How Monetary Policy Works: Main Types of Monetary Policy

Monetary policy is the process by which a nation’s central bank attempts to achieve stable economic growth, keep unemployment low, and mitigate changes in foreign exchange rates and the inflation rate. Central banks do this through a system of tools and measures designed to increase or decrease the money supply in the economy, mainly through influencing other financial institutions’ liquidity levels.

In the United States, the financial system centers around a central bank called the Federal Reserve Bank (or the Fed for short). It’s composed of twelve Federal Reserve Districts, all of which are under the Board of Governors of the Federal Reserve System. These parts of the organization split duties with the Federal Open Market Committee (or FOMC) to create a holistic monetary policy for the US economy. The Federal Reserve Bank has two main goals, known as the dual mandate: keeping unemployment low and achieving price stability.

Monetary policy manages the supply of money in the economy through a central bank. The central bank has the power to change the federal funds rate, which is the interest rate that banks can charge each other to help meet mandatory reserve balances. That change in interest rate then ripples down to individuals and businesses borrowing from or lending money to their banks.

Generally, monetary policy strategy acts as a guiding or moderating force on the economy. By changing how attractive it is to engage in particular economic activity—by raising or lowering banks’ lending rates, for example—central banks hope to slow down large economic swings that could negatively affect people’s assets and the value of their money.

Generally, the monetary policy framework accommodates two speeds: expansionary and contractionary. Expansionary monetary policy attempts to counteract the high unemployment and sluggish consumer spending characteristic of a recession.

A central bank could lower interest rates to incentivize spending and kickstart the economy in response to a recession. The lower interest rates are, the less likely people and businesses are to hold on to their money because they have less to gain by doing so. But they’re more likely to buy a house or a car since the interest rate on their loan will be low. Expansionary monetary policy can lead to what economists call an increase in aggregate demand.

Alternatively, contractionary monetary policy attempts to decrease the amount of money flowing into the market and increase short-term interest rates. Monetary policymakers increase these rates to control inflation. If inflation rises faster than wages, that means the value of people’s money decreases. One of the Fed’s goals is to maintain a steady inflation target rate, so to bring down inflation, central banks raise interest rates. It may slow growth by disincentivizing spending, but it may also keep prices under control.

Each country has its own strategies for keeping its banking system in check and achieving financial stability. In the US, the Fed has five policy actions at its disposal to keep the economy’s swings and sways under control and keep the potential excesses of the banking system and financial markets in check:

1. 1. Announcements: The Fed can change market conditions simply by releasing forecasts or announcing upcoming monetary policy changes.
2. 2. Open market operations: The Fed can buy or sell short-term bonds (also known as government bonds or government securities such as US Treasury notes) to increase or decrease the amount of money in circulation. (If banks have more money on hand, they’ll lend it out at a lower rate.)
3. 3. Quantitative easing: The Fed has kept interest rates low since the 2008 financial crisis, meaning it’s turned to other strategies to guide the market. Quantitative easing is the buying or selling of large amounts of financial assets (for example, adding stocks or mortgage-backed securities to the Fed’s balance sheet) to alter the market’s liquidity. These asset purchases accomplish a similar goal to the selling of government bonds.
4. 4. The federal funds rate: The interest rate for overnight bank lending between banks is the federal funds rate. The Fed can raise or lower this interest rate in an attempt to change interest rates for everyone.
5. 5. The reserve requirement: The Fed can regulate how much banks need to hold in reserve; the more they need to keep in reserve, the less they can lend out (and vice versa). If a bank needs to use a Federal Reserve Bank as a lender to meet the requirement, the Fed will use a discount rate.

Monetary policy and fiscal policy sound similar and are often involved as disparate parts of a larger economic policy. Still, the difference comes down to who holds the decision-making power. Monetary policy decisions get made by a central bank, while fiscal policy decisions come from the federal government (such as Congress or the executive branch).

Like monetary policy, fiscal policy can be expansionary or contractionary. Examples of fiscal policy include: making tax cuts, running a budget deficit, and ramping up expenditures to add to the available money supply; a contractionary policy would generally follow the opposite.

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