What Is Monetary Policy?

Monetary Policy

Monetary policy is the underpinning of any nation’s economy and its impact affects everyone, from large corporations to consumers. It’s one of the components in the Federal Reserve’s toolbox. While there are many interpretations, monetary policy simply comes down to moderating the supply of money to stabilize prices and achieve the desired inflation rate.

Learn what monetary policy is, how it works, its objectives, and the types of monetary policy.

What Is Monetary Policy?

Monetary policy is a set of decisions and actions central banks use to control the supply of money in a country’s economy. With the help of monetary policy, a central bank may increase or decrease the amount of money in circulation, depending on the goals they are looking to achieve.

In the United States, the Federal Reserve is responsible for influencing the money supply in the economy. Money supply is usually in forms such as cash, credit (loans and bonds), checks, and market mutual funds.

The goals of monetary policy are to stabilize prices, achieve maximum employment, and maintain a stable economic growth rate. For example, in a recession, the central bank could apply an expansionary monetary policy to lower the rate of unemployment. This would involve giving banks more money, and the banks will then reduce interest rates, which will enable businesses to hire more people.

How Does Monetary Policy Work?

Monetary policy controls the amount of money available to the country’s banks, its people, and its businesses.

By managing the amount of cash in the economy, central banks can impact the macroeconomic space, which involves elements like inflation, economic growth, and employment.

Besides adjusting interest rates, the central bank can modify the amount of money banks need to hold as reserves, buy or sell government bonds, and more. 

Types of Monetary Policy

Monetary policy can be classified into two components: expansionary and contractionary.

Expansionary Monetary Policy

The expansionary monetary policy aims to increase economic activity and boost economic growth. It is therefore applicable whenever a country needs to combat unemployment. This may occur due to a recession.

Central banks give commercial banks more money to lend as part of the expansionary monetary policy. As a result of increased liquidity, banks lower interest rates. Businesses can then borrow more to expand their operations and hire employees. Consumers also borrow more to buy property and possessions. This increase in demand usually promotes economic growth.

Since the financial crisis that occurred in 2008, most of the top economies globally have applied expansionary policies to maintain low interest rates. 

Contractionary Monetary Policy

The contractionary monetary policy hikes interest rates, which helps reduce the money supply by limiting the amount of money banks can offer their borrowers.

Although the contractionary monetary policy slows down the growth of the economy, it’s necessary to help curb inflation and balance the economy.

Monetary Policy vs. Fiscal Policy

A country has two tools, namely, monetary policy and fiscal policy, which it can use to influence and regulate the economy. Monetary policy is concerned with controlling interest rates and managing the supply of money, whereas fiscal policy involves taxation and government spending.

The government uses fiscal policy to stimulate the economy by cutting taxes and increasing spending. Fiscal policy is categorized into expansionary and contractionary fiscal policy. Expansionary fiscal policy is used whenever there’s a need to put more money into the economy and promote its growth. The latter, on the other hand, is used to slow down economic booms, lest they become a problem.

While the monetary policy is enacted by the central bank, the fiscal policy is enacted by the government. However, both should work hand in glove to help achieve the best result for the economy. 

Tools of Monetary Policy

Here are monetary tools central banks can use to maintain healthy economic growth.

Discount Rate

The discount rate is the interest rate central banks charge on loans to commercial banks or financial institutions. The Fed’s borrowing rate is usually higher, therefore banks only make these kinds of loans if they can’t secure funds from other banks. Banks can lend more or less depending on the level of the discount rate.

Reserve Requirements

Banks must have a given amount of funds on hand at any time. The reserves can be secured in the bank’s vaults or at the central bank to ensure they are available whenever customers need them. Lowering reserve requirements encourages banks to lend out more money.

On the other hand, high reserve requirements curtail bank lending. This can be especially tough for small banks since they usually have little money to lend. In most cases, the reserve requirements do not apply to small banks.

Open Market Operations

Central banks buy and sell securities such as bonds in the open market. These securities are either bought from or sold to banks. By buying back securities, the central bank increases the supply of money, whereas selling securities reduces the amount of money in circulation.

Public Announcements

Central banks may announce possible future actions to the general public. These announcements may influence the markets as well as the economy.

What Are the Objectives of Monetary Policy?

The main aim of monetary policy is to manage unemployment and inflation.

Unemployment

Monetary policies have an impact on the level of unemployment in a country. Expansionary monetary policy helps tackle unemployment, as it increases the amount of money in the economy. An increase in money supply stimulates business activities, and in this case, businesses hire more people.

Inflation

Monetary policy can be used to maintain healthy levels of inflation. A contractionary monetary policy helps lower inflation.

Exchange Stability

A central bank may regulate exchange rates between the domestic currency and other foreign currencies. If a central bank wants to make its currency cheaper, it increases the supply of money.

How Are Policy Decisions Made?

Different factors are considered while formulating monetary policy. The monetary authority may study macroeconomic components such as industry growth rates, growth domestic product (GDP), and inflation. Additionally, geopolitical events such as trade tariffs are also monitored.

The Bottom Line

Central banks use monetary policy to manage inflation, unemployment, and economic growth. The expansionary monetary policy boosts economic growth, whereas the contractionary monetary policy helps slow down the growth of the economy. Finally, monetary policy can be implemented through discount rates, reserve requirements, open market operations, and public announcements.  

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