Monetary Policy

• Monetary policy is a central bank's actions

and communications that manage the
money supply. The money supply includes
forms of credit, cash, checks, and money
market mutual funds. The most important of
these forms of money is credit. Credit
includes loans, bonds, and mortgages. 
• Monetary policy increases liquidity to create
economic growth. It reduces liquidity to
prevent inflation. Central banks use interest
rates, bank reserve requirements, and the
number of government bonds that banks
must hold. All these tools affect how much
banks can lend. The volume of loans affects
the money supply.
 Key takeaways

• The Federal Reserve uses monetary policy

to manage economic growth,
unemployment, and inflation. 
• It does this to influence production, prices,
demand, and employment.
• Expansionary monetary policy increases
the growth of the economy, while
contractionary policy slows economic
growth. 
• The three objectives of monetary policy are
controlling inflation, managing employment
levels, and maintaining long term interest
rates. 
• The Fed implements monetary policy
through open market operations, reserve
requirements, discount rates, the federal
funds rate, and inflation targeting.
 Three Objectives of Monetary Policy

• Central banks have three monetary policy

objectives.
• The most important is to manage
inflation. The secondary objective is to
reduce unemployment, but only after
controlling inflation. The third objective
is to promote moderate long-term
interest rates.
 
• The U.S. Federal Reserve, like many
other central banks, has specific targets
• for these objectives. It wants the core
inflation rate to be around 2%.
• Beyond that, it prefers a natural rate of
unemployment of between 3.5% and
4.5%.
 Types of Monetary Policy

• Central banks use contractionary monetary

policy to reduce inflation. They reduce the
money supply by restricting the volume of
money banks can lend. The banks charge a
higher interest rate, making loans more
expensive. Fewer businesses and
individuals borrow, slowing growth.
• Central banks use expansionary monetary
policy to lower unemployment and avoid
recession. They increase liquidity by giving
banks more money to lend. Banks lower
interest rates, making loans cheaper.
Businesses borrow more to buy equipment,
hire employees, and expand their
operations. Individuals borrow more to buy
more homes, cars, and appliances. That
increases demand and spurs economic
growth.
 Monetary Policy Tools

• All central banks have three tools of

monetary policy in common. First, they all
use open market operations. They buy and
sell government bonds and other securities
from member banks. This action changes
the reserve amount the banks have on
hand. A higher reserve means banks can
lend less. That's a contractionary policy. In
the United States, the Fed sells Treasurys
to member banks.
• The second tool is the reserve requirement,
in which the central banks tell their
members how much money they must keep
on reserve each night. Not everyone needs
all their money each day, so it is safe for the
banks to lend most of it out. That way, they
have enough cash on hand to meet most
demands for redemption. Previously, this
reserve requirement has been 10%.
However, effective March 26, 2020, the Fed
has reduced the reserve requirement to
zero.
• When a central bank wants to restrict
liquidity, it raises the reserve requirement.
That gives banks less money to lend. When
it wants to expand liquidity, it lowers the
requirement. That gives members banks
more money to lend. Central banks rarely
change the reserve requirement because it
requires a lot of paperwork for the
members.
• The third tool is the discount rate. That's
how much a central bank charges members
to borrow funds from its discount window. It
raises the discount rate to discourage
banks from borrowing. That action reduces
liquidity and slows the economy. By
lowering the discount rate, it encourages
borrowing. That increases liquidity and
boosts growth
• In the United States, the Federal Open
Market Committee sets the discount rate a
half-point higher than the fed funds rate.
The Fed prefers banks to borrow from each
other.
• Most central banks have many more tools.
They work together to manage bank
reserves.
• The Fed has two other major tools it can
use. It is most well-known is the Fed funds
rate. This rate is the interest rate that banks
charge each other to store their excess
cash overnight. The target for this rate is set
at the FOMC meetings. The fed funds rate
impacts all other interest rates, including
bank loan rates and mortgage rates.
• The Fed, as well as many other central
banks, also use inflation targeting. It sets
expectations that the banks want some
inflation. The Fed’s inflation goal is 2% for
the core inflation rate. That encourages
people to stock up now since they know
prices are rising later. It stimulates demand
and economic growth.
• When inflation is lower than the core, the
Fed is likely to lower the fed funds rate.
When inflation is at the target or above, the
Fed will raise its rate.
• The Federal Reserve created many new
tools to deal with the 2008 financial crisis.
These included the Commercial Paper
Funding Facility and the Term Auction
Lending Facility.

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 Liquidity trap

• A liquidity trap is an economic situation

where people hoard financial capital instead
of investing or spending it. As a result, the
nation's central bank can't
use expansionary monetary policy
to boost economic growth. It often occurs
when short-term interest rates are zero.
 Causes

• Central banks are in charge of

managing liquidity with monetary policy.
Their primary tool is to lower interest rates
to encourage borrowing. That makes loans
inexpensive, encouraging businesses and
families to borrow to invest and spend. It's
like stepping on the gas to increase the
engine's speed. When you push the gas
pedal, the car goes.
• The U.S. central bank is the Federal
Reserve. It lowers short-term interest
rates with the fed funds rate. It lowers long-
term rates with open market
operations that buy U.S. Treasurys.
• A liquidity trap occurs after a
severe recession. Families and businesses
are afraid to spend no matter how much
credit is available. It's like a flooded car
engine. You've released so much gas into
the engine that it crowds out the oxygen.
Pumping the gas pedal doesn't help. You've
got to stop and let the gas evaporate before
trying to start the engine.
• That's what happens in a liquidity trap. The
Fed's gas is credit and the pedal is lower
interest rates. When the Fed pushes the
gas pedal, it doesn't rev up the economic
engine. Instead, businesses and families
hoard their cash. They don't have the
confidence to spend it, so they do
nothing. The economic engine is flooded.
 Top Five Signs

• For a liquidity trap to occur, interest rates

must be low. The fed funds rate is at zero. If
it's been there for a while, people believe
that interest rates have nowhere to go but
up. When that happens, no one wants to
own bonds. A bond bought today that pays
low rates won't be as valuable after interest
rates rise. Everyone will want the bonds
issued then because it pays a higher return.
The low-rate bond will be worth less in
comparison.
• Second, businesses don't invest in
expansion. Instead of buying new capital
equipment, they make do with the old. They
take advantage of low interest rates and
borrow money, but they use it to buy back
shares and artificially boost stock prices.
They might also purchase new companies
in mergers and acquisitions or leveraged
buy-outs. These activities boost the stock
market but not the economy.
• Third, companies don't hire as they
should, so wages remain stagnant. Without
rising incomes, families only buy what they
need and save the rest. Low wages
aggravate income inequality.
• Fourth, consumer prices
remain low. Without inflation, there's no
incentive for families to buy now before
prices go up. You might even
get deflation instead of inflation. People
will put off buying things because they know
prices will be lower later.  For example,
people delay making big purchases until the
Black Friday sales. 
• Fifth, banks don't increase lending. They
are supposed to take the extra money the
Fed pumps into the economy and lend it out
in mortgages, small business loans, and
credit cards. But if people aren't confident,
they won't borrow. When banks aren't
confident, they will keep the extra cash the
Fed gives them. They'll either write down
bad debt or increase their capital to protect
against future bad debt. They might raise
their lending requirements, as well.
 Examples

• Japan's economy is in a liquidity trap. Its

interest rates are near zero and the central
bank buys government debt to boost the
economy. But it doesn't work. People
expect low rates and low prices, so they
don't have the incentive to buy now. Without
demand, businesses won't hire as many
additional workers. Pay remains stagnant.
The central bank has done as much as it
could.
• Japan's government has promised to
change other aspects of Japan's economy
that create stagnation. Guaranteed lifetime
employment reduces productivity. The
keiretsu system gives manufacturers
monopoly-like power. That reduces free
market forces and innovation. Japan's
population is aging, but granting citizenship
to young immigrants is discouraged. Until
these curbs to growth are addressed, Japan
will remain in a liquidity trap.
 5 solutions

• Five things can get the economy out of a

liquidity trap. First, the Fed raises interest
rates. An increase in short-term rates
encourages people to invest and save their
cash, instead of hoarding it. Higher long-
term rates encourage banks to lend since
they'll get a higher return. That increases
the velocity of money.
• Second, prices fall to such a low
point that people just can't resist shopping.
It can happen with durable goods or assets
like stocks. Investors start buying again
because they know they can hold onto the
asset long enough to outlast the slump. The
future reward has become greater than the
risk.
• Third, an increase in government
spending. That creates confidence that the
nation's leaders will support economic
growth. It also directly creates jobs,
reducing unemployment and hoarding. 
• Fourth, financial innovation creates an
entirely new market. That happened with
the internet boom in 1999. 
•• Fifth,
Fifth, governments coordinate global
governments coordinate global
rebalancing.
rebalancing. That's
That's when
when countries
countries that
that have
have tootoo
much
much of of one
one thing
thing trade
trade toto those
those that
that have
have too
too little.
little.
For
For example,
example, China
China andand the
the eurozone
eurozone havehave tootoo
much cash
much cash tiedtied up
up in
in savings.
savings. That's
That's aa result
result ofof
consumer
consumer spending
spending in in the
the United
United States
States on on
Chinese
Chinese exports.
exports. China
China must
must invest
invest more
more in in the
the
United
United States
States to
to get
get that
that money
money back
back into
into
circulation.
circulation. Similarly,
Similarly, countries
countries with
with lots
lots of
of
unemployed
unemployed youngyoung people,
people, such
such as
as the
the Middle
Middle
East
East and
and Latin
Latin America,
America, should
should send
send them
them to to
countries
countries with
with an
an aging
aging population,
population, like
like Europe
Europe and and
the
the United
United States,
States, soso they
they can
can become
become productive. 
productive. 
 The bottom line

• A liquidity trap occurs when people don't

spend or invest even when interest rates
are low. The central bank can't boost the
economy because there is no demand. If it
goes on long enough it could lead to
deflation. Japan's economy provides a good
example of a liquidity trap.
• There are five ways out of a liquidity trap.
The two most workable depend on the
nation's central bank and the federal
government. The central bank could raise
rates and trigger inflation. The government
could spend more and instill confidence.

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