Macroeconomics

Monetary Policy

Updated Jan 8, 2023

Definition of Monetary Policy

Monetary policy is the process by which the monetary authority of a country (i.e., usually the central bank) influences the supply of money in an economy. That means it is the set of tools and strategies used by the central banks to manage interest rates and money supply in order to achieve economic objectives such as price stability, full employment, and sustainable economic growth.

Example

To illustrate how monetary policy works, let’s look at the example of the Federal Reserve (FED) in the United States. The Federal Reserve is the central bank of the United States and is responsible for setting monetary policy. To achieve its objectives, it uses a variety of tools, such as open market operations (i.e., buying and selling securities in the open market), reserve requirements (i.e., the amount of funds, commercial banks need to hold as reserves when loaning out money), and discount rates (i.e., the rate of interest commercial banks have to pay on loans from the central bank).

If the Federal Reserve wants to increase the money supply, it can buy government bonds in the open market. This increases the money supply because it pays for those bonds in cash, which stimulates economic growth. On the other hand, if the Federal Reserve wants to reduce the money supply, it can sell government bonds in the open market. This reduces the money supply because the FED essentially takes the money it receives out of circulation, which slows economic growth.

Why Monetary Policy Matters

Monetary policy is an important tool for central banks to manage the economy. It can be used to influence the money supply, interest rates, and inflation, which in turn can have a significant impact on economic growth, employment, and prices. Thus, it is closely related to fiscal policy (i.e., the use of government spending to influence the economy). Both of these concepts are important for policymakers to understand how monetary policy works and how it can be used to achieve their desired objectives.