What Is Monetary Policy?
Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.
The U.S. Treasury Department has the ability to create money, but the Federal Reserve influences the supply of money in the economy, largely through open market operations (OMO). Essentially, this means buying financial securities when easing monetary policy and selling financial securities when tightening monetary policy. The Fed's preferred securities for OMO are U.S. Treasuries and agency mortgage-backed securities.
The goal is to keep the economy humming along at a rate that is neither too hot nor too cold. The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending.
The main weapon at its disposal is the nation's money. The central bank sets the rates it charges to loan money to the nation's banks. When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages.
All of those customers are rate-sensitive. They're more likely to borrow when rates are low and put off borrowing when rates are high.
- Monetary policy is a set of actions that can be undertaken by a nation's central bank to control the overall money supply and achieve sustainable economic growth.
- Monetary policy can be broadly classified as either expansionary or contractionary.
- Some of the available tools include revising interest rates up or down, directly lending cash to banks, and changing bank reserve requirements.
Understanding Monetary Policy
Monetary policy is the control of the quantity of money available in an economy and the channels by which new money is supplied.
By managing the money supply, a central bank aims to influence macroeconomic factors including inflation, the rate of consumption, economic growth, and overall liquidity.
In addition to modifying the interest rate, a central bank may buy or sell government bonds, regulate foreign exchange (forex) rates, and revise the amount of cash that the banks are required to maintain as reserves.
Economists, analysts, and investors eagerly await monetary policy decisions and even the minutes of meetings in which they are discussed. This is news that has a long-lasting impact on the overall economy as well as on specific industry sectors and markets.
What Goes Into Policy Decisions
Monetary policy is formulated based on inputs from a variety of sources. The monetary authority may look at macroeconomic numbers such as gross domestic product (GDP) and inflation, industry and sector-specific growth rates, and associated figures.
Geopolitical developments are monitored. Oil embargos or the imposition (or lifting) of trade tariffs are examples of actions that can have a far-reaching impact.
The central bank may also consider concerns raised by groups representing specific industries and businesses, survey results from private organizations, and inputs from other government agencies.
Monetary authorities are typically given broad policy mandates to achieve a stable rise in gross domestic product (GDP), keep unemployment low, and maintain foreign exchange (forex) and inflation rates in a predictable range.
In addition to monetary policy, fiscal policy is an economic tool. A government may increase its borrowing and its spending in order to spur economic growth. Both monetary and fiscal tools were used lavishly in a series of government and Federal Reserve programs launched in response to the COVID-19 pandemic.
The Federal Reserve Bank is in charge of monetary policy in the U.S. The Federal Reserve (Fed) has what is commonly referred to as a dual mandate: to achieve maximum employment while keeping inflation in check.
That means it is the Fed's responsibility to balance economic growth and inflation. In addition, it aims to keep long-term interest rates relatively low.
Types of Monetary Policies
Broadly speaking, monetary policies can be categorized as either expansionary or contractionary:
Expansionary Monetary Policy
If a country is facing high unemployment due to a slowdown or a recession, the monetary authority can opt for an expansionary policy aimed at increasing economic growth and expanding economic activity.
As a part of expansionary policy, the monetary authority often lowers the interest rates in order to promote spending money and make saving it unattractive.
Increased money supply in the market aims to boost investment and consumer spending. Lower interest rates mean that businesses and individuals can get loans on favorable terms.
Many leading economies around the world have held onto this expansionary approach since the 2008 financial crisis, keeping interest rates at zero or near zero.
Contractionary Monetary Policy
A contractionary monetary policy increases interest rates in order to slow the growth of the money supply and bring down inflation.
This can slow economic growth and even increase unemployment but is often seen as necessary to cool down the economy and keep prices in check.
In the early 1980s with inflation hovering in the double digits, the Fed raised its benchmark interest rate to a record 20%. Though the high rates caused a recession, it managed to bring inflation back to the desired range of 3% to 4% over the next few years.
Tools to Implement Monetary Policy
Central banks use a number of tools to shape and implement monetary policy.
- First is the buying and selling of short-term bonds on the open market using newly created bank reserves. This is known as open market operations. Open market operations target short-term interest rates such as the federal funds rate. The central bank adds money into the banking system by buying assets—or removes it by selling assets—and banks respond by loaning the money more easily at lower rates—or more dearly, at higher rates—until the central bank's interest rate target is met. Open market operations can also target specific increases in the money supply to get banks to loan funds more easily by purchasing a specified quantity of assets. This is the process known as quantitative easing (QE).
- The second option is to change the interest rates or the required collateral that the central bank demands for emergency direct loans to banks in its role as lender-of-last-resort. In the U.S., this rate is known as the discount rate. Banks will loan more freely or less freely depending on this interest rate.
- Authorities also can manipulate the reserve requirements. These are the funds that banks must retain as a proportion of the deposits made by their customers in order to ensure that they are able to meet their liabilities. Lowering this reserve requirement releases more capital for the banks to offer loans or to buy other assets. Increasing it curtails bank lending and slows growth.
- Unconventional monetary policy has also gained popularity in recent times. During periods of extreme economic turmoil, such as the financial crisis of 2008, the U.S. Fed loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed securities (MBS), introducing new lending and asset-purchase programs that combined aspects of discount lending, open market operations, and QE. Monetary authorities of other leading economies across the globe followed suit.
- Central banks have a powerful tool in their ability to shape market expectations by their public announcements about possible future policies. Central bank statements and policy announcements move markets, and investors who guess right about what the central banks will do can profit handsomely.
What Is Monetary Policy vs. Fiscal Policy?
Monetary policy is enacted by a central bank with the mandate to keep the economy on an even keel. The aim is to keep unemployment low, protect the value of the currency, and maintain economic growth at a steady pace. It achieves this mostly by manipulating interest rates, which in turn raises or lowers borrowing, spending, and savings rates.
Fiscal policy is enacted by a national government. It involves spending taxpayer dollars in order to spur economic recovery. It sends money, directly or indirectly, to increase spending and turbo-charge growth.
What Are the Two Types of Monetary Policy?
Broadly speaking, monetary policy is either expansionary or contractionary. An expansionary policy aims to increase spending by businesses and consumers by making it cheaper to borrow. A contractionary policy, on the other hand, forces spending lower by making it more expensive to borrow money.
Depending on which is needed at the time, expansionary or contractionary policies bring inflation into an acceptable range, keep unemployment at acceptable levels, and maintain the value of the currency.
How Often Does Monetary Policy Change?
The Federal Open Market Committee of the Federal Reserve meets eight times a year. After a couple of days of discussion, it will announce whether it will make any changes to the nation's monetary policies, and, if so, what they will be.
That said, the Federal Reserve may act in an emergency if it deems it to be necessary. It has done so in recent crises including the 2007-2008 economic meltdown and the COVID-19 pandemic shutdown.