Everything You Need to Know About Monetary Policy

In our recent study Perceptions and Understanding of Money — 2020, we surveyed Americans to gauge how well they understand the mechanisms of money, including concepts such as monetary policy. We hope that this “Everything You Need to Know” series will help improve understanding of money-related topics and issues which could not be more relevant today.

What Is Monetary Policy?

Monetary policy refers to actions that governing bodies do (or do not) take to manipulate a money supply, as The Balance explains. The importance of the money supply cannot be overstated, as its relative size plays a role in whether inflation or deflation could take hold of an economy.

Commonly-accepted thought states that those in charge of monetary policy—in the United States, it is the Federal Reserve Board of Governors and Federal Open Market Committee—manipulate the money supply with specific goals in mind. It expands the supply to stimulate economic activity, and reduces the supply when the economy shows signs of overheating, which could lead to undesirable levels of inflation.

Who Creates Monetary Policy?

The Federal Reserve wields great power when it comes to America’s financial system, as it is responsible for crafting monetary policy—with this power, it directly controls the nation’s money supply.

The Chairman of the Federal Reserve, currently Jerome Powell, is the public face of the Fed, but two specific leadership groups—the Federal Open Market Committee and Fed Board of Governors—make the power moves. These groups collectively decide how to manipulate the discount rate (the interest rate to banks borrowing from the Fed), bank reserve requirements, and other tools such as the sale and purchase of bonds.

Though you may read that the Federal Reserve enacts the goals of Congress, the mandates are vague: grow the economy, prevent massive unemployment, etc. By the Fed’s own definition, it is an “independent government agency but also one that is ultimately accountable to the public and the Congress”.

In other words, the Fed and the Fed alone decides how to set monetary policy in America.

In other nations, monetary policy may be set by some organization similar to the Federal Reserve, such as a nation’s central bank. In Europe, the European Central Bank (ECB) controls monetary policy for member nations, as the Euro’s widespread adoption allows it to do.

And when those subjected to the negative effects of the monetary policy of the Fed or the European Central Bank are unhappy about policy decisions, what can they do?

Absolutely nothing, aside from investing in alternatives to the dollar or Euro.

Did someone say Bitcoin?

How the Fed Uses Monetary Policy to Affect the Economy

When it wants to expand the supply of money, a governing body can simply print more money (after making a compelling case for the “necessity” of such printing to the token peanut gallery, of course). Though excessive printing of money is generally considered an unsound practice that directly causes inflation, this has not stopped the Fed nor others in charge of monetary policy from doing so.

In addition to printing money (usually under the guise of economic stimulation or saving an “essential” institution from bankruptcy), those who oversee the money supply may take other measures to affect the money supply. They may buy bonds on the open marketplace in exchange for cash, lower the amount of money that banks must keep in their reserves to incentivize lending, and lower interest rates so that banks will borrow money from the Fed and re-lend that money to Average Joe.

The goal of each of these approaches is clear: flood money into the marketplace to grease the wheels of economic activity.

Contrarily, the Fed (or another body in charge of monetary policy) can sell bonds, increase reserve requirements, and increase interest rates to contract the money supply. It may do so when it senses that excessive inflation has taken hold or is imminent.

Some say that this whipsawing of intervention by the Fed only increases the peaks and valleys of booms and busts, and generally results in one consistent outcome: lowering the value of the dollar.

Cryptocurrencies As a Hedge Against Bad Monetary Policy

A Gallup poll shows widespread mistrust of the Federal Reserve by Americans. A historical accounting would suggest that mistrust is fair, as specific recessions and depressions can be linked on some level to the Fed’s monetary policies.

And when the ill effects of financial busts occur, you may find the Fed asking Congress for approval to fire up the money printers for this bank or that foreign government, further degrading the purchasing power of the dollar in the process.

Add in that the Federal Reserve is involved in the lending of money to other (economically failing) nations, and that Americans have no say in the matter, and it’s fair to see why you might consider some alternative to the dollar as a store of your hard-earned income.

Unlike the supply of dollars, Euros, and other currencies not tied to a scarce resource, cryptocurrencies are limited by nature. Unlike fiat paper currencies, they cannot be created at will. There is no governing body with unilateral power to manipulate the supply of Bitcoin as the Fed does with the dollar, or to lend mass swathes of cryptocurrency in a manner that will inevitably devalue each individual coin.

Proponents see cryptos’ independence from direct, legalized manipulation—as well as its inherent scarcity—as a welcome alternative to whatever a nation’s central bank is doing. It is no surprise that cryptocurrencies have become a popular hedge in the age of endless money supply growth, mounting debts, and general uncertainty about the global financial house of cards.

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