Monetary policy is an economic policy that regulates the size and growth rate of the money supply in an economy. For more details on this monetary policy, you can read the following article. Don't forget to follow GIC's Instagram to stay updated on the daily market morning brief.

What is Monetary Policy?

Monetary policy is the process through which a country's central bank strives to achieve stable economic growth, keep unemployment low, and reduce fluctuations in foreign exchange rates and inflation levels. The central bank does this through a system of tools and measures designed to increase or decrease the money supply in the economy, primarily by influencing the liquidity levels of other financial institutions. In the United States, the financial system is centered around the central bank known as the Federal Reserve Bank (or Fed for short). It consists of twelve Federal Reserve Districts, all under the Board of Governors of the Federal Reserve System. These parts of the organization share responsibilities with the Federal Open Market Committee (FOMC) to create a holistic monetary policy for the U.S. economy. The Federal Reserve Bank has two main goals, known as the dual mandate: keeping unemployment low and achieving price stability.

Types of Monetary Policy

There are two main types of Monetary Policy: contractive and expansive.

Contractionary

Usually, Contractionary Monetary Policy is used by central banks to control inflation. They limit the amount of money that can be lent by banks to control the money supply. As a result, banks make loans more expensive by charging higher interest rates. Only a few individuals and businesses with the highest needs manage to borrow.

Expansionary

Expansionary Monetary Policy is used by central banks to avoid recession and control unemployment. They provide more money for loans to increase liquidity. Banks make loans more affordable by charging lower interest rates. Businesses borrow more to hire staff, expand, and purchase equipment. On the other hand, individuals borrow more to buy cars, equipment, and new homes. This drives economic growth and increases demand.

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The result that will occur when Monetary Policy

Here are the effects generated when Monetary Policy occurs. The results are:

Inflation

The way Monetary Policy affects the real economy – output and employment, for example – and inflation, is called the transmission mechanism of Monetary Policy. The transmission mechanism is not just one, but several different mechanisms that interact with each other. Some of these have a direct impact on inflation, while others take longer to have an effect. It is generally believed that changes in the policy rate have the greatest impact on inflation after one to two years. However, the experience following the 2011 debt crisis, both in Indonesia and internationally, shows that inflation can remain below target for a long time even when the policy rate is very low or even negative.

Unemployment

The goal of expansionary Monetary Policy is to increase aggregate demand and economic growth through interest rate cuts. Lower interest rates mean that the cost of borrowing is reduced. When it is easier to borrow money, people spend more and invest more. This increases aggregate demand and GDP and reduces cyclical unemployment. Additionally, when interest rates are lower, exchange rates are also lower, making the economy's exports more competitive. Sometimes, policymakers may also introduce specific initiatives targeting certain areas of the economy to reduce unemployment and increase output. Examples of these unique initiatives include streamlining the approval process for government projects that create jobs, providing cash incentives to businesses to hire workers, and paying businesses to train workers for specific positions.

Exchange Rate

Monetary Policy, led by the Federal Reserve and involving changes in the money supply and credit availability to individuals, it can also affect the exchange rate. Similar to fiscal policy, it can influence the exchange rate through three channels: income, prices, and interest rates.

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Instruments to determine Monetary Policy

Central banks use various tools to implement Monetary Policy. The commonly used policy tools include:

Open Market Operations

One of the primary tools of monetary policy is Open Market Operations, which refers to the purchase and sale of financial instruments by the central bank. For example, the Federal Reserve buys: “Holdings of Treasury, agency, and mortgage-backed securities; discount window loans; loans to other institutions; limited liability company (LLC) assets that have been consolidated onto the Federal Reserve’s balance sheet; and foreign currency holdings linked to reciprocal currency arrangements with other central banks (foreign central bank liquidity swaps).” These financial instruments are also known as securities. The central bank buys these from private banks by creating money and adding it to the central bank’s reserves. These reserve accounts are like our checking accounts. The central bank buys securities from private banks and puts the money into their reserve accounts. If we compare it to real life, it’s like selling your old car and the customer transferring the money into your account. The main difference is that the customer is essentially creating money out of thin air. So when the central bank buys securities from private banks, the money goes into their reserve accounts. In turn, these securities are added to the central bank’s asset sheet, while the private banks now have extra cash flow to use in other ways.



Interest Rates

The last tool of monetary policy is the discount rate, which refers to the interest rate charged by the central bank to private banks. So, if they cannot find enough liquidity from other banks, they must borrow from the central bank as the lender of last resort. For example, a private bank may not be able to meet its obligations and may require a short-term loan to cover it. The Federal Reserve offers the discount rate in three formats: primary credit, secondary credit, and seasonal credit – each with its own interest rate. Primary credit is provided to the safest financial institutions and receives the best price. Secondary credit is available to institutions that do not meet the same standards and pose higher risks. Finally, seasonal credit is extended to relatively small depository institutions that experience recurring intra-year funding needs, such as banks in agricultural communities or seasonal resorts.

Reserve Requirements

The second monetary policy tool held by central banks is reserve requirements. This is the percentage that each bank must keep when lending out depositor funds. For example, the reserve requirement might be 10 percent. So, if a depositor deposits $100 into a bank, the bank must keep $10 and is then allowed to lend out the remaining $90. Reserve requirements are regulations applied by most central banks worldwide, though at varying levels. In turn, commercial banks must maintain the specified reserve requirements. This can be kept as cold cash or in their central bank reserve accounts. The key is that they must have enough funds to meet the immediate demands of their depositors.

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Beda Monetary Policy dengan Fiscal Policy

Monetary Policy and fiscal policy are two distinct tools that impact the economic activity of a country. Monetary Policy is created and managed by a country's central bank, and it involves the management of the money supply and interest rates within an economy. Fiscal policy, on the other hand, relates to how the government manages aspects of spending and taxation. It is the government's way of stabilizing the economy and supporting economic growth. The government can modify fiscal policy by implementing measures and changing tax rates to control the fiscal deficit of the economy. Below are some key differences between Monetary Policy and fiscal policy.
Monetary Policy Fiscal policy

Definition
This is a financial tool used by the central bank to regulate the flow of money and interest rates within an economy It is a financial tool used by the central government to manage tax revenues and policies related to expenditures for the benefit of the economy

Managed by
Central Bank of an economy Ministry of Finance of the economy

Measurement
It measures the prevailing interest rate for lending money in the economy This measures the capital expenditure and taxes of an economy

Area fokus
Economic stability Economic growth

Impact on the exchange rate
The exchange rate increases when there are higher interest rates It does not affect the exchange rate

Target
Monetary Policy targets inflation within an economy Fiscal policy does not have a specific target

Impact
Monetary Policy impacts loans within the economy Fiscal policy impacts the budget deficit
 

Does Monetary Policy Change Often? How Often?

The Federal Open Market Committee of the Federal Reserve meets eight times a year to determine changes in the country's Monetary Policy. The Federal Reserve can also act in emergencies, as seen during the 2007-2008 economic crisis and the COVID-19 pandemic.

How is this Monetary Policy used to curb Inflation in the United States?

Inflation is caused by too much money in the economy, or as economist Milton Friedman said, "Inflation is always and everywhere a monetary phenomenon." In the United States, the Federal Reserve (or The Fed) is responsible for controlling the money supply. In the European Union, the European Central Bank has that responsibility. These central banks seem to have an easy job: if they see inflation rising, they need to reduce the money supply. It can be difficult to measure the money supply. Central banks know how much currency—such as paper dollars and coins—is in the economy. But bank deposits are also counted as money, and the total size depends on the bank reserve ratio (the amount of reserves banks hold relative to their deposits). Secondly, inflation depends on the velocity of money, or how quickly money circulates during a given period. If the velocity is low, then, all else being equal, an increase in the money supply will have less of an impact on inflation than when the velocity is high. Most modern central banks target the inflation rate in a country as their main metric for Monetary Policy. If prices rise faster than their target, the central bank tightens Monetary Policy by raising interest rates or using other hawkish policies. Higher interest rates make loans more expensive, limiting consumption and investment, both of which heavily rely on credit. Similarly, if inflation falls and economic output decreases, the central bank will lower interest rates and make loans cheaper, along with other expansionary policy tools. As a strategy, inflation targeting views the primary goal of central banks as maintaining price stability. All of the Monetary Policy tools available to central banks, including open market operations and discount loans, can be used in the general strategy of inflation targeting. Inflation targeting can be contrasted with strategies where central banks focus on other economic performance measures as their primary goals, such as targeting exchange rates, unemployment rates, or nominal GDP growth. After understanding Monetary Policy, its types, outcomes, tools, and differences, you can explore more trivia through the GIC Journal. You can also trade at GIC starting from 150,000 Rupiah by registering through the official GIC website!