Definition of 'Monetary Policy'
Imperative to the health and financial well-being of a country, monetary policy are the actions taken by a regulatory committee or central bank to determine size and growth rate of the country’s economy. For instance, the Federal Reserve in the United States establishes monetary policy.
TheStreet Explains ‘Monetary Policy’
The overall goals with monetary policy are to create a healthy economy with low unemployment, price stability and moderate, fixed interest rates.
With regard to the Federal Reserve (the Fed), the Fed establishes monetary policy to ensure money doesn’t grow too fast, which would cause inflation or too slowly, which could hamper economic development. In a balanced situation, inflation should be at 2% to 3% annually, which maintains pricing stability. The Fed also monitors and maintains unemployment levels, which should be at approximately 5%. The Fed also applies monetary policy by buying and selling U.S. treasuries in the open market, setting the discount interest rates for banks (banks with a positive credit rating receive the discount rate) and setting the reserve requirements.
The Fed uses five major tools to create monetary policy. First, the Fed sets the reserve requirement, which means it advises banks on how much money they must have on reserve. Next, the Fed sets the interest rates, which influences consumer and commercial borrowing (and savings rates). The Fed also holds Federal Open Market Committee (FOMC) meetings, which sets the central bank’s discount rate. Next, the Fed uses open market operations to buy and sell treasuries from member banks. Finally, the Fed uses inflation targeting to set prices at central banks.
Monetary policy has two types--expansionary and contractionary. Expansionary policy focuses on lowering unemployment through raising the money supply, while also honing in on increasing private sector borrowing and enhancing consumer spending. With contractionary policy, the opposite occurs. The money supply growth rate slows in order to manage inflation. The slower growth rate can have a negative impact on unemployment and reduce borrowing. Most recently, quantitative easing, another type of monetary policy, became more commonplace as markets crashed and countries fell deep into a recession. Quantitative easing is when the central bank buys securities from the market to lower interest rate and boost the money supply.
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The Federal Reserve, commonly referred to with no disrespect as the...
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