What is Monetary Policy?

Monetary policy is like balancing a scale...

Just as the two sides of a scale are out of balance if one side is heavier than the other, monetary policy generally seeks to balance high employment and low inflation.

In a nutshell, in the United States the Fed uses monetary policy to maintain low inflation and high employment. When unemployment is high, the economy suffers. People aren’t working, which means they aren’t spending as much money. High unemployment rates also make the economy less efficient.

The basic need for low unemployment rates might seem like an obvious one. But what’s wrong with high inflation? Just imagine that tomorrow, your milk started costing $10 per gallon. Or that gas prices went through the roof. High inflation is dangerous for the economy because when it rises too quickly, essential goods and services become unaffordable. This makes it hard for people to get what they need and can lead to widespread economic disruption.

When things are running smoothly, the Fed can help keep the economy on an even keel, with strong growth, low unemployment, and low inflation. When things get out of whack, the Fed may use the tools of monetary policy to bring things back into balance.

There are two main types of monetary policy:

1. Expansionary
2. Contractionary

Expansionary monetary policy helps the economy grow more quickly. Contractionary monetary policy pumps the brakes.

Expansionary policy is used when growth is needed. This policy gets implemented when the economy’s demand for goods and services starts to slow down. This might also mean that unemployment has increased, and inflation is in decline.

To fix this, the federal government will employ expansionary monetary policy — Which lowers interest rates and stimulates demand. Think about it this way: When interest rates are low, loans become cheaper and more affordable. This affordability stimulates the economy by allowing businesses to grow and hire more people. When people have jobs, they spend money — All of which contribute to economic growth.

The opposite scenario happens when the overall demand is too high. This might make unemployment rates unsustainably low, and lead to inflation getting out of control.

In this situation, the federal government would use contractionary monetary policy. This policy would raise interest rates and guide unemployment and inflation back to their desired levels.

The federal funds rate is the interest rate at which banks can borrow reserves from other banks — and it’s one of the fundamental tools in monetary policy. This rate determines interest rates for the entire economy.

The Fed has a number of tools to implement monetary policy.

One tool is that the Fed targets the federal funds rate to control the short-term rates at which banks borrow from each other’s reserves. This process helps them determine what interest rates look like throughout the banking system. The Fed can also tighten or loosen reserve requirements — how much money banks are required to keep on hand — to encourage them to lend more or less freely.

Another tool is open market operations, where the Fed can expand or contract the money supply through the purchase and sale of short-term bonds. Increasing the money supply encourages banks to lend more freely (and is thus expansionary); decreasing the supply has the opposite effect (and is thus contractionary).

Forward guidance is another tool used by the Fed, and it helps determine the outlook on the economy. It’s basically a prediction of what future monetary policy will look like. And it’s a key piece of information used by banks to determine their investments. This information is made publicly available and is also used by individuals and businesses.

While the central bank controls monetary policy, the U.S. Government is in charge of fiscal policy. The two are different but work in similar ways. Monetary policy uses tools like interest rates to control the performance of the economy.

Alternatively, fiscal policy involves things like tax rates and government spending. Depending on what’s needed at any given time, these two things can also greatly influence economic growth. For instance, government spending might be boosted to try to put more money in consumers’ pockets and increase demand for business’s products and services. This is called fiscal stimulus. Or, the government might cut taxes or issue tax rebates to try to achieve a similar effect of injecting money into the economy.