Monetary policy

Monetary policy is controlled by the Central Bank. In the U.S., this is the Federal Reserve. The Fed chairman is appointed by the government and there is an oversight committee in Congress for the Fed. But the organization is largely independent and is free to take any measures to meet its dual mandate: stable prices and low unemployment.

Examples of monetary policy tools include:

Interest Rates: Interest rate is the cost of borrowing or, essentially, the price of money. By manipulating interest rates, the central bank can make it easier or harder to borrow money. When money is cheap, there is more borrowing and more economic activity. For example, businesses find that projects that are not viable if they have to borrow money at 5% are viable when the rate is only 2%. Lower rates also disincentivize saving and induce people to spend their money rather than save it because they get so little return on their savings.

Reserve requirement: Banks are required to hold a certain percentage (cash reserve ratio, or CRR) of their deposits in reserve in order to ensure that they always have enough cash to meet withdrawal requests of their depositors. Not all depositors are likely to withdraw their money simultaneously. So the CRR is usually around 10%, which means banks are free to lend the remaining 90%. By changing the CRR requirement for banks, the Fed can control the amount of lending in the economy, and therefore the money supply.

Currency peg: Weak economies can decide to peg their currency against a stronger currency. This tool is usually used in cases of runaway inflation when other means to control it are not working.

Open market operations: The Fed can create money out of thin air and inject it into the economy by buying government bonds (e.g. treasuries). This raises the level of government debt, increases the money supply and devalues the currency causing inflation. However, the resulting inflation supports asset prices such as real estate and stocks.


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