Monetary Policy Meaning, Types, and Tools (2024)

What Is Monetary Policy?

Monetary policy is a set of tools used by a nation's central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements.

In the United States, theFederal Reserve Bankimplements monetary policy through a dual mandate to achieve maximum employment while keeping inflation in check.

Key Takeaways

  • Monetary policy is a set of actions to control a nation's overall money supply and achieve economic growth.
  • Monetary policy strategies include revising interest rates and changing bank reserve requirements.
  • Monetary policy is commonly classified as either expansionary or contractionary.
  • The Federal Reserve commonly uses three strategies for monetary policy including reserve requirements, the discount rate, and open market operations.

Monetary Policy Meaning, Types, and Tools (1)

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.

Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry and sector-specific growth rates influence monetary policy strategy.

A central bank may revise the interest rates it charges to loan money to the nation's banks. As rates rise or fall, financial institutions adjust rates for their customers such as businesses or home buyers.

Additionally, it may buy or sell government bonds, target foreign exchange rates, and revise the amount of cash that the banks are required to maintain as reserves.

Types of Monetary Policy

Monetary policies are seen as either expansionary or contractionary depending on the level of growth or stagnation within the economy.

Contractionary

A contractionary policy increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money.

Expansionary

During times of slowdown or a recession, an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase.

Goals of Monetary Policy

Inflation

Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation.

Unemployment

An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market.

Exchange Rates

The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange.

Tools of Monetary Policy

Open Market Operations

In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and money available to the economy as a whole.

The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that affect other interest rates.

Interest Rates

The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate. Banks will loan more or less freely depending on this interest rate.

The Federal Reserve commonly uses three strategies for monetary policy including reserve requirements, the discount rate, and open market operations.

Reserve Requirements

Authorities can manipulate the reserve requirements, the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities.

Lowering this reserve requirement releases more capital for the banks to offer loans or buy other assets. Increasing the requirement curtails bank lending and slows growth.

Monetary Policy vs. Fiscal Policy

Monetary policy is enacted by a central bank to sustain a level economy and keep unemployment low, protect the value of the currency, and maintain economic growth. By manipulating interest rates or reserve requirements, or through open market operations, a central bank affects borrowing, spending, and savings rates.

Fiscal policy is an additional tool used by governments and not central banks. While the Federal Reserve can influence the supply of money in the economy and impact market sentiment, The U.S. Treasury Department can create new money and implement new tax policies. It sends money, directly or indirectly, into the economy to increase spending and spur growth.

Both monetary and fiscal tools were coordinated efforts in a series of government and Federal Reserve programs launched in response to the COVID-19 pandemic.

How Often Does Monetary Policy Change?

The Federal Open Market Committee of the Federal Reserve meets eight times a year to determine changes to the nation's monetary policies. The Federal Reserve may also act in an emergency as was evident during the 2007-2008 economic crisis and the COVID-19 pandemic.

How Has Monetary Policy Been Used to Curb Inflation In the United States?

A contractionary policy can slow economic growth and even increase unemployment but is often seen as necessary to level the economy and keep prices in check. During double-digit inflation in the 1980s, the Federal Reserve raised its benchmark interest rate to 20%. Though the effect of high rates spurred a recession, inflation was reduced to a range of 3% to 4% over the following years.

Why Is the Federal Reserve Called a Lender of Last Resort?

The Fed also serves the role oflender of last resort, providing banks with liquidity and regulatory scrutiny to prevent them from failing and creating financial panic in the economy.

The Bottom Line

Monetary policy employs tools used by central bankers to keep a nation's economy stable while limiting inflation and unemployment. Expansionary monetary policy stimulates a receding economy and contractionary monetary policy slows down an inflationary economy. A nation's monetary policy is often coordinated with its fiscal policy.

Monetary Policy Meaning, Types, and Tools (2024)

FAQs

What is monetary policy and tools? ›

Key Takeaways. Monetary policy is a set of actions to control a nation's overall money supply and achieve economic growth. Monetary policy strategies include revising interest rates and changing bank reserve requirements. Monetary policy is commonly classified as either expansionary or contractionary.

What are the 3 main tools of US monetary policy? ›

The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements.

What is the simple definition of monetary policy? ›

Monetary policy in the United States comprises the Federal Reserve's actions and communications to promote maximum employment, stable prices, and moderate long-term interest rates--the economic goals the Congress has instructed the Federal Reserve to pursue.

What are the monetary major tools? ›

The Federal Reserve has a variety of policy tools that it uses in order to implement monetary policy.
  • Open Market Operations.
  • Discount Window.
  • Reserve Requirements.
  • Interest on Reserve Balances.
  • Overnight Reverse Repurchase Agreement Facility.
  • Term Deposit Facility.
  • Central Bank Liquidity Swaps.

What is an example of a monetary policy tool? ›

Tools of Monetary Policy

For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.

What are the three main tools of fiscal policy? ›

the use of taxes, government spending, and government transfers to stabilize an economy; the word “fiscal” refers to tax revenue and government spending.

What are the most used monetary policy tools? ›

Traditionally, the Fed's most frequently used monetary policy tool was open market operations. This consisted of buying and selling U.S. government securities on the open market, with the aim of aligning the federal funds rate with a publicly announced target set by the FOMC.

What is the primary tool of monetary policy? ›

Answer and Explanation: The primary tool of monetary policy is the interest rate. Ideally, the Federal Reserve uses the interest rate to manipulate the supply of money in the economy. The strategy is achieved with the help of contractionary and expansionary policies.

What is the US monetary policy tool? ›

It's responsible for conducting monetary policy and controlling the money supply. The primary tools used by the Fed include interest rate setting and open market operations (OMO).

What is the main goal of monetary policy? ›

What is monetary policy and why is it important? Central banks use monetary policy to manage economic fluctuations and achieve price stability, which means that inflation is low and stable. Central banks in many advanced economies set explicit inflation targets.

Which is an example of a monetary policy? ›

The government lowers interest rates to make it cheaper for people and businesses to borrow money. Monetary policies regulate fluctuations in the rate at which loans are given in the market. If the money supply is to be reduced (inflationary phase), the government will increase the interest rate.

What are the pros and cons of monetary policy? ›

The pros of using monetary policy include regulating the production and circulation of currency, while the cons include the risk of economic crisis if the money supply is too small. Monetary policy can impact income distribution, but its effects are complex and fiscal policy has a more direct impact.

What is the meaning of tools in monetary policy? ›

Monetary policy tools are tools that the Federal Reserve uses to ensure economic growth while controlling the supply of money and the aggregate demand in the economy. Why are monetary policy tools important? The importance of monetary policy tools comes from it directly having an impact on our daily lives.

What are the general tools of monetary policy? ›

The 6 tools of monetary policy are reverse Repo Rate, Reverse Repo Rate, Open Market Operations, Bank Rate policy (discount rate), cash reserve ratio (CRR), Statutory Liquidity Ratio (SLR). You can read about the Monetary Policy – Objectives, Role, Instruments in the given link.

What are the problems with monetary policy? ›

Disadvantages of Monetary Policy

Technical limitations: Interest rates can only be lowered nominally to 0%, which limits the bank's use of this policy tool when interest rates are already low. Keeping rates very low for prolonged periods of time can lead to a liquidity trap.

What is the main tool for monetary policy called? ›

The most commonly used tool of monetary policy in the U.S. is open market operations. Open market operations take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates.

What are the tools of monetary policy quizlet? ›

Conventional monetary policy tools include open market operations, discount policy, reserve requirements, and interest on reserves.

What is the difference between monetary and fiscal policy tools? ›

The tools that are used are also distinct between the two. While monetary policy relies on open market operations, reserve requirements, and/or the discount rate, fiscal policy involves the use of government spending and/or changes in government tax policies.

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