What is Monetary Policy? Credit: Gts | Shutterstock

A major factor that can affect the direction of a nation's economy is its monetary policy, which determines the amount of money flowing through the economy.

Set by the Federal Reserve in the United States, monetary policy influences economic activity by controlling the country's money supply and credit. The Federal Reserve is able to control monetary policy by altering rates of interest and changing the amount of money banks must have in their reserves. The Federal Reserve Act of 1913 officially gave the Federal Reserve the power over the country's monetary policy. Since then, the monetary policy has increased tremendously in importance.

The goals of monetary policy, as stated in the Federal Reserve Act of 1913, are to encourage maximum employment, stabilize prices and moderate long-term interest rates. When implemented correctly, monetary policy stabilizes prices and wages, which in turn leads to an increase in jobs and long-term economic growth. U.S. monetary policy plays a significant role not just in the economy as a whole, but in specific decisions consumers make, such as buying house and cars, starting and expanding businesses and deciding to invest money.

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) determine monetary policy. The key in setting monetary policy is finding the perfect balance, since letting the money supply grow too rapidly increases inflation, but allowing it to grow too slowly stunts economic growth. A common misperception about monetary policy is that it is the same thing as fiscal policy. However, while both can be used to influence the economy, the federal government, as opposed to a central bank like the Federal Reserve, sets fiscal policy.  Fiscal policy refers to the tax and spending policies of the federal government.

Tools of monetary policy

When setting monetary policy, the Federal Reserve has several tools at is disposal, including open market operations, the discount rate and reserve requirements. The FOMC, which comprises the members of the Board of Governors of the Federal Reserve System and five Reserve Bank presidents, is responsible for open market operations, while the Board of Governors sets the discount rates and reserve requirements.

Open market operations, the most flexible and commonly used way of implementing monetary policy, revolve around the buying and selling of government securities on the open market. Open market operations expand or contract the amount of money in the U.S banking systems. Adjusting the amount of money in the banking system alters the federal funds rate, which is how much it costs banks to borrow money from each other. A low federal funds rate stimulates the economy by encouraging consumer spending through lower interest rates, while a high federal funds rate slows the economy by raising interest rates and discouraging consumers from spending. Changes in the federal funds rate can affect a wide range of economic conditions, including both short- and long-term interest rates and foreign exchange rates.

Another tool the Federal Reserve uses in setting monetary policy is raising and lowering the discount rate, which is the rate a Federal Reserve Bank charges other banks to borrow money on a short-term basis. Higher discount rates signify a more restrictive policy, while lower rates signal a more expansive policy.

The third tool used is the reserve requirement, which is the amount of cash all commercial banks, savings banks, savings and loans, credit unions and U.S. branches and agencies of foreign banks must have on hand or as reserve account balances at a Reserve Bank.

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