essay of money policy

• Monetary Policy

Written by True Tamplin, BSc, CEPF®

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Updated on November 29, 2023

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Table of contents, what is monetary policy.

To define monetary policy, it refers to the financial policies adopted by the monetary authority of a country, such as the Federal Reserve, to achieve the country's economic goals.

The primary goal of monetary policy is to achieve specific economic objectives, such as promoting price stability, supporting sustainable economic growth , and maintaining low levels of unemployment.

These goals are often a combination of economic growth , price stability and credit availability.

Central banks utilize tools like interest rate changes, open market operations, and quantitative easing to control money supply and interest rates, affecting economic activities.

These actions influence borrowing, spending, and investment , shaping overall economic conditions and results.

What Are the Types of Monetary Policy?

Monetary policies are generally categorized as either expansionary or contractionary.

Expansionary policies are used to accelerate the economy by making capital easily accessible.

Contractionary policies are used to fight inflation and slow economic growth when necessary.

While expansionary policy may seem more intuitive, both expansionary and contractionary policies are needed for the long-term health of an economy.

For example, expansionary policy's low interest rates can result in harmful levels of inflation and undisciplined investments, forming economic bubbles.

Unlike fiscal policy , which pertains to policies on government taxation and spending, monetary policy is independent from the political process.

The Federal Reserve operates autonomously in order to shield it from short-term political pressures, such as a presidential election.

This ensures that the Federal Reserve may make the best decisions for the long-term health of the economy.

What Is the Objective of U.S. Monetary Policy?

According to federalreserve.gov, "Congress has directed the Fed to conduct the nation's monetary policy to support three specific goals:

1. Maximum Sustainable Employment

Central banks aim to achieve the highest level of employment that an economy can sustain over the long term.

By implementing accommodative monetary policies, such as lowering interest rates or engaging in quantitative easing, central banks encourage borrowing and investment, which can stimulate economic activity and lead to job creation.

Conversely, tightening monetary policy by raising interest rates can help prevent excessive inflation and maintain a balance between economic growth and employment.

2. Stable Prices

Maintaining stable prices is a core objective of monetary policy. Central banks strive to keep inflation in check to prevent rapid and unpredictable price increases, which can erode purchasing power and disrupt economic planning.

Through various policy measures, central banks manage the money supply and credit availability to control inflation.

By keeping inflation at a moderate and predictable level, they aim to create a favorable environment for economic growth and financial stability.

3. Moderate Long-Term Interest Rates

Central banks also seek to maintain moderate and stable long-term interest rates. By influencing short-term interest rates through their policy tools, central banks impact the broader interest rate environment.

Moderate long-term interest rates are essential for encouraging borrowing and investment, which contribute to economic growth.

Additionally, stable long-term rates help businesses and individuals make informed financial decisions, as sudden interest rate fluctuations can introduce uncertainty into economic activities.

Categories of Monetary Policy

To achieve these goals, the Federal Reserve institutes three categories of monetary policy:

Open Market Operations

The Fed's purchase and sale of securities in the open market in order to regulate the money supply.

Open market operations involve central banks buying or selling government securities in the open market.

When central banks buy securities, they inject money into the banking system, increasing the money supply and potentially lowering short-term interest rates.

Conversely, selling securities absorbs money from the system, reducing the money supply and potentially raising interest rates.

These actions influence the overall availability of credit and money in the economy, affecting borrowing costs and economic activity.

Discount Rate

The Discount Rate is the interest rate charged to commercial banks on debt borrowed from "the discount window," or the Federal Reserve Bank's lending facility.

By changing the discount rate, central banks can influence the cost of borrowing for banks , which in turn affects the rates at which banks lend to businesses and consumers.

Lowering the discount rate encourages banks to borrow more and lend at lower rates, promoting economic activity.

Conversely, raising the discount rate makes borrowing from the central bank more expensive, which can lead to tighter lending conditions and slower economic growth.

Reserve Requirements

The amount of funds banks are required to hold in its reserves in order to meet its liabilities .

Central banks often mandate that commercial banks hold a certain percentage of their deposits as reserves.

By adjusting these reserve requirements, central banks control the amount of money that banks can lend out relative to their deposits.

Lowering reserve requirements allows banks to lend more of their deposits, increasing the money supply and stimulating economic activity.

Conversely, raising reserve requirements reduces the amount of money banks can lend, which can help control inflation and prevent excessive risk-taking in the financial system.

Advantages of Monetary Policy

Price stability promotion.

Monetary policy, when effectively implemented, is a pivotal tool in maintaining price stability within an economy.

Central banks, such as the Federal Reserve in the U.S., utilize various instruments , like open market operations, to influence the level of money and credit in the economy.

By doing so, they aim to keep inflation at a target rate, preventing both hyperinflation and deflation.

Price stability ensures that purchasing power is maintained, giving consumers and businesses the confidence to spend and invest.

This, in turn, helps in fostering sustainable economic growth, ensuring that economies neither overheat nor fall into prolonged recessions .

Flexibility and Quick Implementation

One of the inherent strengths of monetary policy lies in its ability to be adjusted swiftly in response to changing economic conditions.

Unlike fiscal policy, which often requires lengthy legislative processes and can be mired in political disputes, monetary policy can be enacted relatively quickly.

Central banks can decide on interest rate changes or engage in quantitative easing in a timely manner, allowing them to respond proactively to emerging economic challenges or shifts in the economic landscape.

Additionally, this flexibility means central banks can reverse decisions if they see unintended consequences or if the economic situation changes again.

Long-Term Interest Rates

While central banks typically have a more direct influence on short-term interest rates, their actions undeniably affect long-term rates as well.

By setting expectations about the future course of inflation and monetary policy, they can indirectly sway long-term interest rates.

These long-term rates, in turn, influence decisions related to big-ticket items such as mortgages , business loans, and infrastructure projects.

Lower long-term interest rates can stimulate borrowing and investment, potentially leading to economic expansion.

Conversely, when the central bank signals concerns about inflation, and the expectation is that tighter monetary policy will follow, long-term rates might increase, thereby cooling down excessive borrowing and spending.

Disadvantages of Monetary Policy

Limited effectiveness during economic shocks.

During a liquidity trap – where interest rates are near zero and the demand for money becomes highly elastic – traditional tools like rate cuts might not stimulate borrowing and spending as intended.

In such situations, people and businesses might choose to hoard cash , anticipating further economic downturns.

Even with low or zero interest rates, the demand for loans might remain subdued, making the central bank's policy tools less potent.

Time Lags and Uncertainty

Implementing changes in monetary policy doesn't produce immediate results. There's often a lag between when a policy change is made and when its effects are felt in the broader economy.

This delay can make it challenging for central banks to respond effectively to rapidly changing economic conditions.

Additionally, the exact duration and potency of these lags can be uncertain, making it difficult for policymakers to predict the precise impact of their decisions.

In some cases, by the time the effects are realized, the economic situation might have changed, requiring a different policy response.

Potential for Negative Side Effects

Maintaining low interest rates for extended periods can lead to asset bubbles as investors search for higher yields in riskier assets . Such bubbles, when they burst, can lead to economic downturns.

Furthermore, while low rates can encourage borrowing and investment, they can also discourage savings.

Overreliance on monetary easing can lead to misallocation of resources, with businesses investing in less-than-optimal projects due to the cheap availability of credit.

Monetary policy is the financial strategy adopted by a country's central bank, and plays a crucial role in achieving economic objectives.

These goals include ensuring maximum sustainable employment, stable prices, and moderate long-term interest rates.

By utilizing tools such as interest rate adjustments, open market operations, and quantitative easing, central banks influence economic activities and outcomes.

This policy's advantages lie in its ability to promote price stability, offer flexibility for quick adjustments, and indirectly impact long-term interest rates.

However, its effectiveness can be limited during economic shocks, hampered by time lags and uncertainty in outcomes, and prone to potential negative side effects such as asset bubbles and resource misallocation.

Monetary Policy FAQs

What is monetary policy.

Monetary policy refers to the financial policies adopted by the monetary authority of a country, such as the Federal Reserve, to achieve the country’s economic goals.

How are Monetary Policies categorized?

How is monetary policy different than fiscal policy.

Unlike fiscal policy, which pertains to policies on government taxation and spending, monetary policy is independent from the political process.

What are the main goals when Monetary Policy is implemented?

The goals of different monetary policies are often a combination of economic growth, price stability, and credit availability.

What are the goals of US Monetary Policy

Congress has directed the Fed to achieve the following specific goals: maximize sustainable employment; stabilize prices; moderate long-term interest rates.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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Article Contents

I. introduction, ii. the investment multiplier, the marginal efficiency of capital and unemployment, iii. probability, risk, and long-term expectations, iv. monetary policy and the safe interest rate, v. summary and conclusion, keynes's theory of monetary policy: an essay in historical reconstruction.

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Edwin Dickens, Keynes's Theory of Monetary Policy: An Essay In Historical Reconstruction, Contributions to Political Economy , Volume 30, Issue 1, June 2011, Pages 1–11, https://doi.org/10.1093/cpe/bzr001

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Keynes's theory of monetary policy is composed of three concepts—namely, the investment multiplier, the marginal efficiency of capital and the interest rate. By analyzing how these three concepts interact in the short period, Keynes explains why he is opposed to countercyclical monetary policies. And by analyzing how they interact in the long period, he explains why the economy tends to fluctuate around a long-period equilibrium position that is characterized by unemployment. Keynes concludes that the sole objective of the monetary authority should be to use its influence over the interest rate to dislodge the economy from its long-period equilibrium position that is characterized by unemployment and propel it toward a long-period equilibrium position that is characterized by full employment.

Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management ( Keynes, 1936 , p.206).

The paper is organized as follows. In Section II, I use Keynes's concepts of the investment multiplier and the marginal efficiency of capital to specify the long-period equilibrium position of the economy which is characterized by unemployment.

In Section III, in order to explain why the economy fluctuates around a long-period equilibrium position characterized by unemployment, I specify the difference, as well as the relationship, between Keynes's concepts of probability and risk and the orthodox ones.

In Section IV, I use Keynes's concept of the interest rate to explain the effects of monetary policy, both in the short-period and in the long-period.

Lastly, in Section V, I provide a summary and conclusion.

Let N s be the supply of labor and N d the demand for labor, or the actual volume of employment ( n ). We can then define full-employment ( n o ) as N d / N s = 1; unemployment ( n k ) as N d / N s < 1; and the unemployment rate as 1 − n k .

For Keynes (1936 , pp. 25–29 ff. ), n is determined by the aggregate level of output ( Y ) and the productivity of labor ( P ). That is to say, by definition P = Y/N d . Re-arranging terms, N d = Y/P . Substituting into our definition of n , we thus get n = Y/P N s .

Equation (6) is derived from the law of large numbers and incorrectly assumes that the underlying causal structure that determines the outcome of investment projects is known in the same way that the underlying causal structure that determines the outcomes of coin tosses or turns of the roulette wheel is known. In fact, the underlying causal structure that determines the outcome of investment projects is either knowable but unknown or, as Keynes (1937a , b , c ) argues, unknowable. Following Markowitz (1959 , p. 39 ff. ), orthodox economists take this fact into account by interpreting equation (6) in terms of the principle of non-sufficient reason.

According to the principle of non-sufficient reason, if investors do not have a reason to assign different probabilities to a set of possible outcomes, they must assign them equal probabilities. Therefore, if qualms about factors that are knowable but unknown or unknowable undermine the confidence of investors in their calculations of the outcome of prospective investment projects, orthodox economists instruct them to assign equal probabilities to the outcomes they fear may result from these factors, with the sum of assigned probabilities being equal to one. Orthodox economists thus interpret the expected profit ( E o ) in equation (5) as the mathematical mean of the sum of the products of all possible outcomes of investment projects and their probability. They then interpret the risk of investment projects as the variability (or standard deviation), of the sum of the products of all their possible outcomes and their probability, around the mathematical mean.

Equation (9) can be read as ‘proposition a on the hypothesis h · p o has a probability p k ’. Alternatively, it can be read as ‘the conclusion a can be inferred from the evidence h · p o with a probability of p k ’.

If w ( a|h · p o ) = 1, then the hypothesis h · p o implies the conclusion a with certainty. If w ( a|h · p o ) = 0, then hypothesis h implies that the conclusion a is impossible. If 0 < w ( a|h · p o ) < 1, then there is a probability relation of degree p k between a and h · p o .

In short, Keynes's concept of probability ( p k ), as formulated in equation (9), encompasses the orthodox concept of probability ( p o ), as formulated in equation (6), and the relationship between the two is mediated by Keynes's concept of the weight of arguments ( w ).

For Keynes (1921 , p. 77–80), w measures the vague but pervasive sense of inadequacy that investors feel when they compare what they know with what they think they ought to know in order to make informed investment decisions. If w = 1, then the interpretation of equation 6 in terms of the principle of non-sufficient reason has quelled investors’ sense of inadequacy, p o is completely dominate and equation (9), and p k = p o . If 0 < w < 1, then investors do not suppress the fact that setting w equal to one leads to absurdities (see Dickens (2008 , p. 224–225) for an explanation of why), and the factors making the underlying causal structure determining the outcome of investment projects knowable but unknown or unknowable take the form of propositions in h which weigh against p o 's dominance, so that p k < p o .

Even if w = 1, p k is still less than p o once we add Keynes's concept of risk, as formulated in equation (8), to w as a mediating factor between p k and p o , and thereby obtain equation (7). Keynes (1921 , p. 348) formulates equation (7) in such a way that two conditions are met: If p o = 1 and w = 1, then p k = 1; and if p o = 0 and w = 0, then p k = 0. It follows that, if 0 < w < 1 and/or 0 < p o < 1 (so that q = 1 − p o has a value between zero and one), then p k < p o . Of course, p o = m / z = 1 only if there is apodictic certainty about the underlying causal structure that determines the outcome of investment projects, in the way that there is apodictic certainty about the outcome of tossing a two-headed coin—hardly a relevant case to evaluating prospective investment projects.

If p k < p o , then we know from equations (5), (4), (1), and (2), respectively, that E k < E o → I k < I o → Y k < Y o → 1 − n k > 0. In short, if Keynes's concepts of probability and risk are correct, the long-period equilibrium position of the economy is characterized by unemployment.

The monetary authority directly controls the short-term interest rate. 5 With ‘a modest measure of persistence and consistency of purpose,’ Keynes (1936 , p. 204) asserts that the monetary authority can also influence the long-term interest rate. 6 Orthodox economists (see, for example, Ingersoll, 1989 , pp. 173–178) have accepted Keynes's assertion, taking it to mean that the long-term interest rate is the mathematical mean of the sum of the products of all possible outcomes of the short-term interest rate and their probability. For example, the yield on the 10-year bond allegedly equals the mathematical mean of the expected yields on 3-month securities for the next 10 years, plus an illiquidity premium which reflects the orthodox concept of risk. Unfortunately, orthodox economists ignore the difference between Keynes's concepts of probability and risk and the orthodox ones, and reject the classical long-period method, which Keynes uses to distinguish between the long-period equilibrium values of variables and their short-period values. To reconstruct Keynes's theory of monetary policy, these oversights must be rectified.

For Keynes (1936 , pp. 202, 206 and 313–320), the short-period fluctuations of r a around r s are strictly limited to ‘the difference between the[ir] squares’. 9 In contrast, since the stock market determines the actual expected profit ( E a ) in the short-period, the short-period fluctuations of I a and Y a around I k and Y k are unlimited. 10 Therefore, efforts by the monetary authority to stabilize the short-period fluctuations of the economy are futile for two reasons. First, any drastic changes that the monetary authority makes in the short-term interest rate simply cause a more steeply sloped yield curve as r a reaches the limits of its variability around r s . Second, such drastic changes in the short-term interest rate threaten to shatter the confidence of investors in their calculations of E a . If drastic enough, such changes may thus cause a severe recession as investors contemplate trillions of dollars of losses on their bets in the stock market.

If the monetary authority has the discretion to change the short-term interest rate, investors must take into account the possibility that future investment projects, with lower financing costs, will compete against investment projects undertaken today at higher financing costs. As a result, h 2 weighs more heavily than does h 1 against the dominate proposition for undertaking investments projects ( p o ). That is to say, w 1 > w 2 . It follows from equation (15) that p k1 > p k2 → E k1 > E k2 ; and from equation (16) that r s1 < r s2 .

Looking backward, we observe long-run trends shaping economic events. The confidence to undertake investment projects depends upon our ability to project these trends into the future. The problem is that we know these trends are not governed by natural laws but are instead the result of the series of investment projects undertaken by forward-looking investors in the past. In every short-period situation in which such investment projects were undertaken, the long-run trends of the economy would have taken off in a different direction, if those investment projects had not been undertaken.

For this reason, investors take a two-step approach to the evaluation of prospective investment projects. First, they project long-run trends into the future by assigning probabilities to the likelihood of their continuance, and thereby calculate the expected profit ( E o ). 11 Second, they contemplate the degree to which the principle of non-sufficient reason captures their uncertainty about the degree to which knowable but unknown or unknowable factors may cause the future trends of the economy to differ from past ones, and thereby calculate the expected profit ( E k ).

Monetary policy is a factor that has shaped the long-run trends of the economy. It is thus necessary for investors to assign a probability to the likelihood that the monetary authority will continue to act in the same way that it has in the past, and incorporate it into the calculation of E o . If the monetary authority has the discretion to act differently in the future than it has in the past, investors are compelled to contemplate monetary policy itself as a knowable but unknown or unknowable factor that may cause future trends of the economy to differ from past ones, and thus take it into account as a factor that makes E k < E o . If the monetary authority would make a credible commitment to buying and selling at stated prices gilt-edged bonds of all maturities, this element of uncertainty would be alleviated, thereby reducing the difference between E k and E o . The purpose of this paper has been to show that, as a result, the long-period equilibrium position of the economy would be characterized by less unemployment.

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Ricardo and his successors overlook the fact that even in the long period the volume of employment is not necessarily full but is capable of varying, and that to every banking [monetary] policy there corresponds a different long-period level of employment, so that there are a number of positions of long-period equilibrium corresponding to different conceivable interest policies on the part of the monetary authority ( Keynes, 1936 , p.191).

Keynes applies equation (3) to capital assets rather than investment projects, and thereby obtains his concept of the marginal efficiency of capital. As Garegnani (1983) demonstrates, this application is incorrect because it implies that capital is a factor of production that yields a marginal product when plugged into a (aggregate) production function. However, as Pasinetti (1974 , pp. 37–38) demonstrates, equation (3) still applies to investment projects. To make clear that I am using equation (3) in the valid sense of applying to investment projects, I drop the concept of the marginal efficiency of capital in favor of the concept of net present value.

Dickens (2008 , pp. 224–225) draws upon the literature in behavioral finance to explain why the orthodox concept of expected profit ( E o ) leads to absurdities.

The formulation of Keynes's concept of probability ( p k ) in equation (9) differs from its formulation in equation (7) because, at this point in the argument, we are abstracting from the concept of risk, as formulated in equation (8) . As shown below, equation (7) results from the combination of equations (8) and (9) .

This proposition preempts the analysis of the determination of interest rates by the schedule of liquidity preference and the supply of money.

‘The short-term interest rate’ denotes an index of all market yields on high-quality securities of short maturity and ‘the long-term interest rate’ denotes an index of all market yields on high-quality bonds of long maturity. Using such indexes is legitimate because all short-term market yields move in tandem, as do all long-term market yields. However, the short-term interest rate and the long-term interest rate do not move in tandem. Sometimes the yield curve is positively sloped, sometimes inverted, and sometimes flat.

The owners of wealth will then weigh the lack of ‘liquidity’ of different capital equipments … as a medium in which to hold wealth against the best available estimate of their prospective yields after allowing for risk [ E o ]. The liquidity-premium, it will be observed, is partly similar to the risk-premium [understood as the variability (or standard deviation), of the sum of the products of all possible outcomes and their probability, around the mathematical mean] but partly different;–the difference corresponding to the difference between the best estimates we can make of probabilities and the confidence with which we make them. * When we are dealing, in earlier chapters, with the estimation of prospective yield, we did not enter into detail as to how the estimation is made: and to avoid complicating the argument, we did not distinguish differences in liquidity from differences in risk proper. It is evident, however, that in calculating the own-rate of interest we must allow for both ( Keynes 1936 , p.240).

Tobin's q proposes that the expected profit from investment projects, as determined in the stock market ( E a ), influences long-term expectations ( E k ), and thus the aggregate rate of investment undertaken in long-period equilibrium ( I k ). In contrast, as formulated in equation (1 1), E a influences short-term expectations, and thus the pace at which I k is implemented in the short-period.

For example, if the safe long-term interest rate ( r s ) is 4%, then the actual long-term interest rate ( r a ) is limited to a range of 0.04 − (0.04) 2 = 3.84% to 0.04 + (0.04) 2 = 4.16%. If r s is 2%, then r a is limited to a range of 0.02 − (0.02) 2 = 1.96% to 0.02 + (0.02) 2 = 2.04%.

The short-period fluctuations of n a around n k have an upper bound, given by the supply of labor. However, this does not limit the short-period fluctuations of I a and Y a around I k and Y k ; it simply defines the point at which those fluctuations cause what Keynes (1936 , pp.119 and 303) calls ‘true inflation’. In other words, for Keynes, inflation is a short-period phenomenon.

D'Orlando (2005) also argues that probabilistic, as opposed to deterministic, dynamic models are compatible with the classical long-period method.

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What Is Monetary Policy?

Understanding monetary policy, monetary policy vs. fiscal policy, the bottom line.

• Monetary Policy
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Monetary Policy Meaning, Types, and Tools

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Monetary policy is a set of tools used by a nation's central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements.

In the United States, the  Federal Reserve Bank  implements monetary policy through a dual mandate to achieve maximum employment while keeping inflation in check.

Key Takeaways

• Monetary policy is a set of actions to control a nation's overall money supply and achieve economic growth.
• Monetary policy strategies include revising interest rates and changing bank reserve requirements.
• Monetary policy is commonly classified as either expansionary or contractionary.

The Federal Reserve commonly uses three strategies for monetary policy including reserve requirements, the discount rate, and open market operations.

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Monetary policy is the control of the quantity of money available in an economy and the channels by which new money is supplied.

Economic statistics such as gross domestic product (GDP), the rate of inflation , and industry and sector-specific growth rates influence monetary policy strategy.

A central bank may revise the interest rates it charges to loan money to the nation's banks. As rates rise or fall, financial institutions adjust rates for their customers such as businesses or home buyers.

Additionally, it may buy or sell government bonds, target foreign exchange rates, and revise the amount of cash that the banks are required to maintain as reserves.

Types of Monetary Policy

Monetary policies are seen as either expansionary or contractionary depending on the level of growth or stagnation within the economy.

Contractionary

A contractionary policy increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money.

Expansionary

During times of slowdown or a recession , an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase.

Goals of Monetary Policy

Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation.

Unemployment

An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market.

Exchange Rates

The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange.

Tools of Monetary Policy

Open market operations.

In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and money available to the economy as a whole.

The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that affect other interest rates.

Interest Rates

The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate . Banks will loan more or less freely depending on this interest rate.

Reserve Requirements

Authorities can manipulate the reserve requirements , the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities .

Lowering this reserve requirement releases more capital for the banks to offer loans or buy other assets. Increasing the requirement curtails bank lending and slows growth.

Monetary policy is enacted by a central bank to sustain a level economy and keep unemployment low, protect the value of the currency, and maintain economic growth. By manipulating interest rates or reserve requirements, or through open market operations, a central bank affects borrowing, spending, and savings rates.

Fiscal policy is an additional tool used by governments and not central banks. While the Federal Reserve can influence the supply of money in the economy and impact market sentiment , The U.S. Treasury Department can create new money and implement new tax policies. It sends money, directly or indirectly, into the economy to increase spending and spur growth.

Both monetary and fiscal tools were coordinated efforts in a series of government and Federal Reserve programs launched in response to the COVID-19 pandemic.

How Often Does Monetary Policy Change?

The Federal Open Market Committee of the Federal Reserve meets eight times a year to determine changes to the nation's monetary policies. The Federal Reserve may also act in an emergency as was evident during the 2007-2008 economic crisis and the COVID-19 pandemic.

How Has Monetary Policy Been Used to Curb Inflation In the United States?

A contractionary policy can slow economic growth and even increase unemployment but is often seen as necessary to level the economy and keep prices in check. During double-digit inflation in the 1980s, the Federal Reserve raised its benchmark interest rate to 20%. Though the effect of high rates spurred a recession, inflation was reduced to a range of 3% to 4% over the following years.

Why Is the Federal Reserve Called a Lender of Last Resort?

The Fed also serves the role of  lender of last resort , providing banks with liquidity and regulatory scrutiny to prevent them from failing and creating financial panic in the economy.

Monetary policy employs tools used by central bankers to keep a nation's economy stable while limiting inflation and unemployment. Expansionary monetary policy stimulates a receding economy and contractionary monetary policy slows down an inflationary economy. A nation's monetary policy is often coordinated with its fiscal policy.

Federal Reserve Board. " Monetary Policy Principles and Practice ."

Federal Reserve Bank of St. Louis. " Expansionary and Contractionary Monetary Policy ."

Federal Reserve Board. " Open Market Operations ."

Federal Reserve Board. " The Discount Window and Discount Rate ."

Federal Reserve Board. " FAQs: What Is the Difference Between Monetary Policy and Fiscal Policy, and How are They Related? "

U.S. Department of the Treasury. " Role of the Treasury ."

Federal Reserve Board. " Coronavirus Disease 2019 (COVID-19) ."

Federal Reserve Board. " Federal Open Market Committee: About the FOMC ."

U.S. National Library of Medicine National Institutes of Health. " Modeling U.S. Monetary Policy During the Global Financial Crisis and Lessons for COVID-19 ."

Boston University. " The Incredible Volcker Disinflation ."

Federal Reserve Board. " Speech: The Lender of Last Resort Function in the United States ."

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How Does the Fed Use Its Monetary Policy Tools to Influence the Economy?

The Federal Reserve (the Fed) is the central bank of the United States. As the central bank, it serves several key functions within the economy. One of the most important functions of the Fed is to promote economic stability using monetary policy. The Fed's goals for monetary policy, as defined by Congress, are to promote maximum employment and price stability .

The Federal Open Market Committee (FOMC) is the monetary policymaking arm of the Federal Reserve. The FOMC usually meets eight times per year in Washington, D.C. These two-day meetings include a review of economic data and financial conditions, briefings by economists, policy discussions, and a vote on the setting of monetary policy—including a decision about whether the FOMC will adjust its target range for the federal funds rate. The federal funds rate is the interest rate banks charge each other for overnight loans. The Fed sets a target range for where it wants the interest rates charged to fall within, and it is the setting of this range that the Fed uses to communicate its monetary policy position.

Figure 1: The Federal Funds Rate Target Range

SOURCE: Board of Governors of the Federal Reserve System via FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=COX8 , accessed April 4, 2022.

The FOMC conducts monetary policy by setting the target range for the federal funds rate. This graph shows the target range, determined by the upper and lower limits, and the effective federal funds rate within the range.

Over time, as shown in Figure 1, 2 the FOMC has moved the target range up and down as it steers the economy toward maximum employment and price stability. For example, once the economy recovered from the global financial crisis, the FOMC moved the target range from near zero at the end of 2015 up to 2¼ -2½ percent by early 2019. Then when the COVID-19 pandemic hit, the FOMC quickly moved the target range back to near zero.

What Is the Federal Funds Rate and Why Is It So Important?

The federal funds rate is a very specific short-term interest rate. It involves the transfer of funds between banks that maintain accounts (deposits) with their Federal Reserve Bank; the accounts are called reserve balance accounts. The federal funds market is where banks that may need money in their reserve accounts for cashflow reasons go to borrow from banks that have excess funds in their reserve accounts. Banks who lend funds act as suppliers of reserves in the federal funds market; banks who borrow funds act as demanders of reserves in the federal funds market. The federal funds rate is not "set" by the Fed, but rather determined by the borrowers and lenders in the federal funds market.

Figure 2: Transmission of Monetary Policy

Monetary policy is transmitted through market interest rates to affect consumers' and producers' spending decisions, which ultimately moves the economy toward the Fed's objectives—maximum employment and stable prices. This monetary policy implementation framework ensures that when the FOMC changes its policy stance (raises or lowers the target range for the federal funds rate), market interest rates and financial conditions move in the desired direction.

The FOMC conducts monetary policy by setting the target range for the federal funds rate (Figure 2, Box 1). Then the Fed implements policy by using its monetary policy tools to ensure the federal funds rate stays within the target range (red arrow).

The federal funds rate is important because when the FOMC sets its target range, it influences many other interest rates in the economy (Figure 2, Box 2). In fact, by adjusting the target for this rate, the Fed can influence the spending choices of consumers and producers (Figure 2, Box 3) and ultimately move the economy toward maximum employment and price stability (Figure 2, Box 4).

The Fed's Monetary Policy Implementation Toolbox

The Fed uses its monetary policy tools in the implementation phase. In all, the Fed uses four key tools to help ensure the federal funds rate stays within the target range set by the FOMC. 3 We'll use a simple supply and demand model (Figure 3) to describe how the tools work together. Overall, these are the critical tools the Fed uses because reserves in the banking system are ample. That is, the supply of reserves, set by the Fed, is large enough that it intersects the demand curve where it is nearly flat (see Figure 3).

Figure 3: Monetary Policy with Ample Reserves

In the ample-reserves framework, the Federal Reserve raises (lowers) its administered rates to move the federal funds rate higher (lower). Small shifts of the supply curve have little or no effect on the federal funds rate.

The Fed's Primary Tool: Interest on Reserve Balances

Today, the Fed's primary tool for adjusting the federal funds rate is interest on reserve balances. The interest on reserve balances rate (labeled "IORB rate" in Figure 3) is the interest rate paid on funds that banks hold in their reserve balance account at a Federal Reserve Bank. For banks, this interest rate represents a risk-free investment option. Importantly, the interest on reserve balances rate is an "administered rate," which means it is set by the Fed and not determined in a market (like the federal funds rate is). In fact, there are two key concepts that ensure interest on reserves is an effective tool.

The first concept is the reservation rate , which is the lowest rate that banks are willing to accept for lending out their funds. Banks can deposit their funds at the Federal Reserve and earn the interest on reserve balances rate. Because depositing funds at the Fed is a risk-free option, banks will likely not be willing to lend their funds in the federal funds market for a lower interest rate than they can earn from depositing their funds at the Fed. So, the interest on reserve balances rate serves as a reservation rate for banks.

The second concept is arbitrage , which is the simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price. For example, let's assume reserves are trading in the federal funds market at 2 percent (i.e., the federal funds rate is 2 percent) and that reserves (deposits) at the Fed earn 2.5 percent (i.e., the interest on reserve balances rate is 2.5 percent). Banks will quickly see that they can borrow funds in the federal funds market at 2 percent and deposit those funds at the Fed and earn the interest on reserve balances rate of 2.5 percent, which means that they can earn a profit of 0.5 percent (the difference between the rates).The increase in demand for funds in the federal funds market will put upward pressure on the federal funds rate, and the federal funds rate will rise toward the interest on reserve balances rate. This upward pressure on the federal funds rate will continue until the federal funds rate has risen to the level that banks no longer see the opportunity to profit.

So, arbitrage ensures that the federal funds rate does not fall far below the interest on reserve balances rate . Arbitrage is the reason why these short-term rates remain closely linked. In fact, arbitrage is what makes interest on reserve balances an effective tool for guiding the federal funds rate. Because the Fed sets the interest on reserve balances rate directly, the Fed can steer the federal funds rate down or up by lowering or raising the level of the interest on reserve balances rate. As a result, interest on reserve balances is the Fed's primary tool for adjusting the federal funds rate, but the Fed has other tools that play supporting roles.

Setting a Floor for the Federal Funds Rate: The Overnight Reverse Repurchase Agreement Facility

Interest on reserve balances is available only to banks and a few other institutions. The Fed has an overnight reverse repurchase facility that is open to a broader set of financial institutions. This facility allows these financial institutions to deposit their funds at a Federal Reserve Bank and earn the overnight reverse repurchase agreement rate offered by the Fed. The overnight reverse repurchase agreement rate (labeled "ON RRP rate" on Figure 3) works for these institutions similar to the way the interest on reserve balances rate works for banks. So, this rate acts like a reservation rate for these financial institutions, and the overnight reverse repurchase agreement rate interacts with other short-term market rates through arbitrage. The overnight reverse repurchase agreement facility is a supplementary tool because the rate the Fed sets for it helps set a floor for the federal funds rate (Figure 4).

Figure 4: Steering the Federal Funds Rate

SOURCE: Federal Reserve Bank of New York and Board of Governors of the Federal Reserve System via FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=LP47 , accessed April 4, 2022.

The Fed implements monetary policy by using its monetary policy tools, such as the interest of reserve balances rate (red) and overnight reverse repurchase agreement rate (blue), to ensure interest rates are consistent with the federal funds rate target.

Setting a Ceiling for the Federal Funds Rate: The Discount Window

The discount rate is the rate charged by the Fed for loans obtained through the Fed's discount window . Because banks will not likely borrow at a higher rate than they can borrow from the Fed, the discount rate acts as a ceiling for the federal funds rate: It is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate (Figure 5).

Figure 5: Expansionary Policy with Ample Reserves

When the Federal Reserve lowers its administered rates, the end points of the demand curve shift down. The vertical supply curve is unchanged. The demand curve intersects the supply curve at a lower federal funds rate. In general, the Fed tends to lower all the administered rates by the same amount, keeping the spread between the rates constant.

The Final Tool: Open Market Operations

As noted above, the Fed's current method for implementing monetary policy relies on banks' reserves remaining "ample." So, if the Fed needs to add reserves to ensure they remain ample, it does so by buying U.S. government securities in the open market. This action is known as open market operations . When the Fed buys securities, it pays for them by depositing funds into the appropriate banks' reserve balance accounts, adding to the overall level of reserves in the banking system. As Figure 3 shows, open market operations can be used to shift the supply curve left or right. Prior to 2008, open market operations were the Fed's primary monetary policy tool, which it used daily to make sure the federal funds rate hit the FOMC's target. Today this tool is mainly used to ensure that reserves remain ample.

Now that you understand the Fed's implementation tools, let's see how the Fed uses them to achieve its two goals: maximum employment and price stability.

Expansionary Monetary Policy Using the Fed's Tools

Suppose the following: The economy weakens, with employment falling short of maximum employment, and the inflation rate has been steady at around 2 percent but is showing signs of decreasing. The FOMC might decide to conduct monetary policy by lowering its target range for the federal funds rate. To implement that monetary policy, it would decrease its administered rates—the interest on reserve balances rate, overnight reverse repurchase agreement rate, and discount rate—to ensure the market-determined federal funds rate stays within the target range (see Figure 5). These actions would transmit to other interest rates and broader financial conditions:

• Lower interest rates decrease the cost of borrowing money, which encourages consumers to increase spending on goods and services and businesses to invest in new equipment.
• The increase in consumption spending increases the overall demand for goods and services in the economy, which creates an incentive for businesses to increase production, hire more workers, and spend more on other resources.
• As these increases in spending ripple through the economy, likely moving the unemployment rate down toward its full employment level, inflation could possibly move up.

So, the Fed's monetary policy implementation tools can be effective for moving the economy back toward maximum employment and price stability when the economy is stalling.

Contractionary Monetary Policy Using the Fed's Tools

Suppose the following: The economy is showing signs of overheating, with the unemployment rate very low and businesses finding it hard to fill jobs, and the inflation rate has been above the Fed's 2 percent target for quite some time and is rising. In this case, the FOMC might decide to conduct monetary policy by raising its target range for the federal funds rate. To implement that monetary policy, it would increase its administered rates—the interest on reserve balances rate, overnight reverse repurchase agreement rate, and discount rate—to ensure the federal funds rate stays within the target range. These actions would transmit to other interest rates and broader financial conditions:

• Higher interest rates increase the cost of borrowing money and raise the incentive to save, which dampens consumer spending on some goods and services and slows businesses' investment in new equipment.
• The decrease in consumption spending decreases the overall demand for goods and services in the economy, which will likely lead to a decrease in production levels, fewer employees hired, and less spending on other resources.
• As these decreases in spending ripple through the economy, demand for workers could lessen, inflationary pressures would diminish, and the inflation rate would fall back toward 2 percent.

So, higher interest rates can be used to move the economy back to maximum employment and price stability when the economy is overheating.

The Fed has a congressional mandate of maximum employment and price stability. The FOMC conducts monetary policy by setting the target range for the federal funds rate. Then the Fed uses its monetary policy tools to implement the policy, which guides market interest rates toward the Fed's desired setting of policy. The Fed ensures there are ample reserves in the banking system and uses its administered rates to steer the federal funds rate into the FOMC's target range: Interest on reserve balances is the Fed's primary tool for adjusting the federal funds rate; the overnight reverse repurchase agreement facility is a supplementary tool that sets a floor for the federal funds rate; and the discount rate serves as a ceiling for the federal funds rate. Changes in the federal funds rate are transmitted to other interest rates through arbitrage and affect the decisions of consumers and businesses. Their decisions ultimately move the economy toward maximum employment and price stability.

Arbitrage: The simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price.

Discount rate: The interest rate charged by the Federal Reserve to banks for loans obtained through the Fed's discount window.

Facility: A standing program targeted at a set of counterparties for depositing or lending. The Fed has permanent facilities (like the discount window and the overnight reverse repurchase agreement facility) as well as temporary facilities (like those implemented during the Financial Crisis of 2007-09 and the COVID-19 pandemic).

Federal Open Market Committee (FOMC): A Committee created by law that consists of the seven members of the Board of Governors; the president of the Federal Reserve Bank of New York; and, on a rotating basis, the presidents of four other Reserve Banks. Nonvoting Reserve Bank presidents also participate in Committee deliberations and discussion.

Maximum employment: The highest level of employment that an economy can sustain while maintaining a stable inflation rate.

Open market operations: The buying and selling of government securities through primary dealers by the Federal Reserve. When the securities are bought or sold, reserves in the banking system are increased or decreased, respectively.

Price stability: A low and stable rate of inflation maintained over an extended period of time.

Reservation rate: The lowest rate of return that banks are willing to accept for lending out funds.

Reserve balances (reserves): The deposits a bank maintains in its account with a Federal Reserve Bank.

• Powell, Jerome. " Data-Dependent Monetary Policy in an Evolving Economy ." Board of Governors of the Federal Reserve System, October 8, 2019.
• The effective federal funds rate is the rate used in the figures in this article. On any given day, there are many transactions that settle at slightly different federal funds rates. The effective federal funds rate is the volume-weighted median rate of these transactions.
• The Fed recently introduced two repurchase agreement (repo) backstop tools, the standing overnight repo facility and the foreign and international monetary authorities repo facility. These are used by specific counterparties to help set a ceiling on repo rates. We do not discuss them here because this article is targeted toward a principles of economics audience.

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Jane E. Ihrig is a senior adviser and economist at the Federal Reserve Board of Governors.

Scott A. Wolla is an economic education officer at the St. Louis Fed.

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Jane E. Ihrig and Scott A. Wolla, " How Does the Fed Use Its Monetary Policy Tools to Influence the Economy? ," Federal Reserve Bank of St. Louis Page One Economics , May 2, 2022.

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Monetary Policy and Central Banking

What is monetary policy and why is it important.

Central banks use monetary policy to manage economic fluctuations and achieve price stability, which means that inflation is low and stable. Central banks in many advanced economies set explicit inflation targets. Many developing countries also are moving to inflation targeting .  Central banks conduct monetary policy by adjusting the supply of money, usually through buying or selling securities in the open market. Open market operations affect short-term interest rates, which in turn influence longer-term rates and economic activity. When central banks lower interest rates, monetary policy is easing. When they raise interest rates, monetary policy is tightening.

How has monetary policy been used recently?

After the global financial crisis that started in 2007, central banks in advanced economies eased monetary policy by reducing interest rates until short-term rates came close to zero, limiting options for additional cuts. Some central banks used unconventional monetary policies, buying long-term bonds to further lower long-term rates. Some even took short-term rates below zero. In response to the COVID-19 pandemic, central banks took actions to ease monetary policy, provide liquidity to markets, and maintain the flow of credit. To mitigate stress in currency and bond markets, many emerging market central banks used foreign exchange interventions, and for the first time, asset purchase programs. More recently, in response to rapidly growing inflation, central banks around the world have tightened monetary policy by increasing interest rates.

Monetary policy and exchange rates

A country’s monetary policy is closely linked to its exchange rate regime . A country’s interest rates affect the value of its currency, so those with a fixed exchange rate will have less scope for an independent monetary policy than ones with a flexible exchange rate. A fully flexible exchange rate regime supports an effective inflation-targeting framework.

Why do countries have macroprudential policies?

The global financial crisis of 2007-2009 showed that countries needed to identify and contain risks to the financial system as a whole. Many central banks adopted the use of prudential tools and established macroprudential policy frameworks to promote financial stability. Macroprudential tools are used to build buffers and contain vulnerabilities that make the financial system susceptible to shocks. This reduces the probability that shocks to the financial system disrupt the provision of financial services and cause serious negative consequences for the economy. Central banks are well placed to conduct macroprudential policy because they are able to analyze systemic risk and often are relatively independent and autonomous. Independence and autonomy are important because the institution responsible for macroprudential policy should be able to withstand political pressures and opposition from industry groups.

What role does the IMF play in monetary policy and central banking?

The IMF promotes the effectiveness of central banks through its policy advice, technical assistance, and data collection. In bilateral policy advice , known as Article IV consultation, the IMF is in regular dialogue with country central banks. It may provide advice on establishing effective frameworks for monetary policy and macroprudential policy, as well as monetary policy actions. As part of its financial surveillance, the IMF’s Financial Sector Assessment Program (FSAP) provides member countries with an evaluation of their financial systems and advice on managing financial stability risks. The assessments often are contained in technical notes, such as these for Finland , Netherlands , and Romania .

Technical assistance helps countries develop more effective institutions, legal frameworks, and capacity. It may entail monetary policy, exchange rate regimes, or macroprudential policies. It can also help countries move toward inflation targeting or improve central bank operations, such as open market operations and foreign exchange management. The IMF’s  Central Bank Transparency Code  (CBT) helps central banks to guide their transparency practices, as a prerequisite for central bank independence. The  CBT reviews , conducted by IMF staff, provide a view on central bank transparency and facilitate more effective dialogue between the central bank and its various stakeholders. To inform policy development and research, the IMF works with its members to create and maintain databases . For example:

This page was last updated in January 2023

Home — Essay Samples — Economics — Political Economy — Monetary Policy

Essays on Monetary Policy

Monetary policy is an important tool used by central banks to manage the money supply and achieve economic goals such as price stability, full employment, and economic growth. It involves the use of interest rates, open market operations, and reserve requirements to influence the level of economic activity. Given its significance in shaping the overall economic landscape, there are numerous topics that can be explored in essays related to monetary policy.

Importance of the Topic

Understanding monetary policy is crucial for individuals, businesses, and policymakers alike. For individuals, it can affect their borrowing and saving decisions, as well as their purchasing power. For businesses, it can impact their investment decisions and access to credit. For policymakers, it is essential for making informed decisions on interest rates and other monetary policy tools to achieve macroeconomic objectives.

Advice on Choosing a Topic

When selecting a monetary policy essay topic, it is important to consider current events and trends in the economy. Some potential areas of focus could include the impact of monetary policy on inflation, the effectiveness of unconventional monetary policies such as quantitative easing, or the role of central banks in financial stability. Additionally, exploring the relationship between monetary policy and other economic variables such as exchange rates, asset prices, and economic growth can provide valuable insights.

Another approach could be to analyze the historical evolution of monetary policy and its impact on different economic periods. This could involve examining the effectiveness of various monetary policy regimes, such as fixed exchange rates versus floating exchange rates, or the implications of different monetary policy rules such as inflation targeting or nominal GDP targeting.

Furthermore, essays could delve into the challenges and limitations of monetary policy in the current global economic environment. This might include discussing the constraints faced by central banks in the aftermath of the 2008 financial crisis, as well as the implications of low and negative interest rates on monetary policy effectiveness.

Monetary policy is a multifaceted topic with a wide range of potential essay topics to explore. Whether delving into contemporary issues, historical perspectives, or theoretical debates, there is no shortage of interesting and relevant subjects to examine. By choosing a well-defined and relevant topic, students and researchers can contribute to the ongoing discourse on monetary policy and deepen their understanding of its impact on the economy. As the economic landscape continues to evolve, the study of monetary policy will remain a crucial area of research and analysis.

The Use of Monetary Policies that Are Focused on Growth

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Monetary Policy and Inflation in Nigeria

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The Government Tools and Means to Alleviate Pressure from Consumers and Businesses Alike

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The Monetary Crisis in Europe

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