a.The main objectives of monetary policy
Monetary policy refers to the systems used by a nation’s central bank or Federal Reserve uses to influence the amount of money or credit available in the economy. These policies affect the interest rates and the overall performance of the economy.
The major objective of a monetary policy is to promote maximum employment, stabilize prices and moderate long term interest rates.
• In order to maximize employment the central banks or federal reserves utilize the monetary policy tools available to it that influence the availability and cost of credit. In order to maximize employment, the central banks lower the interest rates hence it becomes cheaper to borrow money by households and businesses. This intern increases the household spending, which causes a rise in amount of manufactured good demands. With more manufactured goods being demanded the businesses are then forced to employ to meet the labor demanded to manufacture the goods. This is how employment maximization is achieved.
• Monetary policies are also used to stabilize prices in an economy. This is achieved through raising and lowering the interest rate in response to the prevailing economic situation. In the case of inflation, interest rates are raised to counter the excess liquidity in the economy.
• The moderation of long term interest rates is important as it ensures economic stability and price stability in the nation. This is done through the adjustment of the prevailing interest rates by the Federal Reserve through the various monetary tools it has in place.
b. Direct monetary policy tools
The Federal Reserve has several indirect monetary tools it uses to influence monetary policy. These tools are
• Repo rates: this is the interest rate charged for overnight liquidity to banks by the Reserves banks against government securities held by the banks. Used frequently by the federal reserve.
• Reverse repo rates: This is interest rate at which the Federal Reserve absorbs liquidity on an overnight basis from banks against held government securities.
• Bank rate: is the rate at which the reserve banks is willing to rediscount or buy bills of exchange and other instruments from the banks
• Liquidity adjustment facility: It consists of overnight as well as term repo auctions.
• Cash reserve ratio. The average that is to be held by a banks as a share of it net demand and time liabilities in the federal reserve bank
c. Indirect tools of monetary policy
The Federal Reserve has several indirect monetary tools it uses to influence monetary policy. These tools are:
• Open market operations. This involves the purchase and sale of government bonds to influence the amount of money in circulation in the economy. In order to increase the amount of money in circulation the Federal Reserve buys government bonds from the public and in order to reduce liquidity it sells the bond to the public. Lending reserves discount rates. The discount rate is the interest rate the Federal Reserves charges when it issues loans to banks. When the discount rate (interest rate) is lower, it is cheaper for banks to borrow from the Fed, allowing them to increase reserves and thereby increase lending. When the discount rate (interest rate) is higher, it is costlier for banks to borrow from the Federal Reserve, making them to decrease reserves and thereby decrease lending to the public.
• Reserve requirements: Minimum amount of reserves banks must hold against their deposits. To decrease the money supply, the Fed raises the reserve requirement.