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Goals of Monetary Policy

Goals of Monetary Policy

Author: Sophia Tutorial
Description:

Determine how monetary policy relates to inflation and deflation.

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Tutorial
what's covered
This tutorial will cover the goals of monetary policy, focusing on the goals of the Federal Reserve and how its monetary policy relates to inflation and deflation.

Our discussion breaks down as follows:

  1. Role of the Federal Reserve
    1. Full Employment
    2. Price Stability
  2. Hyperinflation
  3. Deflation


1. Role of the Federal Reserve

Initially, the Fed was formed in 1913 to reduce the frequency and likelihood of bank runs and panics. It was meant to bring stability to the banking system--a role that it continues to fulfill today.

However, over time its role in managing our nation's money supply and overseeing our banking system has evolved. Its main goals today are to promote the following in our economy:

  • Full employment
  • Price stability

As mentioned, the Fed manages our money supply, which is classified according to liquidity into M0, M1, and M2.

Category Definition Liquidity
M0 Narrowest definition of money; includes only the stock of physical currency Most liquid, immediately available
M1 Includes demand deposits (checking account balances) + M0 (stock of physical currency) Still liquid, accessible via checks and debit cards
M2 Broadest definition of money; includes time deposits such as savings accounts, money market mutual funds, etc. + M1 (demand deposits + M0, stock of physical currency) Least liquid, accessibility requires a couple steps

terms to know
M0
The narrowest definition of money; includes only the stock of physical currency
M1
Includes demand deposits (checking account balances) + M0 (stock of physical currency)
M2
Time deposits + M1 (demand deposits + stock of physical currency)

1a. Full Employment
Let's discuss the first goal of the Fed, which is to promote full employment.

When the economy is slowing, as it does in a recession, the economy is at less than full employment.

Now, the Fed is different from the federal government. The Fed can help in this situation by increasing the money supply. These are the three broad categories of actions that they can take:

  • Lower the reserve requirement
  • Lower the discount rate or fed funds target rate
  • Buy Treasury securities

Any of these tools will help banks to make loans and get money into people's hands and into circulation, hopefully lowering the unemployment rate and steering the economy back towards full employment.

On the other hand, when the economy is growing too quickly, the economy, in the short term, can be beyond full employment--almost like an overheated situation.

The major concern is not necessarily that the unemployment rate is too low, but when the unemployment rate is as low as, for instance, under 5%, inflation can become a major concern.

Therefore, the Fed can cool things down by decreasing the money supply, through the following actions:

  • Raise the reserve requirement
  • Raise the discount rate or fed funds target rate
  • Sell Treasury securities

Any of these tools will encourage banks to make fewer loans and keep money in the banks, slowing things down enough to bring our economy back to full employment.

1b. Price Stability
The second goal of the Fed is to promote price stability.

So, we know that it is typical for an economy to experience a slow, overall increase in prices over time. Obviously, things today are more expensive than the day you were born.

Most economists say that about 2% annual inflation rates are reasonable and just fine.

think about it
However, what if prices were completely unpredictable? Think about how that would change things. If you had no idea what the prices of things were going to be a year from now, a month from now, a week from now, or even a couple of hours from now, how would that change your decisions?

Unstable prices can really change people's ability to purchase with a currency. They can also change our banks' ability and willingness to make loans.


2. Hyperinflation

Let's begin with an example to discuss inflationary risk--in this case, we will use the example of Weimar Germany.

After World War I, Germany had huge costs and reparations to pay. They chose to borrow the money in order to pay for these things.

Now, as they borrowed the money, their exchange rate began to fall, devaluing their currency. They began printing more money, which made their currency even weaker. The result was hyperinflation.

did you know
To provide some context, at the beginning of the war, about four Marks were required to buy one dollar. At one point, their currency was so devalued that it would have taken over four trillion Marks just to purchase $1.

This is not average inflation; this is hyperinflation that resulted from the massive borrowing and printing of money.

So, what was the result of this hyperinflation? Well, prices were rising so quickly that people had to be paid by the hour. They would try to spend that money as quickly as possible before it lost even more value.

People had to shop with wheelbarrows full of money. Restaurants could not even print menu prices because the prices were changing so quickly.

The key idea here is that when there is hyperinflation in an economy--like what happened in Weimar Germany--eventually people resort to barter or using commodities, like gold, since their currency becomes essentially worthless.

In Weimar Germany, the rich were able to survive. Most of the rich owned land and could grow their own food or had connections.

However, the poor and the middle class suffered. People's hard-earned savings completely vanished almost overnight, and they had to sell what they could just to survive, like old family heirlooms.

Many of these people turned to Hitler to "fix" the situation. As you can see, there can be some very negative consequences of hyperinflation, which is why it is such a concern.


3. Deflation

Deflation is the opposite of inflation. It means that prices are falling over a period of time.

Now, you might be wondering how this could be a problem. Isn't it a good thing if our money can actually buy more? Well, deflation also carries its own set of risks.

During a period of significant deflation, people actually tend to hoard money. They do not tend to spend it. They put off their purchases until prices fall even further, because realistically, if you know that prices are going to continue to fall, why would you buy that item now? You would wait until it is even cheaper.

Businesses will do the same thing. They will put off investment. So, with both consumption and investment spending down--remember, these are both components of aggregate demand--then aggregate demand falls along with the overall economic activity.

It is quite easy for a downward spiral to begin and to enter into a recession.

IN CONTEXT

In the early 2000s, prices of homes in certain parts of our country were rising rapidly. Clearly, this is not an example of deflation, but what happened was that many people borrowed money to invest in housing in areas they felt they could quickly flip the house.

Flipping a house means that the buyer does not purchase it to live there, but rather to sell it for more than they purchased it for.

Well, unfortunately, this continual increase in the housing prices did not last forever. It was a bubble, and it burst. Home values plummeted in some of these areas.

For instance, if you had purchased a house in California for $1 million, thinking that in a year, you could flip it and make $2 million, all of a sudden the housing bubble burst and your house is only worth $400,000.

The problem is, though, you still owe almost $1 million on it, so you owe far more than the worth of your home.

A similar series of events happened leading up to the Great Depression. Many people were borrowing money to invest in companies that were continually rising in value. People thought the stock market was never going to fall in value again.

However, it did, and when the bubble burst, not only did they lose money on those investments, they still owed money.

Therefore, the impact of deflation on M0 and M1 can be dramatic. Even though the Fed was taking action to increase the money supply and pump money into M0, since people were hoarding cash, taking it out of the bank, and putting off purchases, the size of M1 was actually decreasing.

big idea
Price stability is very important for a healthy economy because predictability helps consumer and businesses to keep the economy going through purchases and investments. Predictability also helps banks continue to make loans available to both consumers and businesses. Therefore, it is a major goal of the Fed.


summary
Today we learned about the role of the Federal Reserve, specifically that its major goals are to promote full employment and price stability. We learned that rapid inflation, or hyperinflation, can destroy a currency and force people to resort to barter or trading commodities. Remember, 2% inflation is generally the goal. Lastly, we learned that deflation could slow economic activity by encouraging individuals to hold onto cash. Therefore, price stability is a very important and major goal of monetary policy.

Source: Adapted from Sophia instructor Kate Eskra.

Terms to Know
M0

The narrowest definition of money; includes only the stock of physical currency.

M1

Includes demand deposits (checking account balances) + M0 (stock of physical currency).

M2

Time deposits + M1 (demand deposits + stock of physical currency).