 Central banks and monetary policy

 Federal Reserve and its monetary policy tools

 Monetary policy tools- conventional and nonconventional
 Its reasons and impacts
 Monetary policy and inflation
 Modern tendency (during pandemic situation)

Central banks and monetary policy

Monetary policy of a central Bank is a huge part of a country and its economy or politics. The
main purpose of a monetary policy is to maintain the economic stability, purchasing power of
money, an effective system of payments and decrease in inflation or unemployment.
Undoubtedly, monetary policy is a combination of series of important events inside the
country. With its help, the central bank stimulates the emission of money and credit (such as
credit expansion) or the opposite- such as the restriction of money-credit emission during
the upturn of economy.

Federal Reserve and its monetary policy tools

Now I will move to the next point and discuss how the Federal Reserve use the tools to
implement its monetary policy. To begin with, The Fed is the nation’s monetary policy
authority. Congress has given the Fed two main goals: first, maximum sustainable
employment; and, second, stable prices, which means low, stable inflation. This implies a
third goal of moderate long-term interest rates too. So the final result of the FED is to
influence the availability and cost of money and credit to promote a healthy economy. To
meet its price stability mandate, the Fed has set a longer-run goal of 2% inflation. The Fed
describes its monetary policy plans as "data dependent," meaning they would be altered if
actual employment or inflation deviate from its forecast. The Fed targets the federal funds
rate to carry out monetary policy. The federal funds rate is determined in the private market
for overnight reserves of depository institutions (called the federal funds market). At the end
of a given period, usually a day, depository institutions must calculate how many dollars of
reserves they want or need to hold against their reservable liabilities (deposits). If it wishes to
expand money and credit, the Fed will lower the target, which encourages more lending
activity and, thus, greater demand in the economy. Conversely, if it wishes to tighten money
and credit, the Fed will raise the target.
The Fed has traditionally used three tools to conduct monetary policy: reserve requirements,
the discount rate, and open market operations. In 2008, the Fed added paying interest on
reserve balances held at Reserve Banks to its monetary policy tool. More recently the Fed
also added overnight reverse repurchase agreements to support the level of the federal funds
rate. So we can say that the Fed has both conventional and unconventional monetary policy
tools. My group mate will continue talking about these tasks.

Conventional policy tools

Specifically, in the United States, the Federal Reserve has three traditional tools to
implement monetary policy in the economy:

 Open market operations

 Changing reserve requirements
 Changing the discount rate
The discount rate is the interest rate Reserve Banks charge commercial banks for short-term
loans. Federal Reserve lending at the discount rate complements open market operations in
achieving the target federal funds rate and serves as a backup source of liquidity for
commercial banks. Lowering the discount rate is expansionary because the discount rate
influences other interest rates. Lower rates encourage lending and spending by consumers
and businesses. Likewise, raising the discount rate is contractionary because the discount rate
influences other interest rates. Higher rates discourage lending and spending by consumers
and businesses. Discount rate changes are made by Reserve Banks and the Board of
Governors.  If the central bank raises the discount rate, then commercial banks will reduce
their borrowing of reserves from the Fed, and instead call in loans to replace those reserves.
Since fewer loans are available, the money supply falls and market interest rates rise. If the
central bank lowers the discount rate it charges to banks, the process works in reverse.
Open market operations, the buying and selling of U.S. government securities, has been a
reliable tool. This tool is carried out by the Federal Reserve Bank of New York.  The specific
interest rate targeted in open market operations is the federal funds rate. Open market
operations can also reduce the quantity of money and loans in an economy. DOES SELLING
OR BUYING BONDS INCREASE THE MONEY SUPPLY? When a central bank buys bonds,
money is flowing from the central bank to individual banks in the economy, increasing the
supply of money in circulation. When a central bank sells bonds, then money from
individual banks in the economy is flowing into the central bank—reducing the quantity of
money in the economy.
Reserve requirements are the portions of deposits that banks must hold in cash on deposit at
a Reserve Bank. A decrease in reserve requirements is expansionary because it increases the
funds available in the banking system to lend to consumers and businesses. An increase in
reserve requirements is contractionary because it reduces the funds available in the banking
system to lend to consumers and businesses. At the end of 2013, the Federal Reserve required
banks to hold reserves equal to 0% of the first $13.3 million in deposits, then to hold reserves
equal to 3% of the deposits up to $89.0 million in checking and savings accounts. Small
changes in the reserve requirements are made almost every year. In practice, large changes in
reserve requirements are rarely used to execute monetary policy. A sudden demand that all
banks increase their reserves would be extremely difficult to comply with, while loosening
requirements too much would create a danger of banks being unable to meet the demand for
withdrawals.

Unconventional policy tools

Unconventional policy was born of necessity given the financial crisis, deep recession, and
near-zero short-term interest rates. Such extraordinary circumstances may not be often
repeated, in which case, the unconventional monetary policy toolbox may sit on the shelf for
some time.
The unconventional tools are: forward guidance and quantitative easing.

During the past decade, forward guidance has generally been viewed as an effective policy
tool to support the economic recovery. Forward guidance attempts to influence the financial
decisions of households, businesses and investors by providing a guidepost for the expected
path of interest rates. It also guides to prevent surprises that might disrupt the markets and
cause significant fluctuations in asset prices. Through the use of forward guidance, the FOMC
to keeps interest rates low for as long as needed in order to improve credit availability and
stimulate the economy. Forward guidance consists of telling the public not only what the
central bank intends to do, but what conditions will cause it to stay the course and what
conditions will cause it to change its approach. With some sense of where the economy
might be headed, individuals, businesses and investors can have greater confidence in their
spending and investing decisions, and financial markets may be more likely to function
smoothly. For example, if the FOMC indicates that it expects to raise the federal funds rate in
six months, potential home buyers might want to get mortgages ahead of a potential increase
in mortgage rates.

The Fed’s second unconventional monetary policy tool was quantitative easing, or QE, which
involved Fed purchases of longer-term bonds. Buying these securities adds new money to the
economy, and also serves to lower interest rates by bidding up fixed-income securities. It also
expands the central bank's balance sheet. To execute quantitative easing, central
banks increase the supply of money by buying government bonds and other securities.
Increasing the supply of money lowers the cost of money—the same effect as increasing the
supply of any other asset in the market. A lower cost of money leads to lower interest rates.

Policy and its impacts on inflation

The Federal Open Market Committee (FOMC) judges that inflation of 2 percent over the
longer run, as measured by the annual change in the price index for personal consumption
expenditures. For many years, inflation in the United States has run below the Federal
Reserve’s 2 percent goal. It is understandable that higher prices for essential items, such as
food, gasoline, and shelter, add to the burdens faced by many families, especially those
struggling with lost jobs and incomes. At the same time, inflation that is too low can weaken
the economy. When inflation runs well below its desired level, households and businesses
will come to expect this over time, pushing expectations for inflation in the future below the
Federal Reserve’s longer-run inflation goal. This can pull actual inflation even lower,
resulting in a cycle of ever-lower inflation and inflation expectations.
If inflation expectations fall, interest rates would decline too. In turn, there would be less
room to cut interest rates to boost employment during an economic downturn. Evidence
from around the world suggests that once this problem sets in, it can be very difficult to
overcome. To address this challenge, following periods when inflation has been running
persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation
modestly above 2 percent for some time. By seeking inflation that averages 2 percent over
time, the FOMC will help to ensure longer-run inflation expectations remain well anchored
at 2 percent.

Modern Tendency

The Fed’s monetary policy actions did not cause this recession, and they aren’t likely to be
the main driver of the expansion that follows. But monetary policy can play a role in limiting
the economic and financial damage caused by efforts to contain COVID-19 and, in that way,
can help support the strict public-health measures that are needed to save lives and set the
stage for economic recovery. In addition to the steps above, the Federal Reserve expects to
announce soon the establishment of a Main Street Business Lending Program to support
lending to eligible small-and-medium sized businesses, complementing efforts by the SBA.
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