Keeping a modern economy running smoothly requires a pilot who’ll keep it from stalling or overaccelerating.
The United States, like most other countries, tries to control the amount of money in circulation.
Injecting or withdrawing money reflects the monetary policy that the Federal Reserve adopts to regulate the economy.
Monetary policy isn’t a fixed ideology. Instead, it’s a constant juggling act to keep enough money in the economy so that it flourishes without growing too fast.
What is meant by Monetary Policy?
Monetary policy is measures taken by governments to influence economic activity. In particular, it is done by manipulating money and credit supply and changing interest rates.
How fast money goes?
Money’s velocity is the speed at which it changes hands. If a $1 bill is used by 20 different people in a year, its velocity is 20. An increase in either the quantity of money in circulation or its velocity makes prices go up — and, when both increase, an even larger jump typically occurs, driving prices significantly higher.
Monetary policy is a set of actions that the Federal Reserve, the nation’s central bank, does to influence the amount of money and credit in the U.S. economy. As well, monetary policy controls the quantity of money available in an economy and the channels by which new money is supplied.
The goals of monetary policy are to promote maximum employment, stable prices, and moderate long-term interest rates.
There are three Federal Reserve’s monetary policy instruments: open market operations, the discount rate, and reserve requirements. Open market operations are buying or selling government securities (usually bonds). In doing so, the Fed – or a central bank – affects the money supply and interest rates. The discount rate is the interest rate charged by Federal Reserve Banks to depository institutions on short-term loans. Finally, the third tool regards Reserve requirements, which are the portions of deposits that banks must maintain either in their vaults or on deposit at a Federal Reserve Bank.
How monetary policy works?
Changes in monetary policy tend to be gradual, though it may change course over a period of months.
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The Fed can initiate a shift in monetary policy by:
- Ordering the Federal Reserve Bank of New York to buy or sell government securities on the open market.
- Adjusting the credit, it extends to banks through the discount window.
- Changing the reserve requirements of depository institutions
When the FOMC implements monetary policy, it impacts the federal funds rate, which is the rate that banks charge other banks for overnight access to the balances in their reserve accounts. As a result, changes in the rate affect other short-term interest rates almost immediately and influence long-term rates, the value of the dollar against other currencies, and stock prices.
From the FOMC’s perspective, the dilemma is that it must rely on estimates to make policy decisions and assess whether or not the policies it adopts are working. So, for example, it can’t be certain what effect a change in the federal funds rate will actually have or how soon the economy will respond.
How does the Government change the supply?
At about 11:15 a.m. every day, the New York Fed decides whether to buy or sell government securities to implement the Federal Reserve’s Federal Open Market Committee (FOMC) policy decisions.
To slow down an economy where too much money is in circulation, it sells securities, taking in the cash that would otherwise be available for lending. To give the economy a shot in the arm, it creates money by buying securities. There isn’t any limit on the amount of money the Fed can make, and it can – and does – vary.
The Fed’s reserve requirement makes banks hold a percentage* of certain accounts in cash to cover any unusual demand from customers.
4. Why does government adjust the rate and create money?
The Fed can also increase or decrease the discount rate, the rate it charges banks to borrow money. If the rate increases, banks tend to borrow less and have less available to lend. If the rate decreases, banks theoretically tend to borrow more and lend at attractive rates.
The New York Fed buys government securities from banks and brokerage houses known as primary dealers to create money. The money that pays for the securities hasn’t existed before, but it has value or worth because the securities the Fed has bought are valuable.
- More new money is created when the banks and brokerages use the money they receive from selling the securities to lend to customers who spend it on goods and services. These simplified steps illustrate how the process works.
- The Fed writes a check for $100 million to buy the securities from a primary dealer. The firm deposits the check in its own bank (A), increasing the bank’s cash.
- Bank A can lend its customers $90 million of that deposit after setting aside 10%. The Fed requires all banks to hold 10% of their deposits (in this example, $10 million) in reserve. A young couple borrows $100,000 from Bank A to buy a new house. The sellers deposit the money in their bank (B).
- Now Bank B has $90,000 (the deposit minus the required reserve) to lend that it didn’t have before. A woman borrows $10,000 from Bank B to buy a car, and the dealer deposits her check in Bank C.
- Bank C can now loan $9,000. This one series of transactions has created $190,099,000 in just four steps. Through repetition of the loan process involving a wide range of banks and their customers, the $100 million that the Fed initially added to the money supply could theoretically become almost $900 million in new money.
What are the pros and cons of capital control?
Government measures to limit the flow of financial capital and assets are called capital controls. These controls include taxes, tariffs, legislation, volume restrictions, and market-based forces. Capital controls are regulations that restrict or prohibit the movement of capital across national borders. Control over capital can regulate a wide range of cross-border transactions carried out by non-residents and residents in a country.
The introduction of capital control makes the economy stable. And also help to avoid speculative ups and downs. This means that investors cannot flood the economy with funds that increase production and prices and then suddenly leave, causing a collapse.
Of course, we must mention domestic borrowing. By limiting capital outflows, domestic governments have a bigger pool of domestic savings to finance government borrowing. This reduces the cost of borrowing for private and public businesses.
Nevertheless, there are some negative points in capital control. For example, free market economists believe that capital controls prevent the flow of capital to where it is most profitable and most efficient.
How Does Government Control The Money Flow? by Inna Rosputnia
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