What Is Monetary Policy?

Why is monetary policy important?

A major factor in a nation’s economy is its monetary policy, which determines the amount of money circulating throughout the economy. In the United States, the Federal Reserve sets monetary policy, which influences economic activity by controlling the country’s money supply and credit. The Federal Reserve controls monetary policy by altering interest rates and changing the amount of money banks must have in their reserves.

The Federal Reserve Act of 1913 officially gave the Federal Reserve power over the country’s monetary policy. Since then, monetary policy’s importance has increased tremendously.

The goals of monetary policy, as stated in the Federal Reserve Act of 1913, are to encourage the following:

• Maximum employment
• Stabilized prices
• Moderate long-term interest rates

When implemented correctly, monetary policy stabilizes prices and wages, which, in turn, increases available jobs and long-term economic growth. U.S. monetary policy plays a significant role not only in the economy as a whole, but also in specific decisions consumers make, such as buying a home or car, starting and expanding a business, and investing money.

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) determine monetary policy. The key to setting monetary policy is finding the perfect balance. Letting the money supply grow too rapidly increases inflation, but allowing it to grow too slowly stunts economic growth.

What’s the difference between monetary policy and fiscal policy?

A common misconception about monetary policy is that it is the same as fiscal policy. 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.

The government uses fiscal policies to set a target for the country’s level of spending and to determine how money is being used in an economy. For example, if the government doesn’t see enough stimulus, it can encourage spending by increasing its own expenditures. Monetary policy, on the other hand, is mainly a tool for inflation and growth. It doesn’t have as large an impact on the economy as fiscal policy.

Fiscal policy affects consumers by influencing their tax bills or providing them with government employment. Monetary policy impacts consumers by creating a boost in spending and changing the interest rates for loans and credit cards. [Read related article: How to Accept Credit Cards at Your Business]

Types of monetary policy

There are two main kinds of monetary policy: contractionary and expansionary.

• Contractionary monetary policy: This type of policy is used to decrease the amount of money circulating throughout the economy, typically by selling government bonds, raising interest rates and increasing the reserve requirements for banks. The government uses this method when it wants to avoid inflation.
• Expansionary monetary policy: This type of monetary policy can increase the economy’s money supply through decreasing interest rates, lowering reserve requirements for banks and the purchase of government securities by central banks. This policy helps lower the unemployment rate as well as stimulate business activities and consumer spending. The overall goal of this policy is to fuel economic growth, but it can also have an adverse effect, occasionally leading to hyperinflation.

Tools of monetary policy

When setting monetary policy, the Federal Reserve has several tools at its disposal, including open market operations, the discount rate, reserve requirements and interest rates on excess reserves. The FOMC, which comprises 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

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 system.

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, whereas 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 short- and long-term interest rates, as well as foreign exchange rates.

Discount rate

Another tool the Federal Reserve uses in setting monetary policy is raising and lowering the discount rate, which is the rate the 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.

Reserve requirements

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. When the reserve requirement is lowered, there’s more capital for banks to gain assets. This increases the amount of loans available for consumers. When the reserve requirement is raised, the exact opposite effect occurs, and there are fewer loans and less capital to spend.

Interest rates on excess reserves

The fourth tool is not a traditional one, as it was created during the 2008 financial crisis when the amount of reserves in banks increased so much that it exceeded requirements. To mitigate this, the Federal Reserve began to pay interest on the excess. In times of financial crisis, the Federal Reserve will lower the excess reserve interest rates if it wants to increase lending and will raise rates to decrease lending.

What are the three objectives of monetary policy?

No matter what type of monetary policy is being used, it is always connected to one of the following three objectives.

• Managing inflation: Most economists consider this the one true objective of monetary policy. In general, low inflation is most conducive to a healthy, thriving economy. Therefore, when inflation is on the rise, the Federal Reserve may adjust monetary policy to reduce inflation.
• Reducing unemployment: During depressions and recessions, the unemployment rate tends to soar. However, monetary policy also plays a major role in the unemployment rate. Once the Federal Reserve addresses inflation issues, it can implement expansionary policies to help reduce the unemployment rate. The increase in the money supply stimulates the business sector, which also helps to create more jobs. While there may be no way to achieve true full employment, the goal is to reduce the rate of unemployment among those who are ready and willing to work for existing wages.
• Balancing currency exchange rates: Since stable exchange rates play a major role in international trade, it’s essential to find ways to keep them balanced. Central banks have the power to regulate exchange rates between foreign and domestic currencies. For instance, if the central bank opts to issue more currency to increase the money supply, domestic currencies become cheaper than foreign currencies.

How does monetary policy affect businesses?

Monetary policy has an indirect effect on businesses, mainly through interest rates. As the Federal Reserve changes the economy, banks will choose their interest rates for loans and credit cards. For example, low interest rates are seen as favorable changes since businesses have lower interest expenses and consumer spending increases. These changes can also influence stock prices, which can impact consumers’ comfort level when making purchases.

Changing interest rates may also alter exchange rates and can affect companies that outsource employees or work with businesses in other countries. When the rate is higher, the dollar is closer to the amount of other countries’ currencies. This lowers the import and export costs for businesses in the United States. Lower interest rates can decrease the exchange rate and create higher import and export costs.

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Monetary policy matters to small businesses

While small businesses can’t do much to control monetary policy, keeping track of the changes made to it can help entrepreneurs better plan for the future. Monetary policy can dictate whether it’s a good time to borrow and spend or whether saving money is better. It can also affect the labor market and help you decide when it’s the best time to bring on new talent. Small businesses cannot escape the economy, but they can learn to ride its ebbs and flows to grow and succeed. 

Tejas Vemparala contributed to this article.