand this process clearly it would be hard for them to construct an appropriate policy response to the credit crisis of their own.


The Treasury issues Bonds, that are subscribed to by the public, and primary dealers in US Govt. Securities, such as Goldman Sachs, purchase these bonds on behalf of their customers in return for cash. The Federal Reserve then gives a credit to the Treasury in its account with the Fed, instead of remitting the cash received against the Treasury Bond purchases to the Treasury. The Fed then extends new credit to the banks, either against a new receivable or against a collateral security (bad loan) that the bank provides the Fed. Overall, the banks have exchanged either a bad loan, or a new liability to the Fed, for real cash in green dollars.



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