Monetary policy

Monetary policy attempts to control the amount of money in circulation or the cost and availability of credit. The objective is straightforward even if difficult to put into practice. If money is readily available because, say, interest rates are low, people can afford to borrow and spend. But unless production keeps pace, there will not be enough goods and services to meet the demand this borrowinn and spending creates. In the face of the excessive demand, producers and suppliers have incentives to raise their prices. As time goes by, prices spiral upward, leading to uncontrolled inflation during which dollars lose their value. The key to keeping inflation in check is to maintain stable interest rates and not let the money supply grow too rapidly.
Monetary policy fall within the province of the Federal Reserve System, the nation's central bank.
Like fiscal policy, monetarism has a downside. Should the government constrict the flow of cash into the economy too severely, consumers and businesses cannot afford to borrow, spending and investments decline, products sit on store shelves, factories close, and new homes, automobiles, and appliances go unsold. As the economy cools off, more and more workers are laid off and the downward plunge picks up momentum. As we saw at the outset, the Fed's decision to curb the supply of money in 1979 led the United States into its worst recession in 50 years. Nevertheless, just as Democrats traditionally favor stimulative policies, conservative Republicans tend to boost monetary policy as the best way to control inflation, which they argue is a greater evil than unemployment.

Expansionary Monetary Policy

In the United States, when the Federal Open Market Committee wishes to increase the money supply, it can do a combination of three things:

1. Purchase securities on the open market, known as Open Market Operations
2. Lower the Federal Discount Rate
3. Lower Reserve Requirements

These all directly impact the interest rate. When the Fed buys securities on the open market, it causes the price of those securities to rise. In my article on the Dividend Tax Cut we saw that bond prices and interest rates are inversely related. The Federal Discount Rate is an interest rate, so lowering it is essentially lowering interest rates. If the Fed instead decides to lower reserve requirements, this will cause banks to have an increase in the amount of money they can invest. This causes the price of investments such as bonds to rise, so interest rates must fall. No matter what tool the Fed uses to expand the money supply interest rates will decline and bond prices will rise. Increases in American bond prices will have an effect on the exchange market. Rising American bond prices will cause investors to sell those bonds in exchange for other bonds, such as Canadian ones. So an investor will sell his American bond, exchange his American dollars for Canadian dollars, and buy a Canadian bond. This causes the supply of American dollars on foreign exchange markets to increase and the supply of Canadian dollars on foreign exchange markets to decrease. As shown in my Beginner's Guide to Exchange Rates this causes the U.S. Dollar to become less valuable relative to the Canadian Dollar. The lower exchange rate makes American produced goods cheaper in Canada and Canadian produced goods more expensive in America, so exports will increase and imports will decrease causing the balance of trade to increase.
When interest rates are lower, the cost of financing capital projects is less. So all else being equal, lower interest rates lead to higher rates of investment.

What We've Learned About Expansionary Monetary Policy:

1. Expansionary monetary policy causes an increase in bond prices and a reduction in interest rates.
2. Lower interest rates lead to higher levels of capital investment.
3. The lower interest rates make domestic bonds less attractive, so the demand for domestic bonds falls and the demand for foreign bonds rises.
5. The demand for domestic currency falls and the demand for foreign currency rises, causing a decrease in the exchange rate. (The value of the domestic currency is now lower relative to foreign currencies)
6. A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase.

   Contractionary Monetary Policy

   As you can probably imagine, the effects of a contractionary monetary policy are precisely the opposite of an expansionary monetary policy. In the United States, when the Federal Open Market Committee wishes to decrease the money supply, it can do a combination of three things:
7. Sell securities on the open market, known as Open Market Operations
8. Raise the Federal Discount Rate
9. Raise Reserve Requirements

These cause interest rates to rise, either directly or through the increase in the supply of bonds on the open market through sales by the Fed or by banks. This increase in supply of bonds reduces the price for bonds. These bonds will be bought up by foreign investors, so the demand for domestic currency will rise and the demand for foreign currency will fall. Thus the domestic currency will appreciate in value relative to the foreign currency. The higher exchange rate makes domestically produced goods more expensive in foreign markets and foreign good cheaper in the domestic market. Since this causes more foreign goods to be sold domestically and less domestic goods sold abroad, the balance of trade decreases. As well, higher interest rates cause the cost of financing capital projects to be higher, so capital investment will be reduced.

What We've Learned About Contractionary Monetary Policy:

1. Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates.
2. Higher interest rates lead to lower levels of capital investment.
3. The higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls.
4. The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. (The value of the domestic currency is now higher relative to foreign currencies)
5. A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.