The Basics of Monetary Policy

Monetary policy influences investing decisions and economic outlook, but many have a hard time understanding the basics. I am not advocating that monetary policy dictate your investing approach, but it is one more factor to consider when reviewing your financial plan. There are also interesting ramifications in the San Francisco Bay Area, where many companies sell goods and services in foreign markets and tourism plays an important role in the local economy.

America’s monetary policy is set by the Federal Reserve (“the Fed”), our central bank, which influences the amount of money and credit in our economy, and therefore also influences interest rates, inflation, and our economy’s health and performance.

The Fed tries to support a healthy economy, which to the Fed means interest rates and inflation at moderate rates, and low unemployment. The Fed achieves these goals with its three instruments of monetary policy: open market operations, the discount rate, and reserve requirements.

Decisions about open market operations are made by the Federal Open Market Committee, and involve the Fed buying or selling securities such as Treasury bonds, notes, and bills. When it buys them, it pays by depositing money with a bank or securities dealer, and when it sells them, it deducts their value from the accounts of the purchasing banks or securities dealers. In this way, the Fed is adding or removing money from the money supply. Money added can then be loaned out, ultimately to businesses and consumers, stimulating the economy and boosting interest rates. Money removed from the supply can slow down our economy, increasing interest rates, too. A rapid rise in the supply of money boosts inflation — and vice versa — and is another way that monetary policy affects our everyday lives. The Fed would generally like to see inflation rates in the 2% to 3% range.

The discount rate is the rate that Federal Reserve Banks charge other financial institutions for short-term loans. When the rate is low, banks are more likely to borrow, thus increasing the economy’s money supply and stimulating growth. Conversely, a monetary policy involving rising rates will slow down the economy.

Reserve requirements involve the Fed telling banks what portion of deposits they must keep in their vaults or deposited at a Federal Reserve Bank. When the requirements are hiked, banks are less able to lend, the cost of credit rises, and some brakes are applied to the economy. A drop in requirements has the opposite effect.

Monetary policy affects investors because rising interest rates make existing bonds, with their lower rates, less attractive and that leads to falling bond prices. In this situation, stocks become more attractive to many. As do savings accounts, CDs, and newly issued bonds. Alternatively, falling interest rates tend to boost the real estate market, as mortgages become more affordable. If rates are very low, as they are now, they can discourage people from saving, while encouraging people, and businesses, to borrow.

  1. Hello there Aram. Interesting intro to monetary policy there. Just thought I’d drop you a comment on this post (seemed as good as any) to say that I’ve read a few of your posts and I’m enjoying the blog! Expect to see me around in the comments! 😉
    Shaun Hoobler recently posted…hockey training drillsMy Profile

  2. Thank you for reading. If you ever have questions about value investing, San Francisco and Bay Area investment firms, or fee-only compensation; I’m happy to provide answers.

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