Monetary policy is carried out by a nation's central bank to manage the money supply with the objectives of promoting economic growth and stable employment without excessive inflation. This is achieved by influencing the cost of money (interest rates) and the availability of credit.
Business activity is directly influenced by interest rates. Lower interest rates prompt businesses to expand. Lower rates also may be indicative of banks being more eager to lend. For example, assume an investor is interested in purchasing an apartment complex. The current monthly rental income equals $11,000. The investor and bankers would probably not proceed with the acquisition if the monthly mortgage payment equaled $12,000. However, both may want to proceed if the payment dropped to $9,000 following a decline in interest rates. This example illustrates how lower interest rates can increase the likelihood a project will proceed.
Consumers also benefit from lower rates. Savings from lower car payments can be used to purchase other items. Families can purchase a larger home at a lower mortgage rate. All this generates more economic activity.
Monetary policy aims to manage the economy by manipulating interest rates – specifically the federal funds rate. Expansionary monetary policy lowers the federal funds rate by increasing the money supply, making more business ventures worth pursuing and expanding the economy. A central bank uses expansionary policies when the economy is in a recession and wishes to increase employment and economic growth. Expansionary policies are frequently referred to as “easy money” because more money is available for banks to lend. In the graph below, the monetary policy increases the aggregate demand from AD1 to AD2. The economy’s output increases from Q1 to Q2. Higher prices result from expansionary monetary policy, as shown by the price level rising from P1 to P2.
On the other hand, contractionary monetary policy slows the rate of growth of the money supply to decelerate an overheated economy and reduce inflationary pressures. Contractionary policies are also referred to as “tight money” because less money is made available to borrow.
If economic growth is desirable, you may conclude that the Federal Reserve should always have an expansionary policy. However, expansionary policies can go too far. Normally a growing aggregate demand causes demand-pull inflation during expansionary periods. This is when the total demand for final goods and services in an economy at a given time is greater than the supply, allowing producers to raise prices. The Federal Reserve's challenge is to balance economic growth and inflation. Increasing the money supply too much can result in an unacceptable rate of inflation while constraining the growth of the money supply can inhibit an economy’s economic growth.
The Federal Reserve has three ways to manage the money supply.