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.

The Federal Reserve implements monetary policy in the United States 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 change the rates it charges when it lends to the country’s banks. As these rates rise or fall, financial institutions adjust their rates for their customers, such as businesses or home buyers.

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

A central bank may also buy or sell government bonds, target foreign exchange rates, and revise the amount of cash that the banks must keep 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 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 reducing the purchasing power of money.

Expansionary

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

Goals of Monetary Policy

Inflation

Contractionary monetary policy can temper inflation by reducing the level of money circulating in the economy. Expansionary monetary policy increases the 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 increase or reduce the money available to the economy as a whole.

The objective is to adjust 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 change reserve requirements, which are the amounts banks must keep as a percentage of customer deposits to make sure they can pay 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 meant for economic stability and to keep unemployment low. The goal is 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 a tool used by governments, not central banks. While the Fed can influence the economy through the money supply and impact market sentiment, the Treasury Department can create new money and implement new tax policies.

In other words, fiscal policy involves government spending and taxation. 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.