Monetary policy refers to the efforts by governments or central banks to influence economic activity through the money supply. There are different definitions of the money supply, but it generally incorporates any cash, checks, credit accounts and other liquid, exchangeable instruments. Most of the economic tools used in monetary policy center around the creation of new money units or the control of credit accounts through interest rate changes. The efficacy of monetary policy is a controversial topic among economists and policy makers, and the exact means of implementing monetary controls varies among governments and across time.

Many modern governments separate those who enact fiscal policy, taxing and government spending, from those who control monetary policy, often delegating the latter to central banks further removed from the political process. The most basic monetary function of central banks is to increase or decrease the total money supply. According to the quantity theory of money, an increase in the money supply tends to cause inflation, while a shrinking money supply tends to cause deflation.

In practice, however, controlling the money supply can be difficult. Private lenders can actually change the amount of money in circulation through the fractional reserve banking system, and technological innovations have introduced new means of exchange and stores of value. It can be very difficult for central banks to even measure the current money supply, let alone calculate its velocity or estimate the impact of future monetary injections.

Rather than simply printing or gathering units of currency, it is easier for central banks to use measurable metrics such as interest rates and consumer prices to set policy. This is why the Federal Reserve targets the discount rate and the federal funds rate; interest rates influence the cost of credit. Borrowing becomes cheaper when rates are lowered, and this tends to increase the amount of money in the economy through the multiplier effect. The opposite is true when rates are increased and credit is more expensive.

The Fed also sets the reserve ratio requirements for private lenders, which is the total percentage of a bank's lending assets that must be kept on deposit, not lent out, to meet demand account obligations. Banks often borrow money from each other overnight to meet these requirements, so the Fed controls how much interest can be charged on these short-term loans.

Central banks can actually enter the securities markets to influence prices and either inject or absorb money from the economy. If the Fed purchases U.S. Treasurys, for example, it increases the demand for that asset and simultaneously injects money into the market. Conversely, selling U.S. Treasurys increases supply for the asset and pulls money out of the market. This type of monetary activity is known as open market operations.

As a tool of economic reform, monetary policy is crude and inexact. Many standard measurements of economic performance, such as unemployment, inflation, total spending, capital investment, etc., are either lagging or difficult to estimate. That said, monetary policy remains one of the most important influences on modern economies and the subject of continual study.

  1. How does monetary policy influence inflation?

    Take a deeper look at how contemporary central banks attempt to target and control the level of inflation through monetary ... Read Answer >>
  2. What's the difference between monetary policy and fiscal policy?

    Discover the distinctions between these two tools designed to influence national economies. Read Answer >>
  3. How is money supply used in monetary policy?

    Learn about the three components of the Federal Reserve's monetary policy. Understand how these three components use the ... Read Answer >>
  4. How is free enterprise affected by monetary policy?

    Find out how state-run monetary policy changes a free enterprise system by adjusting market rates of interest and manipulating ... Read Answer >>
  5. How does the law of supply and demand affect monetary policy in the United States?

    Learn about how the law of supply and demand affects monetary policy in the United States. Changing interest rates leads ... Read Answer >>
  6. What are some examples of operations management in healthcare?

    Learn how open market operations and monetary policy are related. Since the Great Recession, open market operations have ... Read Answer >>
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