Monetary Intervention Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Monetary intervention is the action of a government, especially outside the course of its ordinary activity, to influence the economy. Typically this involves changes to the interest rate and/or the money supply, in order to manipulate the economy’s growth, the strength of the nation’s currency, or inflation. Attitudes toward monetary intervention are key to a nation’s monetary policy, and different forms of intervention are recommended (not always unanimously) for different economic malaises.

Expansionary intervention increases the money supply or lowers interest rates; contractionary intervention decreases the money supply or raises interest rates. When the goal is to reduce inflation, this is called tight monetary policy; if an interest rate is altered to stimulate economic growth, this is accommodative monetary policy.

Money Supply

Money supply refers to the total amount of money available in the national economy, and there are four different measures used. M0 is the amount of physical currency circulating in the economy—paper money and coins. M1 is M0 plus checking account deposits; M1 is the measure used most often when talking about the money supply with respect to monetary policy and intervention. M2 is M1 plus savings account deposits and time deposits (such as money market mutual funds) under $100,000.

M2 is generally useful as an inflation-forecasting economic indicator. M3 is M2 plus large time deposits (over $100,000), repurchase agreements, and liquid assets—the broadest category, the one that most meaningfully and inclusively measures “how much money there is.” Though these definitions seem straightforward, deriving the values is no easy task, and there is often dispute among economists about exactly which methods to use and which money to count for M0–M2.

The money supply is contracted or expanded by manipulating the monetary base and the reserve requirements. Reserve requirements refer to the minimum amount that must be held in each bank’s reserves—in the form of physical cash in the bank’s vault and the bank’s holdings in the central bank. Since banks vary in size, this requirement is expressed as a nonflat amount—for instance, 10 percent of transaction deposits, as in the United States.

In other countries, reserve requirements vary from 2 percent (in the Eurozone) to 80 percent (in Jordan). Reserve requirements affect the amount of money a bank can lend out; in a system with a 10 percent reserve requirement, an initial $10 deposit can be expanded to as much as $100. These days, reserve requirements are not changed frequently, and never without significant advance notice; even a moderate change would cause liquidity problems.

A more common way of impacting the money supply these days is through open market operations— the buying and selling of government-issued financial instruments, precious metals (almost exclusively gold), and foreign currency. There was a time when increasing the money supply required printing more money; these days, in the United States for example, only a twentieth of the money supply exists in the physical form of paper currency or coins. When the government sells bonds, currency, or gold to banks, the money the banks use to make the purchase can be removed from circulation, contracting the money supply; when they buy such instruments, the money supply is increased. These operations have been possible only since the abandonment of the gold standard. Open market operations were a prominent feature of monetary policy under Paul Volcker, the chairman of the Fed from 1979 to 1987, whose policies begun under the Carter administration and continued through the Reagan administration were instrumental in pulling the country out of the economic slump of the 1970s’ stagflation.

Since the 1990s, the Fed has become more likely to target interest rates rather than the money supply. Economists like Robert Mundell argue that you cannot target both interest rates and foreign currency exchange rates at the same time, and policy has generally followed this belief, at least in the United States.

Bibliography:

Bruce Champ and Scott Freeman, Modeling Monetary Economies (Cambridge University Press, 2001);
Kathryn Mary Dominguez and Jeffrey A. Frankel, Does Foreign Exchange Intervention Work? (Institute for International Economics, 1993);
Barry Eichengreen, Globalizing Capital: A History of the International Money System (Princeton, 2005);
Felix Hufner, Foreign Exchange Intervention as a Monetary Policy Instrument (Physica-Verlag Heidelberg, 2004);
Richard H. Timberlake, Monetary Policy in the United States: An Intellectual and Institutional History (University of Chicago, 1993).

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