Monetary Policy

A central bank's actions to affect short-term interest rates, the supply of money, and credit to promote national economic goals. Monetary policy is the government's attempt to manage the money supply of a country or transnational region to achieve specific economic objectives. The European Central Bank and U.S. Federal Reserve are examples of institutions that exist independently of the government to form and maintain monetary policy. These institutions are called central banks. Globally, the Bank for International Settlements also plays a role in standardizing policy but sets no monetary policy of its own.

The goals of monetary policy are to promote maximum sustainable output and employment and to support stable prices by controlling aberrant cycles of inflation and deflation. The U.S. Federal Reserve System can achieve this aim in two ways. Most obviously, it can raise or lower short-term interest rates to control inflation and influence output and employment by introducing the additional cost of borrowing. The aim of implementing policy through raising or lowering interest rates is to influence demand for goods and services.

[Page 475]More subtly, the Federal Reserve Bank (FRB) can also become active in open market operations in the federal funds market. Open market operations refer to the FRB buying and selling government securities in the open market to expand and contract the nation's money supply and the amount of money in the banking system. Open market operations influence short-term interest rates and the volume of money and credit in the economy. Purchases inject reserves into the banking system and stimulate growth of money and credit; sales do the opposite by taking disposable income and funds out of the system.

National monetary policy also has repercussions and implications beyond a country's borders—although this was not the case prior to the 1960s. From the period following World War II until that time, each country maintained its own capital controls in general isolation. Because monetary affairs and financial affairs were in separate spheres, there was little interdependence in the system, which could trigger the type of causal-effect conditions we have in today's global economic order. These circumstances began to unravel with the emergence of the Eurodollar market and inflationary pressures on the U.S. economy. These events forced international finance and the international monetary system to interlock and thus influence one another.

U.S. government financing of the Vietnam War and the costs of the Great Society programs of President Lyndon B. Johnson created a string of events that transformed the rule-based international monetary system of fixed exchange rates (a rate established by the government or national central bank). In its place emerged an informal political agreement arrangement among the dominant economic powers (known as the G-7 powers).

To compensate for the inflationary policies of the 1960s, the United States abandoned the gold standard in 1971 and rescinded the promise to holders of U.S. currency that their assets could be redeemed in gold. The world was also undergoing a major oil crisis during the early 1970s as scarcity of oil, high inflation, and a sluggish economy created a worldwide global recession.

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