Monetary Policy: Meaning, Types, and Tools

What Is Monetary Policy?

Monetary policy is a set of tools used by a nation's central bank to control the overall money supply and promote economic growth.

It involves strategies such as adjusting interest rates and changing bank reserve requirements.

In the United States, the Federal Reserve Bank (Fed) implements monetary policy to meet its dual mandate from Congress: to achieve maximum employment while keeping inflation in check.

Understanding Monetary Policy

Monetary policy is the control of the quantity of money available in an economy and the channels by which new money is supplied.

Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry and sector-specific growth rates influence monetary policy strategy.

A central bank may revise the interest rates it charges to loan money to the nation's banks. As these rates rise or fall, financial institutions adjust their rates for their customers, such as businesses or home buyers.

This can either slow or encourage borrowing, spending, business activity, hiring, and economic growth. It can also affect the rate of inflation.

Additionally, a central bank may buy or sell government bonds, target foreign exchange rates, and revise the amount of cash that the banks are required to maintain as reserves.

Types of Monetary Policy

Monetary policies are seen as either expansionary or contractionary, depending on the level of growth or stagnation within the economy.

Contractionary

A contractionary policy increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money.

Expansionary

During times of slowdown or a recession, an expansionary policy supports economic activity. By lowering interest rates, saving becomes less attractive, business and consumer borrowing increases, as does business and consumer spending.

Goals of Monetary Policy

Inflation

Contractionary monetary policy is used to temper inflation by reducing the level of money circulating in the economy. Expansionary monetary policy increases the amount of money in circulation and fosters inflationary pressure due to greater economic activity.

Unemployment

An expansionary monetary policy decreases unemployment as a larger money supply and attractive interest rates stimulate business activities and expansion of the job market.

Exchange Rates

The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency can become less attractive and cheaper relative to other currencies.

Tools of Monetary Policy

Open Market Operations

In open market operations (OMO), the Fed buys bonds from investors or sells additional bonds to them to increase or reduce the money available to the economy as a whole.

The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates that affect other interest rates.

Interest Rates

The central bank may change interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate. It's the rate that the Fed charges financial institutions for loans it makes to them.

The level of the discount rate can affect other interest rates, such as those that banks charge customers for loans. Banks will loan more or less freely depending on the discount rate.

Reserve Requirements

A central bank can manipulate the reserve requirements, which govern the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities.

Lowering this reserve requirement releases more capital for the banks to offer as loans or with which to buy other assets. Increasing the requirement curtails bank lending and slows growth.

Monetary Policy vs. Fiscal Policy

Monetary policy is enacted by a central bank to sustain a level economy and keep unemployment low. It is intended to protect the value of the currency and maintain economic activity.

By manipulating interest rates or reserve requirements, or through open market operations, a central bank affects borrowing, spending, and savings rates.

Fiscal policy is an additional tool used by governments but not central banks. While the Federal Reserve can influence the economy through the money supply, and impact market sentiment, the U.S. Treasury Department can create new money and implement new tax policies.

In other words, fiscal policy involves government spending and taxing. It spends to add money, directly or indirectly, into the economy to increase business and consumer spending and spur growth.

Both monetary and fiscal policies were used in response to the COVID-19 pandemic.

Frequently Asked Questions (FAQs)

The Bottom Line

Monetary policy employs strategies and tools to keep a nation's economy stable while limiting inflation and unemployment.

Expansionary monetary policy stimulates a weakening economy, while contractionary monetary policy slows down an inflationary economy. A nation's monetary policy is often coordinated with its fiscal policy.