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Monetary Policy

What Does Monetary Policy Refer To?

Monetary policy is the use of economic tools by a country’s central bank or other government agency, to control critical economic factors such as money supply, inflation, employment, and economic growth. Monetary policy does not include such political mechanisms as fiscal policy, which is often administered by unrelated government representatives and includes tax policy, infrastructure spending, military operations, etc.

Monetary policy must consider the effects of fiscal policy to meet its goals, but the directors of fiscal policy may not need to consider the objectives of monetary policy when making decisions.

How Many Types of Monetary Policy Are There?

The two types of monetary policy are contractionary and expansionary. The former is used when an economy is accelerating at a pace that puts goals at risk, e.g. the threat of higher inflation. By raising interest rates or selling assets--which removes cash from the system--a central bank can reduce the money supply and thereby contract an economy that is at risk of overshooting its goals.

Expansionary policy is used when an economy is weak and needs help reaching the stability targets of the central bank. By lowering interest rates or buying assets, the money supply is increased, which makes investment easier because of the easier availability of capital.

In the United States, the Federal Reserve (Fed) administers monetary policy with a mandate to promote maximum employment, stable prices, and moderate long-term interest rates, as instructed by the Congress of the United States in its original charter. Influencing short-term interest rates is the highest profile tool the Fed uses to steer the cost and availability of credit in the economy.

The force exerted on short-term interest rates has an indirect influence on long-term interest rates, currency rates, and other assets that affect wealth and economic activity.

Four Fed Monetary Policy Tools

The Fed uses four major tools to achieve its goals: the discount rate, reserve requirements, open market operations and interest on reserves.

The discount rate is the interest rate charged to commercial banks for short term loans. Lowering the discount rate is expansionary because borrowing is less costly, thereby making it more attractive. Raising the discount rate is contractionary because the higher cost reduces the demand for loans.

Reserve requirements are the cash percentages of total deposits that must be maintained in vaults or on deposit with a Reserve bank. Higher reserve requirements reduce the money supply, which is contractionary, while lower requirements increase the money supply, making this expansionary.

Open market operations are the buying and selling of U.S. government securities. To increase the money supply securities are purchased; to decrease the money supply securities are sold. When the Fed buys securities, it gives cash to the buyer, which can then be used for deposits and loans. When the Fed sells securities, it takes cash from the buyer, which makes less money available for other investments.

Interest on Reserves is relatively new since it was first employed in 2007-09. This interest is paid to banks on any amount that exceeds the reserve requirement. The Fed lowers the interest paid on excess reserves to increase the money supply, making it more attractive for banks to find other sources of income. The rate is increased to shrink the money supply, making it more attractive to get paid from the Fed instead of other endeavors.

Finding Information About Monetary Policy on Investing.com

The Fed Rate Monitor Tool page at Investing.com provides critical market information about expectations for upcoming Fed activity. The first section of the page indicates what market participants are expecting by charting the probability of possible actions. Scroll down to a chart of preceding Fed Fund Rates targets over the last few decades that can be adjusted to custom time frames. Below that are publications and the rates of other central banks along with news and analysis.