Monetary tools: Monetary policy
Contents
- 1 Money creation: Monetary policy
- 2 Banks
- 3 Check cashing
- 4 Money creation
- 5 Money cancellation
- 6 Required reserves
- 7 Required reserve ratio
- 8 Monetary multiplier
- 9 Government securities
- 10 Monetary policy tools
- 11 Open market operations
- 12 Discount rate
- 13 Tight money policy
- 14 Easy money policy
- 15 Minor monetary policy tools
Money creation: Monetary policy
The purpose of this topic is to outline how banks create money and how this money creation is controlled by the Fed. The various monetary policy tools are investigated and open market operations are identified as the most common.
Banks
Banks exist to receive deposits from individuals and businesses, and to lend these funds. Banks derive their revenue from the interest they charge on loans (as well as from fees for other services). Deposits, withdrawals and payments by check do not change the money stock, but loans do. A portion of deposits are held in reserves.
Check cashing
When a check is drawn and a payment is made by check, the total money stock does not change, only the composition, or distribution of money in its different forms, changes. A payment by check results in a shifting of reserves from one bank to another when the check clears through the Fed.
Money creation
Money is created when a bank makes a loan: the bank accepts a promissory note from the borrower (which is not money) and gives the borrower the ability to make payments in the form of demand deposits up to the amount of the loan. When a loan is repaid money is canceled. In normal circumstances, the volume of new loans exceeds repayment of loans, and thus, the money supply keeps increasing. However, a bank can only loan up to its available excess reserves.
Money cancellation
When a loan is repaid money supply is decreased because the borrower must use demand deposits to make the repayment. This takes some cash or demand deposits out of circulation.
Required reserves
Funds held by a bank in its vaults or in its account at the Fed, are its reserves. A proportion of its deposits must be kept in reserves, and only the excess are the excess reserves which can be lend out. The portion of reserves which must be kept by the bank are referred to as required reserves. (Reserves are never part of money supply. They are called "high powered money" because they can permit the creation a multiple of money stock).
Required reserve ratio
The proportion between required reserves and deposits is the required reserve ratio. There are actually several different ratios according to the degree of permanency of the deposits. The ratios vary from less than 2% to over 15%. They are occasionally changed by the Fed according to economic needs.
Monetary multiplier
When the proceeds of a loan are used to make a payment, the excess reserves of the first bank are transferred to a second bank. A portion of these funds must remain as required reserves, but the excess reserves can be lent out. Successive relending of the excess reserves cumulates in a total money creation which is several times the initial loan. This monetary multiplier is equal to the inverse of the required reserve ratio.
Government securities
Banks have a strong preference for government securities because of the safety (as well as liquidity) they offer as compared to loans to private businesses. Excess reserves are often held in government securities. When a bank buys a government security from an individual, the transaction is equivalent to a loan and increases money supply. The Fed holds a large stock of government securities and is responsible for their issuance and redemption.
Monetary policy tools
The tools of monetary policy are those available to the Fed to control the excess reserves of banks. They include open market operations, changes in required reserve ratios and changes in the discount rate. Changes in required reserve ratios affect reserves directly but are too authoritarian and not used often. Changes in the discount rate make bank borrowing from the Fed more or less difficult, but the volume of bank borrowing is very small.
Open market operations
Open market operations consist of buying and selling of government securities by the Fed. It is the most common and most potent tool of monetary policy because it is flexible, subtle and effective.
Discount rate
The discount rate is the interest charged by the Fed on loans to member banks. The amount of such loans is very small. When a change in the discount rate occurs it is most often a reflection of changing conditions rather than an intended monetary policy action. However, such change contains a strong message about the direction of monetary policy.
Tight money policy
A tight money policy consists in reducing the excess reserves of banks and, thus, their money creation ability. This is done by selling government securities to banks in the open free market for government securities. Banks are eager to put some of their excess reserves in government securities because of their safety. Tight money policy can also be carried out by increasing the required reserve ratios or the discount rate.
Easy money policy
An easy money policy is intended to increase the excess reserves of banks and, thus, make money creation by banks more possible. This is accomplished by purchasing government securities from banks (since banks commonly hold a large proportion of them). An easy money policy can also be carried out by lowering the required reserve ratios or the discount rate.
Minor monetary policy tools
In addition to open market operations, changes in required reserves ratios and the discount rate, the Fed may also affect the money supply by changing margin requirements (the proportion which must be present in a securities dealer account for transactions), consumer credit terms such as the downpayment or the length of car loans. Another, less common, method is to persuade banks to adopt some desirable conduct; this is called moral suasion.