Monetary Policy: Definition, Types, and Examples

Central banks use monetary policy to manage the financial systems and influence the economy in their country. In the U.S., the Federal Reserve (the Fed) uses an array of tools and techniques to influence the economy.

The goal of central banks is to use monetary policy to create economic stability and balance factors like growth, inflation, employment levels, and economic development. The methods for achieving this stability can vary but often include setting interest rates and controlling cash liquidity.

Monetary policy can directly affect your finances in terms of loan interest rates, employment opportunities, and prices for consumer goods. It’s important to keep up with monetary policy news and ensure you get your information from reliable sources.

What Is the Difference Between Monetary Policy and Fiscal Policy?

Monetary and fiscal policies take different approaches to ensuring economic health. While central banks manage monetary policy, governments oversee fiscal policy. Fiscal policy involves using tools like tax rate adjustment and spending to help with economic growth and employment, while monetary policy focuses primarily on interest rates to indirectly impact these areas.

Examples of fiscal policy can include lowering taxes to encourage spending or investment or investing in social programs or infrastructure projects to increase employment and well-being for citizens.

Fiscal policy impacts the economic situation directly, targeting specific areas like employment. Monetary policy sets the stage for positive economic conditions by influencing private lending and investment. Because they work indirectly, monetary policies often take longer to impact the economy.

What Are the Typical Goals of Monetary Policies?

Monetary policy shares most of the goals of fiscal policy. Here is a look at what central banks like the Fed hope to achieve with monetary policy.

• Stable prices: The Fed tries to control inflation, which causes higher prices, and deflation, which limits growth and investment.
• Employment: The Fed tries to make employment rates as high as possible by adjusting its policy to stimulate growth.
• Sustained economic growth: The Fed uses interest rates and money supplies to promote growth in the economy that is sustainable for the long term and does not lead to out-of-control inflation.

Monetary policies can also help respond to economic crises or external events that affect the country’s financial system. In these cases, the goal is to limit the economic damage and speed recovery, as during COVID-19 or the 2008 financial crisis.

Common Challenges to Effective Monetary Policy

Central banks sometimes struggle to implement and manage their monetary policy. They need to account for a range of factors and challenges that complicate their efforts.

Here are some of the most common roadblocks.

• Delayed effects: The effects of monetary policy won’t be evident right away. For instance, it can be difficult to see if interest rate hikes are sufficient to stop inflation.
• Political pressure: Central banks are supposed to be independent, but the government may sometimes pressure the bank to make decisions that favor lawmakers.
• Public sentiment: Businesses and consumers may not act as expected. They may still see risk in the economy and not lend or spend despite lower rates.

Also, exterior events, like the economic conditions in other countries, can inflate a country’s currency value, negating the impact of interest rate changes or increased cash supply.

Types of Monetary Policies

The Fed and other central banks have different monetary policy options in their financial toolboxes for specific circumstances. Each of these policies fits into one of two broad categories: expansionary and contractionary.

Expansionary Monetary Policy

Expansionary policies seek to promote growth or economic recovery. In addition to spurring consumer spending and business development, expansionary policies focus on decreasing unemployment.

Common expansionary policies include lowering interest rates so that it’s cheaper for businesses and consumers to get loans.

Contractionary Monetary Policy

Contractionary policies are meant to slow down economic growth and reduce inflation. The Federal Reserve may try to put the brakes on the economy when inflation gets too high. In these cases, monetary policies are often the opposite of expansionary steps.

The central bank will raise interest rates and sell government bonds to decrease lending activities and lower the cash supply. They may also change reserve requirements, giving banks less liquidity for lending.

Real-World Examples of Monetary Policies

In the real world, monetary policies are seldom straightforward. However, they can work to influence the economy. Here are three examples of how central bank actions affected the economies of major countries.

• Inflation in the 1980s: The U.S. Federal Reserve increased the fed funds rate to its highest since records began in 1954 (nearly 20%) by limiting the cash supply to combat steep inflation. The step did lower inflation, but it also caused a recession.
• The 2008 Financial Crisis: The Fed lowered interest rates to 0 to 25 basis points and kept them low for the long term in response to the housing market crash in 2008. This, along with quantitative easing, slowly led to a recovery.
• Response to COVID-19 pandemic: The Fed tried to stabilize the economy in response to the COVID-19 pandemic. In addition to cutting the fed funds rate as much as possible (to nearly 0%), the Fed supported loans to small businesses and local governments. The economy remained functional during the pandemic, and many businesses were able to remain open.

These examples also show the different policy tools banks like the Fed use.

Monetary Policy Tools

Central banks have a variety of monetary policy tools to control cash supply and influence interest rates and lending activities. Here are the most common of these tools the Federal Reserve uses to implement monetary policy.

• The fed funds rate: The rate banks charge for overnight lending to meet reserve requirements. The rate either encourages or discourages banks from lending and serves as a benchmark for consumer and business rates.
• Open market operations: The buying and selling of government securities. The Fed does this to influence the funds rate so that it remains within the desired range.
• Quantitative easing: The purchase of large amounts of government or mortgage-backed securities to further influence interest rates. Banks use this strategy when lowering federal rates alone isn’t enough to spur the economy.

The Fed uses reserve requirements to influence banking activity. Increasing these requirements, which are meant to protect against a run of withdrawals, can decrease cash and cause interest rates to rise while lowering the requirements has the opposite effect.

Who Controls Monetary Policy?

Central banks control monetary policy. In the U.S., the Federal Reserve is responsible, with the Federal Open Market Committee (FOMC) working to set and manage interest rates.

Most banks, including the Fed, are independent of the government, but some, such as the Bank of China, have to consider the government’s objectives when using monetary policies.

Finally, some banks, like the Bank of England, have set goals, such as a 2% inflation rate. Meanwhile, the Fed has a more flexible mandate to maximize employment and economic health, but it does not have specific inflation or employment targets.

What Is a Monetary Policy Committee?

A specialized group of decision-makers within each country’s central bank is responsible for making monetary policy. For example, in the UK, this group is called the Monetary Policy Committee (MPC). In the U.S., a similar group called the Federal Open Market Committee (FOMC) is responsible for monetary policy decisions.

The FOMC, for instance, consists of a board and representatives from the different Fed branches. This group votes on policy decisions and adopts the decision of the majority.

Monetary policy has an impact on inflation, the prices of consumer goods, and interest rates. As a consumer or business owner, understanding these policies helps you grasp the big picture as you plan your finances.