2/26/23, 5:08 PM Monetary Policy Meaning, Types, and Tools

MONETARY POLICY FEDERAL RESERVE

Monetary Policy Meaning, Types, and

Tools
By THE INVESTOPEDIA TEAM Updated July 25, 2022
Reviewed by THOMAS BROCK
Fact checked by PETE RATHBURN

Xiaojie Liu / Investopedia

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, the Federal Reserve Bank implements 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.

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2/26/23, 5:08 PM Monetary Policy Meaning, Types, and Tools

Monetary Policy

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 target a high level of inflation and
reduce the level of money circulating in the economy.

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.

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2/26/23, 5:08 PM Monetary Policy Meaning, Types, and Tools
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. [1]

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.

3
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,
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. [2]

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. [3]

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

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The Fed also serves the role of lender of last resort, providing banks with
liquidity and regulatory scrutiny to prevent them from failing and creating
financial panic in the economy. [4]
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.

ARTICLE SOURCES

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Meaning, Types, and Manages Money Supply Easing (QE), and How Monetar
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Related Terms
What Is Contractionary Policy? Definition, Purpose, and
Example
Contractionary policy is a macroeconomic tool used by a country's central bank or
finance ministry to slow down an economy. more

What Are Open Market Operations (OMOs), and How Do

They Work?
The Federal Reserve uses open market operations (OMO) such as buying or selling U.S.
Treasuries to adjust the federal funds rate for monetary policy. more

Federal Open Market Committee (FOMC): What It Is and

Does
The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve System
that determines the direction of monetary policy. more

What is a Fed Pivot and Why Does It Matter?

A Fed pivot is when the Federal Reserve reverses course on its monetary policy, from
expansionary to contractionary—or vice versa. more

Terminal Federal Funds Rate: What It Is and Why It’s

Important
The terminal federal funds rate is the final interest rate that the Federal Reserve sets as its
target for the federal funds rate. more

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All About Fiscal Policy: What It Is, Why It Matters, and

Examples
Fiscal policy uses government spending and tax policies to influence macroeconomic
conditions, including aggregate demand, employment, and inflation. more

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