Sunday, September 21, 2014

What is Monetary Policy?

The Federal Reserve was created in 1913 through the Federal Reserve Act.  The purpose of the Federal Reserve, or central bank, is to provide the country with a safe, liquid, and stable monetary system. The Federal Reserve does this by manipulating the Federal Funds Rate and changing the monetary supply..
In times of financial panic, the central bank tries to keep financial markets liquid and prevent the monetary supply from tightening. To keep the monetary supply from decreasing, the Fed can lower interest rates. When interests are low, individuals and businesses are more likely to borrow money, because it is cheaper. When businesses and individuals take out loans, they have money to spend, which can create economic growth.
 In the recent collapse, the Fed took many unprecedented measures to create loose monetary conditions. They created multiple programs that bought toxic assets from investors, which created liquidity within markets. (If a market is liquid, the asset can be converted to cash easily. This allows people to sell assets in return for cash, rather than being stuck with assets that they couldn’t sell.) Another program called Quantitative Easing was created to lower interest rates and increase the monetary supply. This was achieved by buying Treasury Securities.
            The Fed influences the money supply and interest rates by setting a target for the Federal Funds Rate. To reach this target, the Fed will either buy or sell large quantities of Treasury Securities. When the Fed sells Treasury Securities, they deduct the total cost the purchasing bank bought from that bank’s reserves. This bank is then required to borrow money from other banks so they have enough money to meet their required reserves. (The rate at which banks loan each other reserve money is called the Federal Funds Rate, which influences almost every interest rate.) The Federal Funds Rate will rise because there is more demand for borrowed reserves. The opposite occurs when the Fed sells Treasury Securities; interest rates decrease and the monetary supply increases. The Fed credits the bank’s account allowing the bank to lend out more of their deposits. 

Treasury Securities, such as bonds, bills or notes, are debt obligations issued by the US government. They a very liquid asset and are considered riskless because investors do not believe that the United States will default on their loans.