The Nuts and Bolts of Monetary Policy
Monetary policy /
Pages: 24 (5851 words) /
Published: Aug 3rd, 2012
THE NUTS AND BOLTS
OF MONETARY POLICY
This chapter discusses monetary policy and explores the monetary and financial systems in the U.S. in more detail. The chapter starts by illustrating some features of the Federal Reserve Bank (Fed). Then, it looks at the financial assets and liabilities of the financial system and the role of money in the economy. Details about the operations of the Fed and the conduct of monetary policy are also provided in this chapter.
The Fed is the central bank of the U.S. It consists of 12 regional Federal Reserve Banks. The central committee in the Fed is the Federal Open Market Committee (FOMC). This committee consists of 12 members; 7 board of governors, the president of the N.Y. Fed, and a rotating group of 5 regional bank presidents.
FOMC is the committee that decides on the future monetary policy, which changes money supply and, as a result, short-term interest rates. The three tools used to change money supply are the reserves requirements, the discount rate, and the open market operations. The reserve requirement rate is the percentage of new deposits that banks must keep at the Fed. By changing the rate, the Fed changes the monetary base (the sum of currency and reserves) and the money supply. The discount rate is the interest rate that banks pay the Fed for borrowing funds. Although banks do not like to borrow from the Fed, the latter changes the discount rate to indicate the direction of monetary policy. The Fed conducts open market operations when it sells or buys government securities. Selling bonds decreases money supply, while buying them increases money supply.
The impact of changes in money supply as a result of changes in the monetary base depends on the money multiplier. The simple money multiplier equals 1/r, where r is the reserve requirement ratio. This multiplier is built on three simplifying assumptions; there is only one bank, there are no excess