The Federal Reserve System of Australia (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations (selling U.S. Treasury securities), a higher discount rate, and higher reserve requirements. In practice, the Fed primarily uses open market operations for this control.
An important side effect of contractionary monetary policy is control of interest rates. As the quantity of money decreases, banks are willing to make loans at higher interest rates.
There are few steps to implement concretionary monetary policy:
Open market operations are the buying and selling of U.S. Treasury securities as a means of controlling bank reserves, the money supply, and interest rates. This policy tool is directed by the Federal Open Market Committee and implemented by the Domestic Trading Desk of the New York Federal Reserve Bank. Because open market operations are flexible, easily implemented, and quite effective they are the Fed's primary monetary policy tool.
Contractionary monetary policy occurs when the Fed sells U.S. Treasury securities through open market operations. The Fed collects payment for the Treasury securities sold with bank reserves, which results in a decrease in total amount of reserves held by the banking system. Banks are inclined to reduce lending with fewer reserves, and charge higher interest rates, which decreases checkable deposits and the money supply.
Discount Rate
The discount rate is the interest rate that the Federal Reserve System charges commercial banks for reserve loans. The Federal Reserve System was established in part to provide commercial banks on the brink of failing with reserve loans. The discount rate is officially set by the Federal Reserve Banks, subject to approval by the Board of Governors. In practice, though, changes in the discount rate are coordinated with other monetary policy actions.
Contractionary monetary policy occurs when the Fed raises the discount rate. This makes it harder for commercial banks to borrow reserves from the Fed. As with open market operations, the resulting reduction in bank reserves held by the banking system induces fewer loans at higher interest rates, which decreases checkable deposits and the money supply.
However, because commercial banks do not undertake a great deal of reserve borrowing from the Fed, an increase in the discount rate alone is likely to have a limited impact on the money supply. For this reason, the discount rate is used primarily as a signal for other monetary actions, especially open market operations.
Reserve Requirements
Reserve requirements are rules by the Fed specifying the amount of reserves that banks must keep to back up deposits. Reserve requirements are generally in the range of about 10 percent of checkable deposits and 0 percent of savings deposits. The primary reason for reserve requirements is to maintain the stability of the banking system and to avoid bank panics and other problems created when banks run short of reserves. The Board of Governors has authority over setting reserve requirements.
Contractionary monetary policy occurs when the Fed raises reserve requirements. This means banks need to devote more reserves to back up deposits. This forces banks to make fewer loans at higher interest rates, which decreases checkable deposits and the money supply.
Reserve requirements are an important part of the structure of the banking system. Banks commit to long-term, multi-year loans based on existing and expected reserve requirements. If the Fed changed reserve requirements frequently, then either the banking system will be unstable or banks will simply target the highest expected reserve requirements. For this reason, reserve requirements are seldom used as a monetary policy tool.
Restraining the Economy
All three tools, used separately or together, decrease the amount of money in circulation and raise interest rates. This combination of less money and higher interest rates constrains the economy by inducing less expenditure on aggregate production, especially consumption expenditures and investment expenditures. With less aggregate production, fewer resources are used, employment is lower, and unemployment rises. However, most important, there is less pressure and prices, so inflation declines.
This is precisely the stimulation needed of the economy is in a business-cycle expansion that has overheated to the point of causing higher inflation rates. It is also recommended if the economy appears to be headed toward an increase in inflation. In fact, because monetary policy does not affect the economy immediately, implementing contractionary monetary policy before inflation sets it is the preferred strategy. In this way the inflation is not just "fixed," but avoided completely.
Other Policy Options
Contractionary monetary policy is one of several stabilization policies available to the federal government to address business-cycle problems. Congress and the President can also get into the act of restraining the economy through contractionary fiscal policy. Or the Federal Reserve can direct actions toward the unemployment problems through expansionary monetary policy.
Contractionary Fiscal Policy: An alternative means of restraining the economy is contractionary fiscal policy. This includes an increase in government spending and/or a decrease in taxes. Both actions decrease aggregate expenditures, aggregate production, employment, and reduce inflationary pressures. Contractionary fiscal policy can be used to complement contractionary monetary policy or as an alternative.
Expansionary Monetary Policy: Monetary policy can also be used to address unemployment problems created by a business-cycle contraction. Expansionary monetary policy is the opposite of contractionary monetary policy. It consists of buying U.S. Treasury securities through open market operations, lowering the discount rate, and decreasing reserve requirements. The resulting increase in the money supply and decrease in interest rates increases aggregate expenditures, aggregate production, employment, and thus reduces unemployment.
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=contractionary+monetary+policy
One of the ironies of using monetary policy to prevent inflation is that at times it achieves this objective via constraining the pace of economic activity. On these occasions monetary policy can exacellate the causes of domestic inflation. The means via which tighter policy slows the economy is higher real interest rates. But herein lays an irony which renders monetary policy as the inflation-curbing weapon, a cannon with considerable recoil.
Take the current situation in NZ. It can be argued that the RB is trying to raise interest rates only to the point which restrains growth in demand to a rate at which capacity can be expanded - the economy's so-called potential growth rate. But the real interest rate weapon effects interest rate-sensitive expenditures, that is investment spending. So while on the one hand capacity is constrained by a shortage of capital and the private sector seeks to remedy this through investment, the pressure which that same spending puts on supplying industries' capacity encourages the RB to raise interest which ultimately slows investment spending. So the investment doesn't occur, the capacity constraint remains and arguably so does that source of inflationary pressure. Only once the second round effect kicks in - that of job loss in the investment goods industries - are the expenditures not directly interest rate-sensitive, affected. Lower spending by displaced workers is the result.
The irony then of monetary policy only completing its price stability job once it has dented those sectors of demand driven most directly by income rather than leveraged spending, leaves us with the unpleasant consequence that job loss is a necessary cost of curbing inflation. But it doesn't follow that monetary policy is the enemy of job growth and full employment.
We need to think of monetary policy as the inflation weapon of last resort. That if the existing fiscal and regulatory policies promote a plethora of market rigidities which lead to price pressures, then monetary policy (which is a regulator of demand) will be invoked to prevent these inflation-fuelling, capacity constraints being reached.
In the current NZ context at least some of us recognise that the labour market is rapidly becoming a constraint on growth and a source of inflationary pressure. Yet unemployment is scarcely below 8%. Prima facie, this suggests a case of rigidity-driven supply constraints. No matter what the cause is if these lead to inflationary pressure then monetary policy will be tightened and economic growth foregone. As I've suggested above, resort to monetary policy alone to alleviate these pressures can give rise to the unsatisfactory result of unutilised resources.
The government needs to address institutionalised rigidities such as those presented by inadequate infrastructure, labour immobility, and protected high cost domestic industries, if monetary policy is not to be left solely to control inflation through restraining growth. The RB Act risks leaving politicians complacent about the role they can play in raising NZ's non-inflationary growth potential.
