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 and employ strategies such as revising interest rates and changing bank reserve requirements.
In the United States, the Federal Reserve Bank implements monetary policy through a dual mandate to achieve maximum employment while keeping inflation in check.
Monetary Policy
Monetary policy refers to the management of a country’s money supply and interest rates by its central bank or monetary authority. The primary goal of monetary policy is to achieve and maintain price stability and promote sustainable economic growth. Central banks use various tools and techniques to influence the money supply, interest rates, and overall economic activity.
Key objectives of monetary policy include:
- Price Stability: Central banks aim to control inflation, which is the general rise in prices over time. Moderate inflation is often targeted as it can indicate a healthy economy, but high and volatile inflation can lead to economic instability.
- Full Employment: Monetary policy can also be used to stimulate economic growth and employment. By lowering interest rates and increasing the money supply, central banks can encourage borrowing and spending, which in turn can lead to increased economic activity and job creation.
- Economic Growth: Central banks can influence economic growth by adjusting interest rates. Lowering rates can encourage borrowing and spending, while raising rates can moderate borrowing and control inflation. The goal is to strike a balance that supports sustainable economic expansion.
- Stabilizing Financial Markets: Central banks monitor and respond to disruptions in financial markets to prevent financial crises. They might provide liquidity to banks and financial institutions during times of stress.
The central bank employs various tools to implement monetary policy:
- Open Market Operations: The central bank buys or sells government securities in the open market. Buying securities injects money into the economy, while selling them removes money. This affects the money supply and can influence interest rates.
- Interest Rate Policy: The central bank sets certain interest rates, such as the federal funds rate in the case of the U.S. Federal Reserve. By changing these rates, the central bank can influence borrowing costs for banks and consumers.
- Reserve Requirements: Central banks mandate that financial institutions hold a certain percentage of their deposits as reserves. By changing these requirements, the central bank can affect the amount of money banks can lend out.
- Discount Rate: The discount rate is the interest rate at which banks can borrow funds directly from the central bank. Changes in the discount rate can influence the cost of borrowing for banks and their willingness to lend.
- Forward Guidance: Central banks communicate their future policy intentions to guide market expectations. This can influence borrowing, spending, and investment decisions.
- Quantitative Easing (QE): In times of economic distress, central banks might implement QE, which involves purchasing a large amount of financial assets, often longer-term government bonds. This injects money into the economy and aims to lower long-term interest rates.
It’s important to note that the effectiveness of monetary policy can be influenced by various factors, including the overall economic environment, the structure of the financial system, and global economic conditions. Additionally, there are limitations to what monetary policy can achieve, especially if structural issues in the economy are not addressed through other means.
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 commonly uses three strategies for monetary policy including reserve requirements, the discount rate, and open market operations.
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 rates rise or fall, financial institutions adjust rates for their customers such as businesses or home buyers.
Additionally, it 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 grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase.
Goals of Monetary Policy
Inflation
Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation.
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
The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange.
Tools of Monetary Policy
Open Market Operations
In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and 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 and that affect other interest rates.1
Interest Rates
The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate. Banks will loan more or less freely depending on this interest rate.
The Federal Reserve commonly uses three strategies for monetary policy including reserve requirements, the discount rate, and open market operations.
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
Monetary policy is enacted by a central bank to sustain a level economy and keep unemployment low, protect the value of the currency, and maintain economic growth. 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 and not central banks. While the Federal Reserve can influence the supply of money in the economy and impact market sentiment, The U.S. Treasury Department can create new money and implement new tax policies. It sends money, directly or indirectly, into the economy to increase spending and spur growth.
Both monetary and fiscal tools were coordinated efforts in a series of government and Federal Reserve programs launched in response to the COVID-19 pandemic.2
How Often Does Monetary Policy Change?
The Federal Open Market Committee of the Federal Reserve meets eight times a year to determine changes to the nation’s monetary policies. The Federal Reserve may also act in an emergency as was evident during the 2007-2008 economic crisis and the COVID-19 pandemic.
How Has Monetary Policy Been Used to Curb Inflation In the United States?
A contractionary policy can slow economic growth and even increase unemployment but is often seen as necessary to level the economy and keep prices in check. During double-digit inflation in the 1980s, the Federal Reserve raised its benchmark interest rate to 20%. Though the effect of high rates spurred a recession, inflation was reduced to a range of 3% to 4% over the following years.3
Why Is the Federal Reserve Called a Lender of Last Resort?
The Fed also serves the role of lender of last resort, providing banks with liquidity and regulatory scrutiny to prevent them from failing and creating financial panic in the economy.4
The Bottom Line
Monetary policy employs tools used by central bankers to keep a nation’s economy stable while limiting inflation and unemployment. Expansionary monetary policy stimulates a receding economy and contractionary monetary policy slows down an inflationary economy. A nation’s monetary policy is often coordinated with its fiscal policy.