Monetary policy, managed by the Federal Reserve, shapes the money and credit in the U.S. economy. It includes expansionary or contractionary measures to influence growth. Delegated by the government, the Federal Reserve aims to maintain stable prices, robust employment, and healthy economic growth, with a significant impact on inflation and overall price levels. Read on to learn more about goals of monetary policy and become the subject matter expert on it.
To achieve its statutory purpose, the Federal Reserve must implement monetary policy “so as to effectively promote the objectives of maximum employment, stable prices, and moderate long-term interest rates.” Despite the fact that the legislation specifies three distinct monetary policy objectives, Congress’ directive to the Federal Reserve in this regard is commonly referred to as the “dual mandate.” A number of criteria must be met in order to achieve interest rate stability at optimal levels.
Goals of Monetary Policy
The Federal Reserve holds significant influence over U.S. economic policy, playing a crucial role in both formulating and implementing monetary policy. While the president can propose laws, only Congress has the authority to pass them. The Federal Open Market Committee (FOMC) can swiftly shape monetary policy, unlike prolonged budgetary debates. The Board of Governors can alter the discount rate and reserve requirements without prior notice. Federal Reserve actions can have substantial and sometimes dramatic economic consequences, impacting interest rates, economic downturns, and inflation rates. This overview provides a detailed explanation of the goals of monetary policy for your convenience.
Currency Markets
With the growing importance of international trade to the US economy, the Federal Reserve has been increasingly concerned about the dollar’s valuation in relation to other currencies. When the value of the dollar declines, inflation rates in the United States tend to climb, and when the value of the dollar rises, American businesses lose international ground. Furthermore, if the value of the dollar does not vary much, consumers and businesses will find it easier to plan for global trade. As a result, some argue that monetary policy should emphasize the stabilization of the dollar’s value on foreign exchange markets. Foreign exchange market stability is extremely important in other countries, particularly those that rely heavily on international trade.
Inflation
Values typically rise in lockstep with the amount of cash in circulation. The widely held belief that price rises create inflation is, in fact, erroneous. The term “inflation” refers to a situation in which the money supply expands. Prices rise overall when more money is spent to acquire a fewer range of items and services. This is because those with excess income are more likely to spend whatever is necessary to attain their desired objects, resulting in an increase in the cost of goods and services.
Consistency in Costs
In recent decades, U.S. officials have become more aware of the social and economic consequences of inflation, emphasizing price stability as a primary goal in economic policy. This shift is evident in European perspectives as well. Price stability is crucial because inflation induces economic uncertainty, impeding progress. Fluctuations in the overall pricing level complicate decision-making for lawmakers, corporations, and consumers. Research indicates that inflation hinders economic development, and public opinion polls show widespread dislike for price swings. Countries like Russia, Argentina, and Brazil have experienced hyperinflation, contributing to slowed growth. Inflation complicates future planning, making decisions on expenses like education challenging. Additionally, it can strain a country’s social fabric by fostering competition among social groups to generate sufficient income to cope with the rising cost of living.
Considerations
Low interest rates universally hinder motivation to save, affecting savings, CD rates, and bond yields. Economic growth highlights the inadequacy of a 5% income decrease against price rises of 10% or more. Individuals and corporations seek better profitability through investments, stimulating economic circulation with purchases like machinery, houses, cars, and local businesses. As a result, loose monetary policy is effective.
Discordant Objectives
While specific objectives may seem aligned, strong economic growth and high employment rates are not always synchronized. Calm financial markets and low inflation may not necessarily coincide. Short-term objectives of maximum employment, interest rate stability, and price stability often clash. However, this is less likely to persist in the long run. In economic expansion with decreasing unemployment, inflation and interest rates tend to rise together. Central banks must intervene to prevent an increase in interest rates, avoiding overheating if they want to curb inflation. On the contrary, raising interest rates to combat inflation may lead to short-term unemployment. Central institutions, such as the Federal Reserve, grapple with challenging decisions due to these competing aims. In later chapters, we’ll explore how central banks should prioritize their objectives and examine the impact of monetary policy on the economy.
Stability in Interest Rates
Interest rate stability is critical because interest rate changes confound economic forecasting and worsen an already uncertain economic situation. When loan rates fluctuate in a way that influences customers’ proclivity to buy a home, for example, consumers find it more difficult to determine the best time to buy a home, while builders face greater difficulty in selecting the optimal number of homes to build.
The presence of turbulent financial markets, as discussed in Chapter 8, can hinder the flow of cash for potential investments, posing a threat to the economy. Hence, a central bank’s primary goal should be to establish a safer and more stable monetary system to proactively prevent financial crises. As highlighted in Chapter 14, interest rate stability is crucial for financial market stability. The Federal Reserve System, established in 1907 in response to the 1907 bank crisis, reflects this historical need for stability. Changes in interest rates introduce volatility, particularly affecting long-term bonds and mortgages, potentially causing insolvency for institutions holding such securities. In recent years, savings and loan associations and cooperative savings institutions have struggled due to increased interest rate volatility, exacerbating the interconnected challenges of these financial sectors.
A Policy of Expansion
Expansionary monetary policy stimulates economic activity and increases the money supply. Monetary authorities employ this strategy, as defined by the Financial Times. They maintain low interest rates to incentivize borrowing by banks, corporations, and individuals. The United States achieves this through open market purchases of government bonds. To keep interest rates low, the Federal Reserve buys Treasury securities from financial institutions including banks and brokerages. The Fed reduces the amount of reserves it expects commercial banks to keep in addition to the amount it expects commercial banks to keep.
Effect of Liquidity
The Federal Reserve restricts the money supply by increasing the minimum amount of reserves that banks are required to keep on deposit and selling Treasury securities. Lenders raise loan rates in response, hoping to profit from the increased demand for loans. This causes interest rates to rise. High interest rates and a limited money supply can both lead to a drop in economic activity and, in extreme instances, an economic recession. When money is scarce, businesses are compelled to lay off workers, and consumers cut back on their spending. As the number of people who can afford the extravagant costs that were prominent during the economic expansion declines, so do house prices. As a result, when high liquidity prevails, the effect of low liquidity on the economy reverses.
Strong Job Growth
An increase in consumer spending leads to an increase in sales and earnings for enterprises. This allows firms to invest in new equipment, diversify their workforce, and improve working conditions. Expansionary monetary policy by the Federal Reserve increases labor force accessibility for growing businesses, lowering unemployment rates. Enhanced labor force participation generates more discretionary income, boosting corporate profits and creating additional job opportunities.
Expanding Economy
Sustained economic development requires full employment, as it fosters enterprise investment in machinery, boosting output and income by reducing unemployment. However, in an environment of high unemployment and idle factories, investing in revolutionary machinery becomes financially unsustainable for companies. Despite the fact that these goals are inextricably linked, government action may also seek to foster economic development. There are two potential ways for increasing the amount of capital available for corporate investment: encouraging businesses to invest directly or inspiring individuals to save. This is, in fact, the avowed goal of proponents of supply-side economics. The goal of these policies is to boost economic growth by encouraging increased capital investment and savings among both individuals and businesses. Similarly, the role of monetary policy in supporting economic expansion is a hotly debated topic.
FAQ
To what Extent does Monetary Policy Stimulate the Economy?
Monetary policy affects interest rates on savings accounts, mortgages, and business loans. Mortgage rates, small business loans, and savings account rates are all included. Individuals’ spending and saving decisions are influenced by interest rate volatility, which has an impact on inflation, employment, and economic expansion.
The Impact of Monetary Policy on International Trade
The re-allocation of expenditure is the result of changes in the relative costs of local and foreign products, which are caused by the Federal Reserve’s monetary policy operations. This reallocation has an impact on the trade balance. Exchange rate pass-through has varying degrees of impact on both domestically produced and imported goods.
What Role does Monetary Policy have in Lowering Income Disparity?
Monetary policy has an impact on both the distribution of capital and income to varying degrees. For example, a reduction in interest rates could boost wage growth among those in the lowest income groups, resulting in an increase in employment and a decrease in income inequality.
Summary
Monetary policy’s overarching goals are to maintain price stability, stimulate economic expansion, and achieve full employment. To achieve these goals, central banks such as the Federal Reserve in the United States use a variety of monetary policy instruments in addition to interest rate adjustments and open market activities. Central banks assist to economic stability by keeping inflation stable and low, which encourages investment and growth. We hope you found this guide, in which we explained goals of monetary policy, informative and useful. Gain more insights on role of monetary policy topic by checking out this informative blog post.
