What is monetary policy? | American News
Monetary policy is an approach taken by a central bank or government authority that aims to influence economic growth by expanding or restricting the money supply in that region.
The vast majority of money in the world is “fiat currency,” or government-issued currency that has no connection to a hard asset like gold. Instead, it is valued simply by faith in the government that issued it – including the monetary policies it deploys to control the supply of that currency.
The economy is incredibly complex, but the Federal Reserve has a surprisingly simple mission: to support as many jobs as possible while supporting price stability. This is often referred to as the Fed’s “dual mandate” and theoretically guides all of its actions.
For example, as recently as 2020 the Fed claimed a long-term inflation target of 2% or less – so the record inflation of 2022 is not in line with that target. This played a role in the US central bank’s decision to embark on a series of interest rate hikes to fight inflation and limit the money supply.
While monetary policy influences many things, one of the main areas of focus for many central bankers is inflation. Inflation can occur for a host of reasons, but one of the most common is simply that the economy is doing so well that consumers and businesses are spending freely, and the supply of goods and services simply cannot follow. This high demand and limited supply means stores have the power to raise prices without scaring businesses too much.
If a central bank can slow spending by raising interest rates or using other tools, it can ensure that demand does not spiral out of control and lead to hyperinflation.
When monetary policy allows easier access to capital, firms are more likely to take risks by hiring new workers or starting new businesses. In addition to reducing borrowing costs for businesses themselves, looser monetary policy, including lower interest rates, can also encourage spending by potential customers. This provides a natural economic tailwind.
Lower interest rates generally allow consumers and businesses to take on debt and spend more, as borrowing costs are naturally lower. They also incentivize institutions to invest in growth for the future instead of sitting on big piles of cash that don’t generate much return in a low interest rate environment.
Conversely, higher rates can make business loans or personal mortgages more expensive and discourage economic activity. They also make it more attractive to save more in conservative interest-bearing investment vehicles, such as bonds or even your local bank’s savings account.
Although monetary policy largely affects the money supply, there are different levels of this supply. The M1 and M2 offer are technical labels used by central bankers to designate these different levels.
The “base” money supply is simply the sum of all physical currency currently in circulation or held in dedicated accounts at the Federal Reserve or other relevant central banks. M1 is slightly off because it is transaction-related money that was recently deposited by consumers or businesses in local banks other than the Fed. The supply of M2 is even more remote, in that it is the total of all deposits in M1 as well as savings and other instruments such as certificates of deposit or monetary UCITS.
These layers are all “cash” in a sense, but they have varying levels of liquidity and are therefore classified separately by central bankers and economists because monetary policy influences them in slightly different ways.
It’s overly simplistic, the way some politicians are referred to as aggressive hawks or peaceful doves in defense policy, but the terminology has become accepted shorthand on Wall Street.
As such, Federal Reserve monetary policy decisions are extremely important to global economic growth as well as national success. Other entities, such as the European Central Bank which governs the euro or the Bank of England which governs the pound, also have international weight. However, many investors view the US Federal Reserve as a general indicator of the direction of global monetary policy.
A government that relies on fiat currency can simply print more or less paper money to increase supply. But there are also more sophisticated tools that can be used to influence the rate at which money changes hands, even if there isn’t really “more” or “less” of them. This usually involves a central bank like the Fed or the European Central Bank changing short-term interest rates.