Monetary Policy Explained Including Its Objectives,Types, and Tools

Six Ways to Legally Create Money Out of Thin Air

© The Balance, 2018

Monetary policy is how central banks manage liquidity to create economic growth. Liquidity is how much there is in the money supply. That includes credit, cash, checks, and money market mutual funds

The most important of these is credit. It includes loans, bonds, and mortgages. 

Objectives of Monetary Policy

The primary objective of central banks is to manage inflation. The second is to reduce unemployment, but only after they have controlled inflation. 

The U.S. Federal Reserve, like many other central banks, has specific targets for these objectives. It seeks an unemployment rate below 6.5 percent. The Fed says the natural rate of unemployment is between 4.7 percent and 5.8 percent. It wants the core inflation rate to be between 2 percent and 2.5 percent. It seeks healthy economic growth. That's a 2 to 3 percent annual increase in the nation's gross domestic product.

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They have many tools to do this. The most common are raising interest rates and selling securities through open market operations.

They use expansionary monetary policy to lower unemployment and avoid recession. They lower interest rates, buy securities from member banks, and use other tools to increase liquidity. 

Monetary Policy Versus 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. To put it bluntly, it’s about rewarding voters and campaign contributors. As a result, fiscal policy is usually expansionary. To avoid inflation in this situation, monetary policy must be restrictive.

Ironically, during the Great Recession, politicians became concerned about the U.S. debt. It exceeded the benchmark debt-to-GDP ratio of 100 percent. 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

Six Tools of Monetary Policy

All central banks have three tools of monetary policy in common. Most have many more. They all work together in an economy by managing bank reserves.

The Fed has six major tools. First, it sets a reserve requirement, which tells banks how much of their money they must have on reserve each night. If it weren't for the reserve requirement, banks would lend 100 percent of the money you've deposited. Not everyone needs all their money each day, so it is safe for the banks to lend most of it out.

The Fed requires that banks keep 10 percent of deposits on reserve. That way, they have enough cash on hand to meet most demands for redemption. When the Fed wants to restrict liquidity, it raises the reserve requirement. The Fed only does this as a last resort because it requires a lot of paperwork.

It's much easier to manage banks' reserves using the fed funds rate. This is the interest rate that banks charge each other to store their excess cash overnight. The target for this rate is set at the eight annual Federal Open Market Committee meetings. The Fed funds rate impacts all other interest rates, including bank loan rates and mortgage rates.

The Fed's third tool is its discount rate. That's how it charges banks to borrow funds from the Fed's fourth tool, the discount window. The FOMC sets the discount rate a half-point higher than the Fed funds rate. The Fed prefers banks to borrow from each other.

Fifth, the Fed uses open market operations to buy and sell Treasurys and other securities from its member banks. This changes the reserve amount that banks have on hand without changing the reserve requirement.

Sixth, many central banks including the Fed use inflation targeting. It clearly sets expectations that they want some inflation. The Fed’s inflation goal is 2 percent for the core inflation rate. People are more likely to buy if they know prices are rising.