Monetary Policy Meaning, Types, and Tools

What Is Monetary Policy?

Monetary policy is a set of instruments used by a nation's central bank to control the overall money supply, promote economic development, and implement strategies such as adjusting interest rates and bank reserve requirements.

In the United States, the Federal Reserve Bank implements monetary policy with the dual objectives of maximizing employment and controlling inflation.

KEY TAKEAWAYS

• Monetary policy is a set of actions to control a nation's overall money supply and achieve economic growth.
• Monetary policy strategies include revising interest rates and changing bank reserve requirements.
• Monetary policy is commonly classified as either expansionary or contractionary.
• The Federal Reserve typically employs three monetary policy strategies, including reserve requirements, the discount rate, and open market operations.

Understanding Monetary Policy

The management of an economy's money supply and the mechanisms through which new currency enters circulation constitute monetary policy.

Monetary policy is influenced by indicators in the economy, such as GDP, inflation, and industry and sector growth rates.

The interest rate at which a central bank lends money to commercial banks in a country is subject to change. Rates for consumers like businesses and homebuyers are adjusted by financial institutions as rates rise and fall.

It also has the power to buy and sell government bonds, manipulate foreign exchange rates, and adjust the reserve requirements for financial institutions.

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

The goal of a contractionary policy is to impede economic development and minimize inflation, which is the process by which rising prices for goods and services in an economy erode the purchasing power of money. A contractionary policy will increase interest rates and limit the outstanding money supply.

Expansionary

A policy that is expansionary will increase economic activity even when it is occurring during a period of slowness or recession. When interest rates are lowered, saving loses some of its appeal, which leads to a rise in consumer spending as well as borrowing.

Goals of Monetary Policy

Inflation

The goal of a contractionary monetary policy is to reduce the money supply and hence slow the rate of inflation. Inflationary pressures are encouraged and the money supply is boosted by an expansionary monetary policy.

Unemployment

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

Exchange Rates

Monetary policy has an impact on the value of one currency relative to another. When the money supply rises, the value of the home currency rises relative to other currencies.

Tools of Monetary Policy

Open Market Operations

In order to affect the total quantity of outstanding government securities and the amount of money accessible to the economy as a whole, the Federal Reserve Bank engages in open market operations (OMO), in which it either buys bonds from investors or sells extra bonds to investors.

The goal of open market operations (OMOs) is to manipulate short-term interest rates, which in turn affects other interest rates, by adjusting the level of reserve balances.

Interest Rates

The central bank has the authority to alter interest rates and collateral standards at any time. This rate is referred to as the discount rate in the United States. Depending on the interest rate, banks will be more or less willing to make loans.

Reserve Requirements

Authorities can manipulate the reserve requirements, 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 loans or buy other assets. Increasing the requirement curtails bank lending and slows growth.

Monetary Policy vs. Fiscal Policy

The goal of monetary policy implemented by a central bank is to keep unemployment at manageable levels, preserve the purchasing power of the currency, and promote sustainable economic growth. A central bank can influence the levels of borrowing, spending, and savings by adjusting interest rates, reserve requirements, or conducting open market operations.

Governments, not central banks, can also employ fiscal policy. The Federal Reserve can affect the money supply, but the United States Treasury can issue new currency and alter tax policies. It injects funds into the economy, either immediately or indirectly, to boost consumption and productivity.

The government and the Federal Reserve initiated a series of coordinated policies using both monetary and fiscal tools in response to the COVID-19 pandemic.

How Often Does Monetary Policy Change?

The Federal Reserve's Open Market Committee convenes eight times a year to discuss potential alterations to the country's monetary policy. As seen during the 2007–2008 financial crisis and the COVID-19 epidemic, the Federal Reserve is also able to act in an emergency.

How Has Monetary Policy Been Used to Curb Inflation In the United States?

A contractionary strategy may limit economic growth and even cause a rise in unemployment, but it is sometimes considered as necessary to level the economy and keep prices under control. The Federal Reserve hiked the benchmark interest rate to 20% in the 1980s, when the country was experiencing double-digit inflation. Inflation was brought down to a range of 3% to 4% during the course of the subsequent years, despite the fact that the effect of high rates caused a recession.

Why Is the Federal Reserve Called a Lender of Last Resort?

The Federal Reserve acts as a lender of last resort by providing liquidity to banks and overseeing their operations closely so that failure on their part does not trigger a financial panic.

The Bottom Line

Monetary policy refers to the use of various instruments by central bankers in an effort to maintain economic stability while simultaneously controlling inflation and unemployment levels. An economy that is contracting can benefit from expansionary monetary policy, whereas an inflationary economy could benefit more from contractionary monetary policy. The fiscal policy of a nation and its monetary policy are frequently coordinated with one another.

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