Monetary policy is the official stance taken by the central bank of a country to manipulate either the base interest rate or the currency supply, both of which are important tools for stabilizing the national currency. Central banks in most nations follow some form of monetarism – a philosophy that the supply of money is determined through the action of private citizens. In practice, central banks may adjust the level of their currencies to make room for future needs. For instance, a sudden tightening of monetary policy may be brought about by political pressure or need, such as large unexpected fluctuations in oil prices. However, most central banks have a flexible stance, since it is in their best interest to avoid inflation, deflation and trade wars.
The primary role of the federal reserve bank is to maintain the stability of the national monetary system and the functioning of the economy as a whole. It influences the lending and credit decisions of other financial institutions, the level of the Federal funds rate and the amount of reserves held by the banking system. Its efforts are also aimed at preventing financial panics and bubbles, which are the result of excessive credit financing, large scale borrowing and risky speculative activities on the part of certain groups of people. In addition, the central bank plays a major role in stabilizing aggregate demand in the economy, especially during times of excess debt and sluggish economic growth. To perform these functions, the Federal Reserve System obtains interest from the commercial banking system, the balance of the monetary supply and tries to curb over-heaviness in the credit market.
A main function of monetary policy is to influence the structure of the money supply. Interest rates are established to keep the economy from becoming too dependent on debt. In this regard, low interest rates on loans are used to allow debt-financed goods and services to be purchased by firms without depleting the balance of the money supply. Thus, a higher level of inflation is avoided, as the aim is to make purchases possible for all segments of the population. On the other hand, changes in the level of money supply may lead to excessive asset and commodity price inflation.
In order to stabilize the level of the short-term real rates of interest, the base interest rate is normally decided by the central bank. Changes in the level of short-term interest rates can either bring about an improvement or deterioration of economic policies. When there is a rise in long-term interest rates, the tendency is for firms to borrow in order to purchase new assets that will provide them with increased income. Such actions to stimulate the economy, but they also have serious implications on the capacity of the country to finance its deficit, let alone stimulate growth.
In order to promote economic recovery and strengthen the economy against future downturns, central banks should set flexible monetary policy with three objectives in mind. First, inflation should be kept below the target level, with any increase coming under close supervision. Second, effective measures should be taken to reduce unemployment and increase job opportunities. Thirdly, flexibility should be allowed to ensure that the zero lower bound on interest rates is maintained. Monetary policy may thus help in achieving the objectives of the central government as stated in the economic strategy.
The flexibility provided by a monetary policy can be used effectively in different circumstances, such as when establishing or maintaining the exchange rate. In addition to these three objectives, the monetary policy can also be used to gain additional market share. In this context, a central bank can allow the economy to utilize base money that it already has in order to achieve the three objectives stated above. In addition to this, it can use special policy tools, which are designed to tighten the money policy's control over inflation, debt, and surplus.
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