Monetary policy is a central bank's actions and communications that manage the money supply. Central banks use monetary policy to prevent inflation, reduce unemployment, and promote moderate long-term interest rates.
Learn more about how monetary policy affects the economy, how it relates to fiscal policy, and which tools central banks use to manage it.
Definitions and Examples of Monetary Policy
Monetary policy increases liquidity to create economic growth. It reduces liquidity to prevent inflation. Central banks use interest rates, bank reserve requirements, and the number of government bonds that banks must hold. All these tools affect how much banks can lend. The volume of loans affects the money supply.
The money supply includes forms of credit, cash, checks, and money market mutual funds. The most important of these forms of money is credit. Credit includes loans, bonds, and mortgages.
In a recession, central banks might combat high unemployment by giving banks more money. Banks in turn lower interest rates, which allows businesses to hire more employees. This is an example of expansionary monetary policy.
How Does Monetary Policy Work?
Central banks have three monetary policy objectives. The most important is to manage inflation. The secondary objective is to reduce unemployment, but only after controlling inflation. The third objective is to promote moderate long-term interest rates.
The U.S. Federal Reserve, like many other central banks, has specific targets for these objectives. It wants the core inflation rate to be around 2%. Beyond that, it prefers a natural rate of unemployment of between 3.5% and 4.5%.
The Fed's overall goal is healthy economic growth. That's a 2% to 3% annual increase in the nation's gross domestic product.
Types of Monetary Policy
Central banks use contractionary monetary policy to reduce inflation. They reduce the money supply by restricting the volume of money banks can lend. The banks charge a higher interest rate, making loans more expensive. Fewer businesses and individuals borrow, slowing growth.
Central banks use expansionary monetary policy to lower unemployment and avoid recession. They increase liquidity by giving banks more money to lend. Banks lower interest rates, making loans cheaper. Businesses borrow more to buy equipment, hire employees, and expand their operations. Individuals borrow more to buy more homes, cars, and appliances. That increases demand and spurs economic growth.
Monetary Policy vs. Fiscal Policy
Ideally, monetary policy should work hand-in-glove with the national government's fiscal policy. It rarely works this way. Government leaders get re-elected for reducing taxes or increasing spending. As a result, they adopt an expansionary fiscal policy. To avoid inflation in this situation, the Fed is forced to use a restrictive monetary policy.
For example, after the Great Recession, Republicans in Congress became concerned about the U.S. debt. It exceeded the debt-to-GDP ratio of 100%. As a result, fiscal policy became contractionary just when it needed to be expansionary. To compensate, the Fed injected massive amounts of money into the economy with quantitative easing.
Monetary Policy Tools
All central banks have three tools of monetary policy in common.
Open Market Operations
Central banks all use open market operations (OMO). With OMO, the central bank can create new money by buying government securities, such as Treasury bonds, and issuing new money. The central bank can likewise contract the money supply by selling those securities from its balance sheet and removing the money received from circulation.
The Reserve Requirement
The reserve requirement is when the central banks tell their members how much money they must keep on reserve each night. Not everyone needs all their money each day, so it is safe for the banks to lend most of it out. That way, they have enough cash on hand to meet most demands for redemption. Previously, this reserve requirement has been 10%. However, effective March 26, 2020, the Fed has reduced the reserve requirement to zero.
When a central bank wants to restrict liquidity, it raises the reserve requirement. That gives banks less money to lend. When it wants to expand liquidity, it lowers the requirement. That gives members banks more money to lend. Central banks rarely change the reserve requirement because it requires a lot of paperwork for the members.
The Discount Rate
The discount rate is how much a central bank charges members to borrow funds from its discount window. It raises the discount rate to discourage banks from borrowing. That action reduces liquidity and slows the economy. By lowering the discount rate, it encourages borrowing. That increases liquidity and boosts growth.
In the United States, the Federal Open Market Committee typically sets the discount rate higher than the federal funds rate. The Fed prefers banks to borrow from each other.
Most central banks have many more tools that work together to manage bank reserves.
The Fed has two other major tools it can use. It is most well-known is the Fed funds rate. This rate is the interest rate that banks charge each other to store their excess cash overnight. The target for this rate is set at the FOMC meetings. The fed funds rate impacts all other interest rates, including bank loan rates and mortgage rates.
The Fed, as well as many other central banks, also use inflation targeting. It sets expectations that the banks want some inflation. The Fed’s inflation goal is 2% for the core inflation rate. That encourages people to stock up now since they know prices are rising later. It stimulates demand and economic growth.
When inflation is lower than the core, the Fed is likely to lower the fed funds rate. When inflation is at the target or above, the Fed will raise its rate.
The Federal Reserve created many new tools to deal with the 2008 financial crisis. These included the Commercial Paper Funding Facility and the Term Auction Lending Facility. It stopped using most of them once the crisis ended.
- The Federal Reserve uses monetary policy to manage economic growth, unemployment, and inflation.
- It does this to influence production, prices, demand, and employment.
- Expansionary monetary policy increases the growth of the economy, while contractionary policy slows economic growth.
- The three objectives of monetary policy are controlling inflation, managing employment levels, and maintaining long-term interest rates.
- The Fed implements monetary policy through open market operations, reserve requirements, discount rates, the federal funds rate, and inflation targeting.