How Monetary Policy Impacts the Economy
Frequently Asked Questions
What is monetary policy?
Monetary policy is a strategy that is used to adjust the money supply in an economy and how much it costs to borrow. A country’s central bank—like the Federal Reserve in the U.S.—may use monetary policy to lower interest rates, which then encourages consumers to spend more money on goods and services.
Who conducts monetary policy?
The Federal Open Market Committee (FOMC) conducts monetary policy in the U.S.. The FOMC is part of the Federal Reserve and it meets eight times per year to discuss the U.S. economy. The FOMC implements monetary policy to promote maximum employment, stable prices, and moderate interest rates over time.
What are the tools of monetary policy?
There are three tools commonly used to conduct monetary policy: reserve requirements, the discount rate, and open market operations. These tools then impact the federal funds rate which leads to changes in other interest rates. This may lower the cost of borrowing for individuals and businesses, which then increases money and credit in the economy, and can reduce unemployment and inflation.
What is the difference between monetary policy and fiscal policy?
Monetary policy is used to promote maximum employment, stable prices, and moderate long-term interest rates. Fiscal policy is what’s used to manage the tax and spending policies of the U.S. government. The Fed conducts monetary policy, while Congress and the administration determine fiscal policy decisions.
Contractionary Monetary Policy
Contractionary monetary policy is when a central bank uses its monetary policy tools to fight inflation. It's how the bank slows economic growth. Inflation is a sign of an overheated economy. It's also called a restrictive monetary policy because it restricts liquidity.
Open Market Operations
When the Federal Reserve buys or sells Treasury notes and other securities from its member banks, it's engaging in what's known as Open Market Operations (OMO). OMO serves as one of the major tools the Fed uses to raise or lower interest rates.
Expansionary Monetary Policy
Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. That increases the money supply, lowers interest rates, and increases demand. It boosts economic growth. It lowers the value of the currency, thereby decreasing the exchange rate. It is the opposite of contractionary monetary policy.
Quantitative Easing (QE)
Quantitative easing is a nontraditional technique used by the Federal Reserve to stimulate the economy in times of crisis. It increases the money supply and lowers long-term interest rates, making it easier for banks to lend. This in turn spurs economic growth.
Restrictive Monetary Policy
Restrictive monetary policy, also known as contractionary monetary policy, is how central banks constrict demand to slow economic growth and inflation. It's called restrictive because the banks restrict liquidity. It reduces the amount of money and credit that banks can lend, and lowers the money supply by making loans, credit cards, and mortgages more expensive
Deflation occurs when asset and consumer prices fall over time. While this may seem like a great thing for shoppers, the actual cause of widespread deflation is a long-term drop in demand.
Inflation reduces the purchasing power of each unit of currency, which leads to increases in the prices of goods and services over time. It's an economics term that means you have to spend more to fill your gas tank, buy a gallon of milk, or get a haircut. In other words, it increases your cost of living.
The reserve requirement is the total amount of funds a bank must have on hand each night. It is a percentage of the bank's deposits. The nation's central bank sets the percentage rate.
The U.S. money supply is all the physical cash in circulation throughout the nation, as well as the money held in checking accounts and savings accounts. It does not include other forms of wealth, such as long-term investments, home equity, or physical assets that must be sold to convert to cash. It also does not include various forms of credit, such as loans, mortgages, and credit cards.
The Beige Book is a Federal Reserve survey of the nation's economic conditions. Each of its 12 banking districts discuss how fast the economy is growing in their areas. That includes how difficult or easy it is to hire. It also addresses the general pace of business activity.