January 23, 2019 

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Control over the money supply and interest rates by a central bank or monetary authority to stabilize business cycles, reduce unemployment and inflation, and promote economic growth. In the United States monetary policy is undertaken by the Federal Reserve System (the Fed). In principle, Federal Reserve policy makers can use three different tools--open market operations, the discount rate, and reserve requirements--to manipulate the money supply. In practice, however, the primary tool employed is open market operations. An alternative to monetary policy is fiscal policy.
Monetary policy is controlling of the quantity of money in circulation for the expressed purpose of stabilizing the business cycle and reducing the problems of unemployment and inflation. In days gone by, monetary policy was undertaken by printing more or less paper currency. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking.

The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations, the discount rate, and reserve requirements. In practice, the Fed primarily uses open market operations, the buying and selling of U.S. Treasury securities, for this control.

An important side effect of money supply control is control of interest rates. As the quantity of money changes, banks are willing to make loans at higher or lower interest rates.

Monetary policy comes in two basic varieties--expansionary and contractionary:

  • Expansionary monetary policy or easy money results if the Fed increases the money supply and lowers interest rates and is the recommended policy to counter a recession.

  • Contractionary monetary policy or tight money occurs if the Fed decreases the money supply and raises interest rates and is the recommended policy to reduce inflation.

Three Goals

The general goal of monetary policy is to keep the economy healthy and prosperous. More specifically, monetary policy seeks to achieve the macroeconomic goals of full employment, stability, and economic growth. That is, monetary policy is used to stabilize the business cycle and in so doing reduce unemployment and inflation, and the while promoting an environment that is conducive to an expanding economy.

A word about these three macroeconomic goals and associated problems is in order.

  • Full Employment: This results when all available resources (especially labor) willing and able to engage in production are producing goods and services. Falling short of this goal results in unemployment. Because some degree of unemployment naturally exists in a modern complex economy, full employment is achieved if the unemployment rate is about 5 percent. Unemployment means the economy forgoes the production goods and services.

  • Stability: This exists when fluctuations in prices, production, and employment have been eliminated. While stability for all aspects of the economy are important, monetary policy tends to be most concerned with price stability, that is, keeping the price level in check and eliminating inflation. Inflation erodes the purchasing power of financial wealth.

  • Economic Growth: This occurs when the production capacity of the economy increases over time, which is achieved by increasing the quantity and/or quality of resources. When the economy grows and production capacity expands, then more goods and services are available to satisfy wants and needs. Without economic growth, the economy stagnates, and often even experiences a falling living standard.

Three Tools

The Federal Reserve System has three tools that, in principle, can be used to control the money supply and interest rates.
  • Open Market Operations: The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.

  • Discount Rate: The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.

  • Reserve Requirements: The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve requirements, then banks can use existing reserves to make more loans and thus increase the money supply. If the Fed raises reserve requirements, then banks can use existing reserves to fewer more loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply.
The Federal Reserve System has another monetary policy tool, termed moral suasion that can be exceptionally effective--in limited circumstances. Moral suasion is a policy tool in which the Fed, usually the Chairman of the Board of Governors, requests that the banking system take some specific action, such as making more loans or fewer loans. Such requests are usually contrary to what banks are currently doing and are not mandated in any legal or regulatory sense.

The Tool of Choice: Open Market Operations

While all three tools affect the money creation process undertaken by banks and thus, in theory, can be used to change the quantity of money in circulation, open market operations is the tool of choice.

Open market markets are very precise and can be easily implemented. The Fed can buy or sell just the right amount of Treasury securities to achieve the amount of bank reserves that will generate the desired quantity of money and interest rate. Any buying or selling can be implemented within hours.

The discount rate works only if commercial banks actually borrow reserves from the Fed. Such borrowing is often dependent on factors other than the discount rate, such as the health of the banking system. A low discount rate does not guarantee banks will borrow more and a high discount rate does not guarantee banks will borrow less.

Reserve requirements are a fundamental part of the structure of the commercial banking system. They determine the division of bank assets between reserves and loans. Because the reallocation of assets between reserves and loans is not easily achieved, frequent changes in reserves requirements that would be needed to control the money supply will likely be ignored by banks as they opt for the highest likely reserve requirements.


In general, monetary policy induces changes in aggregate expenditures, especially investment but also consumption, which then results in changes in aggregate production (gross domestic product), the price level, and employment. However, the actual transmission mechanism runs through a variety of routes, termed the channels of monetary policy.
  • Interest Rate: The most noted monetary policy channel works through interest rates. Monetary policy, particularly open market operations, trigger changes in interest rates which affects the cost of borrowing by both the household and business sectors and subsequently investment expenditures and consumption expenditures. The result is changes in aggregate production and other macroeconomic variables.

  • Exchange Rate: A monetary policy channel that has become increasingly important with the integration of the global economy works through exchange rates. Monetary policy induced changes in interest rates also affect the flow of financial capital between countries, which then affects currency exchange rates. Currency exchange rates consequently impact the relative prices of imports into and exports out of a country. The resulting change in net exports then changes aggregate production and other macroeconomic variables.

  • Wealth: One of two related monetary policy channels works through the value of financial assets. By changing the financial wealth of the economy, monetary policy induces an adjustment in the portfolio of consumer assets. In particular, consumers are induced to modify the relative mix of financial and physical wealth, which is accomplished through consumption expenditures and which then affects aggregate production and other macroeconomic variables.

  • Equities: The second of two related monetary channels working through value of financial assets relates specifically to the value of corporate stock (that is, equities). As the value or price of equities change relative to the resource cost of producing capital goods, the financial return on investment by the business sector also changes, which induces changes in investment expenditures and subsequent changes in aggregate production and other macroeconomic variables.

  • Bank Lending: One of two related channels based on credit works through the willingness of banks to make loans to the business sector. As monetary policy changes the amount of available bank reserves, banks are more or less willing to make loans for business investment expenditures, which like the other channels also affects aggregate production and other macroeconomic variables.

  • Balance Sheet: The second of two related monetary policy channels based on credit works through the balance sheets of business sector firms. As monetary policy affects the value of financial assets, the relative values of assets and liabilities change. As net worth changes, business sector firms are more or less able to the borrow funds that are used for investment expenditures, from banks and other sources. This results in a change in investment expenditures and subsequently changes in aggregate production and other macroeconomic variables.
These six channels of monetary policy are neither independent nor mutually exclusive, nor are they equally important. Some channels tend to generate a bigger impact on the macroeconomy. And that impact changes over time under different circumstances. However, they inevitably work together. Monetary policy causes changes in interest rates, exchange rates, and the value of financial assets, which affect consumption expenditures, investment expenditures, and net exports, all of which then cause changes in the aggregate production and the macroeconomy.


While the general goal of monetary policy is to promote a stable, healthy, prosperous economy, the effectiveness of monetary policy is evaluated based on one or more specific targets--measurable aspects of the macroeconomy.

The common targets are:

  • Interest Rates: The most noted interest rate target is the interbank lending rate, commonly termed the Federal funds rate. This is the interest rate that banks change each other for short term reserve loans.

  • Monetary Aggregates: Another important set of targets are the monetary aggregates, commonly termed M1, M2, and M3. M1 is the money supply, the financial assets used for actual payments, including currency and checkable deposits. M2 is a broader measure of the money supply and includes highly liquid near monies (savings deposits) in addition to currency and checkable deposits. M3 is a broader measure that includes M2 plus slightly less liquid assets.

  • Exchange Rates: These are the prices one nation's currency in terms of the currencies of other nations.
Modern monetary policy generally works with a mix of targets, keeping an eye on interest rates, monetary aggregates, and exchange rates. However, in years past it was common practice to pursue one target to the exclusive of others. That is, for example, to implement whatever monetary policy was needed to effectively fix the Federal funds rate at a constant value, even though doing so might cause a great deal of volatility for the monetary aggregates and exchange rates.

Some modern nations, especially smaller countries, target exchanges rates. That is, they implement monetary policy that ensures the exchange rate between their domestic currency and that of another country, usually a larger country like United States, is essentially fixed. This provides a direct link between the two countries, meaning any monetary policy by the larger country also affects the smaller one.

The Monetary Authority

Monetary policy is undertaken by the monetary authority of a country, usually the central bank. In the United States, the Federal Reserve System is the monetary authority charged with controlling the money supply and implementing monetary policy.

The Board of Governors of the Federal Reserve System is generally in charge of monetary policy, but specific control rests with different parts of the Fed. The Board of Governors has complete control only over the reserve requirements. The Federal Open Market Committee (which includes the Board of Governors plus the Presidents of 5 Federal Reserve District Banks) is responsible for open market operations and thus has the primary control of monetary policy. The discount rate is under the direct authority of the 12 Federal Reserve District Banks, subject to approval by the Board of Governors.

Fiscal Policy

Monetary policy is one of two types of stabilization policies that seek to limit business-cycle fluctuations, reduce unemployment and inflation, and promote economic growth. The other is fiscal policy.

Fiscal policy makes use of the federal government's powers of spending and taxation to stabilize the business cycle. This policy is under the control of legislative and executive branches of the federal government charged with collecting taxes and spending available revenues.

If the economy is mired in a recession, then the appropriate fiscal policy is to increase spending or reduce taxes--termed expansionary fiscal policy. During periods of high inflation, the opposite actions are needed, to decrease spending or raise taxes--that is, contractionary fiscal policy.

Although some policy makers and economists prefer fiscal policy over monetary, or monetary policy over fiscal, both tend to be used in modern economies. However, the two policies are not necessarily coordinated. The monetary authority (the Fed) might pursue a contractionary monetary policy, while the fiscal authority (Congress and the President) pursues an expansionary fiscal policy.

Discretionary Control, or Not?

Most monetary policy undertaken by the Fed is termed discretionary policy. That is, the Fed sees or anticipates a problem with the macroeconomy, then takes explicit corrective actions. That is, the Fed makes a point to buy more Treasury securities or to raise the discount rate to achieve a particular goal.

The alternative to discretionary policy is nondiscretionary policy, that is, monetary policy that occurs automatically, usually according to a set of rules, that does not involve any explicit decisions or actions by the Fed.

The most noted nondiscretionary monetary policy is money supply rule. Such a rule would fix the growth of the money supply from year to year at a specific rate based on the long run growth of aggregate production. This provides a just enough extra money to purchase any additional production. In theory, this avoids the problems of inflation (too much money for available production) or unemployment (too little money for available production).

This might be an effective policy if money is the only factor creating an inflation and unemployment. Critics of a constant money supply growth rule contend that the demand for production can exceed or fall short of available production for reasons other than the money supply. If this occurs, then the monetary authority needs the ability to make compensating adjustments through discretionary monetary policy.

Politics: Two Views

Politics are never far from economics, especially when policies are involved. Such is the case for monetary policy of the Federal Reserve System. In some cases the Fed leans philosophically toward expansionary monetary policy (easy money) and in other cases toward contractionary monetary policy (tight money). The inclination for tight or easy money often results from political philosophy--conservative and liberal.
  • Conservatives tend to favor individual choices over government, producers over consumers, and lower inflation over lower unemployment. Conservatives tend to prefer tighter, contractionary controls on the money supply. This keeps inflation rates down, even though higher unemployment rates might result.

  • Liberals tend to favor government restrictions on individual choices, consumers over producers, and lower unemployment over lower inflation. Liberals tend to prefer looser, expansionary use of the money supply. This ensures lower unemployment rates, even though higher inflation rates might result.
The Federal Reserve System, especially the Chairman of the Board of Governors, tends to lean more in one political direction or the other. Some Fed Chairmen have tended to be more liberal, using monetary policy to keep unemployment rates low. Other Fed Chairmen have tended to be more conservative, using monetary policy to keep inflation rates low. While Fed Chairmen, in theory, can be absolutely, positively, completely neutral when it comes to politics, such almost never happens.


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Check Out These Related Terms...

     | monetary economics | open market operations | discount rate | reserve requirements | central bank | expansionary monetary policy | contractionary monetary policy | Federal Reserve pyramid | Board of Governors, Federal Reserve System | Chairman of the Board of Governors, Federal Reserve System | Federal Reserve Banks | Federal Open Market Committee | Federal Advisory Council |

Or For A Little Background...

     | fractional-reserve banking | banks | money | bank reserves | bank panic | business cycles | check clearing | money creation | macroeconomics | monetary base | monetary aggregates | unemployment | inflation | investment expenditures | consumption expenditures | macroeconomic goals | political views |

And For Further Study...

     | Federal Deposit Insurance Corporation | Comptroller of the Currency | barter | aggregate market | inflation | bank balance sheet | gross domestic product | circular flow | goldsmith money creation | fiscal policy |

Related Websites (Will Open in New Window)...

     | Federal Reserve System |

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