Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and foster economic growth. Employing strategies like revising interest rates and adjusting bank reserve requirements, these policies aim to retain economic harmony.
In the United States, the Federal Reserve Bank implements monetary policy with the dual mandate of achieving maximum employment and maintaining inflation within reasonable bounds.
Key Takeaways
- Monetary policy uses tools to manage a nation’s money supply to stimulate economic growth.
- Strategies include adjusting interest rates and altering reserve bank requirements.
- Monetary policy types are categorized as either expansionary or contractionary.
- Three primary tools used by the Federal Reserve include reserve requirements, discount rate adjustments, and open market operations.
Embracing Monetary Policy
Monetary policy is all about controlling the money quantity available in an economy and determining the mechanisms by which new money enters the supply. Economic indicators like Gross Domestic Product (GDP), inflation rates, and industry-specific growth rates play pivotal roles in shaping monetary policy strategies.
A central bank may revise the interest rates it handles banks, influencing how these banks fix rates for businesses and home buyers. Moreover, it might buy or sell government bonds, target foreign exchange rates, or adjust the required reserves for banks.
Types of Monetary Policy
Monetary policies can be classified based on the economy’s performance: expansionary for boosting growth or contractionary for subduing inflation.
Contractionary
A contractionary policy escalates interest rates and restrains the money supply to slow growth, aiming to curb inflation—thus maintaining the purchasing power of money.
Expansionary
In times of recession or economic slowdown, an expansionary policy endeavors to stimulate economic activity. Lowering interest rates makes saving less appealing, thereby encouraging consumer spending and borrowing.
Goals of Monetary Policy
Inflation Control
Contractionary Monetary Policy: Prevents rising inflation and reduces excess money in circulation.
Expansionary Monetary Policy: It creates inflationary pressure by increasing the money supply.
Unemployment Reduction
An expansionary monetary policy reduces unemployment by stimulating business activities via increased money supply and favorable interest rates, thereby expanding the job market.
Exchange Rate Stability
Monetary policy influences the exchange rates between domestic and foreign currencies. A higher money supply generally results in a cheaper domestic currency compared to its foreign counterparts.
Tools of Monetary Policy
Open Market Operations
Open Market Operations (OMO) involve the Federal Reserve buying or selling government securities from/to investors to modify the amount of outstanding money and government securities available in the economy. This strategy targets short-term interest rates which, in turn, affect other key rates.
Interest Rates
The central bank can adjust interest rates or demand higher collateral for security (in the U.S., this is the discount rate). Depending on these rates, banks are more or less willing to issue loans.
Reserve Requirements
Authorities may tweak the reserve requirements, which are the funds banks must retain relative to their customer deposits. A lower requirement enables banks to offer more loans, while a higher mandate restrains lending, thus slowing economic growth.
Monetary Policy vs. Fiscal Policy
Monetary policy, managed by the central bank, seeks to maintain economic stability by regulating money supply, interest rates, and reserve requirements—thereby impacting borrowing, spending, and saving behaviors. On the other hand, fiscal policy is a governmental process involving tax policy and expenditure adjustments, often executed by the Treasury Department.
Both policies work in tandem, as seen during responses to crises like the COVID-19 pandemic.
Frequency of Monetary Policy Changes
The Federal Open Market Committee meets eight times annually to discuss monetary policy shifts. In emergency situations, as witnessed during the 2007-2008 economic meltdown and the COVID-19 pandemic, the committee may convene special sessions.
Historical Impact: Curbing Inflation in the U.S.
A contractionary policy, though sometimes leading to higher unemployment and slower economic growth, is crucial for maintaining price stability. For instance, during the high inflation period of the 1980s, the Federal Reserve increased its benchmark interest rate to 20%, curbing inflation to about 3-4% over subsequent years, despite the accompanying recession.
The Federal Reserve: Lender of Last Resort
Acting as the lender of last resort, the Federal Reserve steps in to provide liquidity and regulatory oversight, aiming to prevent bank failures and avert financial turmoil.
The Bottom Line
Monetary policy is crucial for economic stability, involving strategies employed by central banks to moderate inflation and unemployment. Whether stimulating a flagging economy or cooling an overheating one, the central bank’s interventions—aligned with fiscal policy—play fundamental roles in guiding a nation’s economic trajectory.
Related Terms: Fiscal Policy, Central Bank, Economic Growth, Inflation, Federal Reserve.
References
- Federal Reserve Board. “Monetary Policy Principles and Practice”.
- Federal Reserve Bank of St. Louis. “Expansionary and Contractionary Monetary Policy”.
- Federal Reserve Board. “Open Market Operations”.
- Federal Reserve Board. “The Discount Window and Discount Rate”.
- Federal Reserve Board. “FAQs: What Is the Difference Between Monetary Policy and Fiscal Policy, and How are They Related?”
- U.S. Department of the Treasury. “Role of the Treasury”.
- Federal Reserve Board. “Coronavirus Disease 2019 (COVID-19)”.
- Federal Reserve Board. “Federal Open Market Committee: About the FOMC”.
- U.S. National Library of Medicine National Institutes of Health. “Modeling U.S. Monetary Policy During the Global Financial Crisis and Lessons for COVID-19”.
- Boston University. “The Incredible Volcker Disinflation”.
- Federal Reserve Board. “Speech: The Lender of Last Resort Function in the United States”.
