Monetary Policy

Monetary Policy

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Monetary Policy

1. The economy is arranged so that the amount of money circulating in the market significantly affects the rate of economic growth. The more money people have, the more goods they are able and willing to buy, that is, they are able to produce higher aggregate demand. In other words, the more money is in the economy, the higher may be economic growth. In turn, the growth of aggregate demand, ceteris paribus, will shift the equilibrium state of the economy to the point with a higher GDP. In other words, a larger amount of money in the economy provides a marked increase in the economy.

Banking system allows to virtually increase the amount of money in the economy due to the money multiplier. For example, institutions with net transactions accounts that exceed $103.6 million must have 10% obligatory reserves. This is the amount of funds that a bank cannot lend and must have on hand each night. With this condition, the banking system will turn a $1,000 cash deposit into a $10,000 cashless one by lending it to their clients.

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Regarding the situation in November, there was a withdrawal of money from the banking system. That is, the impact of the banking multiplier is now extended to the smaller amount of money left in the bank, which slowed down the economy. The Fed has taken measures to eliminate this effect and has poured more money into the banking system on the open market by purchases of US T-bills. At the end of the year, the amount of bank deposits increased again. The increase of money in bank system made Fed use the opposite procedure - the sale of securities in the open market. This operation was necessary in order to prevent excessive growth of the money supply in the economy and avoid inflation. In such a way, the Fed was aimed at ensuring a stable non-inflationary economic growth and smoothing possible undesirable oscillations.

2. The ultimate goal of monetary policy is to ensure sustained economic growth. It coincides with the strategic objective of the government's economic policy. It includes the following targets: price stability (low inflation), full employment, output growth, balance of payments.

However, this goal is achieved through activities within monetary policy, which have their own specifics. They are rather slow, designed for years and do not constitute a quick response to changing market conditions. The problem is compounded by the fact that after selecting the ultimate goal and applying the tools of monetary policy, the central bank cannot immediately and directly control the target parameters. The central bank should identify indicators that affect the ultimate objective and are under its control. They is known as intermediate targets or benchmarks of monetary policy. The intermediate targets are more accessible goals set by the conduction of monetary policy. They are the means of achieving the ultimate goals. The Central Bank in practice uses such intermediate targets as the money supply, the nominal interest rate, the exchange rate and nominal GDP.

Intermediate objectives are usually declared to inform market participants about the decisions of the Central Bank and to focus on the future market behavior of monetary variables. The growth rate of the money supply, interest rates and inflation are among them. If money supply growth exceeds the set targets, for example, if it exceeds the growth rate of production, it will lead to higher inflation. Since the acceleration of inflation is undesirable for the Fed, this option indicates to the Fed that monetary policy is off track. In this regard, it is necessary to take containment measures: increase the interest rate, reserve requirements and expand open market sales.

If the exchange rate is below the target value, then it threatens price stability and requires interest rates and foreign exchange intervention increases to prevent inflation and keep payment balance in equilibrium. If the nominal interest rate exceeds the target, then the economic growth can be slower than planned. In this case, the Fed should apply a stimulating monetary policy such as an expansion of open market purchases.

3. The basic postulate of the Keynesian theory is the statement that the aggregate demand is the sum of household expenditures, enterprises and governments. Moreover, aggregate demand is the most important driving force in the economy. Any increase in demand should come from one of these four components. During the recession powerful forces often weaken demand by lowering costs. For example, during economic downturns uncertainty often breaks consumer confidence forcing them to cut spending, especially on discretionary purchases, such as homes or cars. Reduction in consumer spending could lead to a reduction in investment spending by enterprises, as firms respond to weakening demand for their products. Keynes argued that inadequate aggregate demand can lead to long periods of high unemployment.

The current economic situation is accompanied by decreasing consumer confidence in future and, consequently, shrinking of the aggregate demand. Keynes argued that free markets are not self-balancing mechanisms that lead to full employment. Therefore, he defended that the market sometimes requires active government policies, such as a package of fiscal incentives to push an economy back to full employment and high growth. In other words, Keynesian economic theory explains todays slow economic growth by the reduction in aggregate supply and the need for governments stimulating policy.

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