In order to fully understand the nature of monetary policy, there is a need to define the function of money. According to economists, the general functions of money are as follows: 1) measure of goods and services, 2) standard of value, 3) medium of exchange, 4) storage of wealth, and 5) speculative function (related to contingency). In a very simple economy, efficiency can be achieved through general exchanges of goods and services. Every family unit or community specializes in the production of one commodity.
Goods are exchanged through what economists call ‘barter system.’ As the community grows, transactions within the simple economy become more and more complicated. There is a need to utilize a new medium of exchange. Money, whatever its earliest forms were, serves as the new medium of exchange, reducing bulkiness and inefficiency in the economy.
At some point in time, the quantity of money circulating in this economy increases. This leads to rising price levels of goods and services. As the quantity of money circulating in an economy increases, price levels of goods and services also increase (inflation). The institution tasked to maintain the monetary health of an economy is the central bank. The main functions of central banks are as follows:
1) To regulate price levels in an economy by increasing or decreasing the supply of money circulating in an economy;
2) To provide a manageable amount of credit in an economy (serves as a stimulus to increased investments);
3) To regulate or control exchange rates (in countries where currencies are on a non-floating status);
4) To determine equilibrium interest rates (here monetary policy is directly related to fiscal policy, or more accurately interest rates nominally determine consumption levels, supply of money, and investment levels);
5) To provide financial/monetary information to businesses and households (central banks report on the general status/health of an economy).
The main function of central bank can be summed up as follows: if the general price levels in an economy increases, central banks decreases money supply; if the price levels decreases, central banks increases the supply of money (secondary money markets). Interest rates are also adjusted based on investment, consumption, and government expenditure patterns.
When central banks sells bonds and securities, the monetary base of an economy contracts. When central banks buy bonds and securities (in capital markets), the monetary base of an economy expands. Through this process of adjustment/readjustment, central banks are able to regulate financial transactions in an economy.
In recent years, the US economy experiences relative decrease in overall national output. Fiscal policies are directed to decrease equilibrium interest rate to encourage increased consumption, investment, and government expenditure (increasing output in the long-run). As of the present, the Federal Reserve monetary policy is directed to: 1) increasing the supply of money in the US economy
(Federal Funds Rate), and 2) increasing the flow of credit (provide households and businesses with increased volatile funds).
According to the recent Federal Reserve Report, there are indications that the US economy continues to contract. Household spending has shown signs of stabilization but gravely constrained by job losses, lower housing wealth, and tight credit. Overall sales and demand for manufactures continue to decline.
There are also signs that inflation could persist for a time. To counter these economic difficulties, the Committee of the Federal Reserve will maintain the target range for the fed funds rate at 0 to 25%. To increase the money supply in the US economy (to prevent contraction), the Federal Reserve will buy a total of $1.25 trillion of agency-backed securities. At autumn, the Federal Reserve will purchase about $300 billion of treasury securities as a form of credit collateral. Note that the Federal Reserve is increasing the monetary base of the US economy by purchasing securities and treasuries.
What are the general effects of monetary policy on production and employment? Suppose that the economy is in the process of contraction (not to be confused with the monetary base). The central bank has two complimentary options: decreasing the nominal interest rate and increasing the money supply. An increase in both the interest rate and the money supply would increase aggregate demand. This will shift the aggregate demand to the right, indicating a higher national output.
On the supply side, this will induce firms to decrease their supply of goods to the market; indicating a leftward shift of the aggregate supply. Depending on the strength of income and substitution effect, the increase in national output via the aggregate demand may be higher or lower than the decrease in output via the supply side. In short, a monetary policy only serves to maintain the stability of an economy.