Monetary policy is based on the relationship between money supply and interest rates, where the interest rate is essentially the price of money. The two variables have an inverse relationship. As a result, as the money supply in an economy is increased, the interest rate will generally decrease and if the money supply is contracted, interest rates will generally increase .
Relationship between money supply and interest rates
As money supply increases, the interest rate decreases, as depicted in the graph above.
The money supply is a monetary policy mechanism available to a central bank as part of its mandate to promote economic growth and maintain full employment. Central banks use monetary policy to stabilize the economy; during periods of economic slowing central banks initiate expansionary policy, whereby the bank increases the money supply in order to lower prevailing interest rates. As the cost of money falls the demand for funds increases, thereby expanding consumer and investment spending and promoting economic growth.
Expansionary policy
An active expansionary policy increases the size of the money supply, decreasing the interest rate. Central banks can increase the money supply through open market operations and changes in the reserve requirement.
Bank reserves
Banks and other depository institutions are required to keep a certain amount of funds in reserve in order to maintain enough liquidity to meet unexpected demand for deposits. Banks can keep these reserves as cash in their vaults or as deposits with the Federal Reserve (the Fed). By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.
In an expansionary policy regime, the Fed would reduce the reserve requirement. Banks would be able to issue more loans with the same reserves, thereby increasing the supply of money and the level of economic activity and investment.
Federal Funds market
From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.
The interest rate on the overnight borrowing of reserves is called the Federal Funds rate or simply the "fed funds rate." It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.
At a lower fed funds rate, banks are more likely to increase loans, thereby expanding investment activity (in factories, for example, not financial instruments) and promoting economic growth.
Expansionary monetary policy will seek to reduce the fed funds target rate (a range). The Fed does not control this rate directly but does control the interest rate indirectly through open market operations.
Open market operations
The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.
In an expansionary policy regime, the Fed purchases government securities from a bank in exchange for cash. Payment for the bonds increases the bank's reserves. As a result, the bank may have more reserves than required. The bank can lend these unneeded reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increased the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) falls.