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What Is Monetary Policy?

Sean Peek
Sean Peek

Monetary policy determines the amount of money that flows through the economy.

  • A nation's monetary policy has a major impact on its economy.
  • The U.S. Federal Reserve works to stabilize prices and wages to increase job growth, which impacts the United States' long-term economic growth.
  • Monetary policy has an indirect impact on businesses, primarily through interest rates.
  • This article is for professionals and entrepreneurs who want to better understand monetary policy and the U.S. Federal Reserve.

A major factor in 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 U.S. Federal Reserve can 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 power over the country's monetary policy. Since then, the importance of monetary policy has increased tremendously.

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

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

When implemented correctly, monetary policy stabilizes prices and wages, which leads to an increase in jobs and long-term economic growth. U.S. monetary policy plays a significant role in not just the economy as a whole but also specific decisions consumers make, such as buying a home or a car, starting or 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 monetary policy is finding the perfect balance; letting the money supply grow too rapidly increases inflation, and allowing it to grow too slowly stunts economic growth.

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

A common misperception about monetary policy is that it is the same as fiscal policy. While both can influence the economy, the federal government, as opposed to a central bank like the Federal Reserve, sets fiscal policy.

Fiscal policy comprises the tax and spending policies of the federal government. The government uses fiscal policies to set a target for spending levels and to determine how money is being spent in the economy. For example, if the government doesn't see enough stimulus within the economy, it can stoke stimulus spending by increasing how much it spends.

Monetary policy, on the other hand, is mainly a tool for inflation and growth. Additionally, monetary policy 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 affects consumers by creating a boost in spending and changing the interest for loan rates and credit cards.

Key TakeawayKey takeaway: The federal government sets fiscal policy, which encompasses all its tax and spending policies. The U.S. Federal Reserve is responsible for monetary policy, which is more a tool for inflation and growth.

Types of monetary policy

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

  • Contractionary monetary policy: This purpose of this type of policy is to decrease the amount of money circulating throughout the economy. It is most often achieved through actions such as selling government bonds, raising interest rates and increasing the reserve requirements for banks. This method is used when the government wants to avoid inflation.
  • Expansionary monetary policy: The purpose of this type of monetary policy is to increase the money supply within the economy by completing actions such as decreasing interest rates, lowering reserve requirements for banks and purchasing government securities by central banks. This type of policy helps to lower unemployment rates 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.

Key TakeawayKey takeaway: Monetary policies can either increase or decrease the money supply circulating within the economy, which in turn influences dollar value and interest rates.

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 common 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, 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.

Discount rate

Another tactic 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 is the reserve requirement, which is the amount of cash all commercial banks, savings and loan institutions, credit unions, and U.S. branches and agencies of foreign banks must have on hand or as reserve account balances at a Federal Reserve Bank. When the reserve requirement is lowered, more capital is available for banks to gain assets, increasing the loans available for consumers. When the reserve requirement is raised, it has the opposite effect – 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. There was such a large amount of reserves that it was over the requirements. To mitigate this, the Federal Reserve began to pay interest on these excess reserves. In financial times of crisis, the Federal Reserve will lower the excess reserve interest rates to increase lending and raise the rates to decrease lending.

3 objectives of monetary policy

No matter what type of monetary policy is used, it is always connected to one of these three objectives:

  • Manage 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.
  • Reduce unemployment. During depressions and recessions, unemployment rates tend to soar. However, monetary policies also play a major role in unemployment rates. Once inflation issues have been addressed, expansionary policies can be implemented to reduce unemployment rates. This works because 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 universal employment, the goal is to reduce the rate of unemployment among those who are ready and willing to work for the existing wages.
  • Balance currency exchange rates. Given that stable exchange rates play such a major role in international trade, it's essential to keep them balanced. Central banks have the power to regulate exchange rates between foreign and domestic currencies. For instance, if the central bank issues 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. Low interest rates are seen as one of the favorable changes, resulting in lower interest expenses for businesses and increases in consumer spending. These changes can also influence stock prices, which in turn can affect how much the consumer is comfortable spending.

Changing interest rates may also alter exchange rates, affecting businesses that outsource to or work with businesses in other countries. When the rate is higher, the dollar is closer to the amount of other countries' currencies, which then lowers the import and export costs for businesses in the U.S. Lower interest rates can lower the exchange rate and create higher import and export costs.

Image Credit: ipopba / Getty Images
Sean Peek
Sean Peek
Business News Daily Contributing Writer
Sean Peek has written more than 100 B2B-focused articles on various subjects including business technology, marketing and business finance. In addition to researching trends, reviewing products and writing articles that help small business owners, Sean runs a content marketing agency that creates high-quality editorial content for both B2B and B2C businesses.