What It Is:
Monetary policy is the means by which the Federal Reserve manipulates the U.S. money supply in order to influence the U.S. economy's overall direction, particularly in the areas of employment, production, and prices.
How It Works/Example:
Monetary policy is not the same as fiscal policy, which is carried out through government spending and taxation.
To understand monetary policy, it is important to understand a bit about the Federal Reserve, which is the central bank of the United States.
The Federal Reserve is a bank for banks. It has several branches around the U.S. hold deposits for and lend to banks. As a means of ensuring the safety of the nation's financial institutions, the Federal Reserve requires banks to keep a strict percentage of their deposits on reserve at a Federal Reserve bank. The Federal Reserve determines the appropriate percentage, called the reserve requirement. If a bank is unable to meet its reserve requirement, it can borrow from the Federal Reserve to meet the requirement. The interest rate on these funds is called the discount rate. (Banks can also borrow the excess reserves of other banks, and this interest rate, called the federal funds rate, is determined by the open market. The Federal Reserve works to keep the discount rate close to the federal funds rate.)
Now, let's assume that policymakers feel employment is too low and interest rates are too high. The Federal Reserve could enact expansionary monetary policy and encourage economic growth by doing one or all of these three things:
Lower the reserve requirement
Lower the discount rate
Each of these choices increases the supply of money and creates a chain reaction. For example, when the FOMC (an agent of the Federal Reserve) purchases U.S. Treasuries in the open market, it gives money to the sellers. The sellers deposit these payments at their local banks. The banks then lend most of these new deposits to other bank customers and earn interest. These customers in turn deposit the loan proceeds in themit own bank accounts, and the process continues indefinitely. Thus, every dollar of securities that the Federal Reserve buys increases the money supply by several dollars. This in turn lowers the lending rate as there is more supply of loanable monies, thus encouraging growth.
Likewise, if the Federal Reserve lowers the reserve requirement, more of a bank's deposits become available for lending. This increase in the supply of available funds lowers the price of those funds (i.e., the lending rate), making debt cheaper and more enticing to borrowers. With money being cheaper to borrow, individuals and companies are more likely to take out loans to build and improve, thereby growing the economy.
Additionally, if the Federal Reserve lowers the discount rate, it becomes cheaper for banks to borrow money from the Fed, thus making it cheaper to lend to customers. This leads to the same outcome as both purchasing Treasuries and lowering the reserve requirement.
Now consider what would happen if policymakers felt employment was too high and interest rates were too low. This may sound attractive, but it is a recipe for runaway inflation. If the Federal Reserve wants to encourage an economic slowdown (that is, implement restrictive monetary policy), it can do one or all of these three things:
Direct the FOMC to sell U.S. Treasuries on the open market
Raise the reserve requirement
Raise the discount rate
When the FOMC offers Treasury securities for sale, it bids up interest rates in order to entice investors, who take money out of their bank accounts to buy the Treasuries. This leaves less money in the banking system, which means banks have less money to lend. With less money to lend, the price (that is, the interest rate) on the remaining loanable funds increases, which in turn makes car loans, mortgages, and credit card purchases more expensive. This slows down demand and lowers prices across the economy.
If the Federal Reserve increases the reserve requirement (which leaves less of a bank's deposits available for lending) or increases the discount rate (which makes it more expensive for banks to borrow money from the Federal Reserve, thus making it less lucrative to borrow money to lend to customers), it compounds the slow-down effects.
Economists measure the effectiveness of monetary policy by its influence on inflation, employment, and industrial production. Most economists agree that because monetary policy often takes several months or even several years before the effects are felt, policy action is not something that should be taken in response to current, short-term economic conditions.
One should note that monetary policy also has a global reach, in addition to its domestic effects. When the Federal Reserve's actions result in lower interest rates, this makes domestic bonds less attractive than bonds issued in countries with higher working capitals. Therefore, money tends to flow out of the U.S. and into these other countries. This causes demand for and thus the value of American dollars to fall in relation to other currencies, which makes the prices of American goods seem cheaper to foreign purchasers. This encourages them to import more American goods, raising the balance of trade. At the same time, improved demand from foreign sources causes more U.S. businesses to borrow money to expand, and this in turn leads to more jobs.
Why It Matters:
Ultimately, the goal of monetary policy is to promote a stable economy. Many economists agree that the Federal Reserve is the most important political tool a government has, because each of a monetary policy's effects influences the everyday financial decisions of the citizens of the economy: Whether they should buy a car, save more money, or start a business.