# Monetary Policy: Meaning, Types, and Tools

> **Definition**
>
> Monetary policy is the combination of strategy and actions that the Federal Reserve employs to achieve the economic goals set for it by Congress.

## What Is Monetary Policy?

Monetary policy is a set of tools used by a nation's central bank to control the overall money supply and promote economic growth.

It involves strategies such as adjusting interest rates and changing bank reserve requirements.

In the United States, the Federal Reserve Bank (Fed) implements monetary policy to meet its dual mandate from Congress: to achieve maximum employment while keeping inflation in check.

### Key Takeaways

*   Monetary policy controls a nation's overall money supply for the purpose of economic growth.  
    
*   Monetary policy strategies include revising interest rates and changing bank reserve requirements.
*   It is commonly classified as either expansionary or contractionary.
*   The Fed uses three main tools to implement its monetary policy: reserve requirements, the discount rate, and open market operations.

![Monetary Policy](https://www.investopedia.com/thmb/jtC7SQ0a3j_rSTah1MlbnymLyfo=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Monetary-Policy-ca2313abbf3646e38301b40f3a53a476.png)

*— Xiaojie Liu / Investopedia*

## Understanding Monetary Policy

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)](https://www.investopedia.com/terms/g/gdp.asp), the rate of [inflation](https://www.investopedia.com/terms/i/inflation.asp), 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 these rates rise or fall, financial institutions adjust their rates for their customers, such as businesses or home buyers.

This can either slow or encourage borrowing, spending, business activity, hiring, and economic growth. It can also affect the rate of inflation.

Additionally, a central bank may buy or sell government bonds, target [foreign exchange](https://www.investopedia.com/terms/f/foreign-exchange.asp) rates, and revise the amount of cash that the banks are required to maintain as reserves.  

> **Important**
>
> The Federal Reserve commonly uses three tools for monetary policy: reserve requirements, the discount rate, and open market operations.

## 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](https://www.investopedia.com/terms/c/contractionary-policy.asp#:~:text=Contractionary%20Policy%20as%20a%20Monetary,money%20circulating%20in%20the%20economy.) 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](https://www.investopedia.com/terms/e/expansionary_policy.asp) policy supports economic activity. By lowering interest rates, saving becomes less attractive, business and consumer borrowing increases, as does business and [consumer spending](https://www.investopedia.com/terms/c/consumer-spending.asp#:~:text=What%20Is%20Consumer%20Spending%3F,%2C%20nondurable%20goods%2C%20and%20services.).

## Goals of Monetary Policy

### Inflation

Contractionary monetary policy is used to temper inflation by reducing the level of money circulating in the economy. Expansionary monetary policy increases the amount of money in circulation and fosters inflationary pressure due to greater economic activity.

### Unemployment

An expansionary monetary policy decreases unemployment as a larger 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 can become less attractive and cheaper relative to other currencies.

## Tools of Monetary Policy

### Open Market Operations

In [open market operations (OMO)](https://www.investopedia.com/terms/o/openmarketoperations.asp), the Fed buys bonds from investors or sells additional bonds to them to increase or reduce the 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 that affect other interest rates.

### Interest Rates

The central bank may change interest rates or the required [collateral](https://www.investopedia.com/terms/c/collateral.asp) that it demands. In the U.S., this rate is known as the [discount rate](https://www.investopedia.com/terms/d/discountrate.asp). It's the rate that the Fed charges financial institutions for loans it makes to them.

The level of the discount rate can affect other interest rates, such as those that banks charge customers for [loans](https://www.investopedia.com/the-best-personal-loans-8761582). Banks will loan more or less freely depending on the discount rate.

### Reserve Requirements

A central bank can manipulate the [reserve requirements](https://www.investopedia.com/terms/r/requiredreserves.asp), which govern the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their [liabilities](https://www.investopedia.com/terms/l/liability.asp).

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

## Monetary Policy vs. Fiscal Policy

Monetary policy is enacted by a central bank to sustain a level economy and keep unemployment low. It is intended to protect the value of the currency and maintain economic activity.

By manipulating interest rates or reserve requirements, or through open market operations, a central bank affects borrowing, spending, and savings rates.

[Fiscal policy](https://www.investopedia.com/terms/f/fiscalpolicy.asp) is an additional tool used by governments but not central banks. While the Federal Reserve can influence the economy through the money supply, and [impact market sentiment](https://www.investopedia.com/terms/m/moralsuasion.asp), the U.S. Treasury Department can create new money and implement new tax policies.

In other words, fiscal policy involves government spending and taxing. It spends to add money, directly or indirectly, into the economy to increase business and consumer spending and spur growth.

Both monetary and fiscal policies were used in response to the COVID-19 pandemic.  

## Frequently Asked Questions (FAQs)

## How Often Does Monetary Policy Change?

The Federal Open Market Committee of the Federal Reserve meets eight times a year to determine any changes to the nation's monetary policies. The [Federal Reserve](https://www.investopedia.com/terms/f/federalreservebank.asp) may also act in an emergency, as 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](https://www.investopedia.com/terms/c/contractionary-policy.asp) can slow economic growth and even increase unemployment, but is often seen as necessary to level the economy and keep inflation 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](https://www.investopedia.com/terms/l/lenderoflastresort.asp), providing banks with [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) and maintaining regulatory scrutiny to prevent them from failing and causing financial panic.

## The Bottom Line

Monetary policy employs strategies and tools to keep a nation's economy stable [while limiting inflation](https://www.investopedia.com/ask/answers/122214/how-does-monetary-policy-influence-inflation.asp) and unemployment.

Expansionary monetary policy stimulates a weakening economy, while contractionary monetary policy slows down an inflationary economy. A nation's monetary policy is often coordinated with its fiscal policy.

> **Article Sources**
>
> 1.  Federal Reserve Board. "[Monetary Policy Principles and Practice](https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm)."
>     
> 2.  Federal Reserve Bank of St. Louis. "[Expansionary and Contractionary Monetary Policy](https://www.stlouisfed.org/in-plain-english/expansionary-and-contractionary-policy)."
>     
> 3.  Federal Reserve Board. "[Policy Tools: Open Market Operations](https://www.federalreserve.gov/monetarypolicy/openmarket.htm)."
>     
> 4.  Federal Reserve Board. "[Policy Tools: Discount Window](https://www.federalreserve.gov/monetarypolicy/discountrate.htm)."
>     
> 5.  Federal Reserve Board. "[Policy Tools: Reserve Requirements](https://www.federalreserve.gov/monetarypolicy/reservereq.htm)."
>     
> 6.  Federal Reserve Board. "[FAQs: What Is the Difference Between Monetary Policy and Fiscal Policy, and How are They Related?](https://www.federalreserve.gov/faqs/money_12855.htm)"
>     
> 7.  U.S. Department of the Treasury. "[Role of the Treasury](https://home.treasury.gov/about/general-information/role-of-the-treasury)."
>     
> 8.  Federal Reserve Board. "[Coronavirus Disease 2019 (COVID-19)](https://www.federalreserve.gov/supervisory-regulatory-action-response-covid-19.htm)."
>     
> 9.  Federal Reserve Board. "[Federal Open Market Committee: About the FOMC](https://www.federalreserve.gov/monetarypolicy/fomc.htm)."
>     
> 10.  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](https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7456449/)."
>      
> 11.  Goodfriend, Marvin, and Robert G. King. "[The Incredible Volcker Disinflation](https://www.bu.edu/econ/files/2011/01/GKcr2005.pdf)." _Journal of Monetary Economics_, vol. 52, August 2005, pp. 981 - 1015.
>      
> 12.  Federal Reserve Board. "[Speech: The Lender of Last Resort Function in the United States](https://www.federalreserve.gov/newsevents/speech/fischer20160210a.htm)."