What Is Monetary Policy?

What Is Monetary Policy?

Monetary Policy Explained

By Kimberly Amadeo Updated February 17, 2022 Reviewed By Thomas J. Brock  Fact Checked By Leila Najafi

In the most recent FOMC meeting, on March 15-16, 2022, the Fed announced it would be raising interest rates for the first time since 2018, in order to combat rising inflation. The target range was increased by 0.25% (25 basis points), from 0% to 0.25% to 0.25% to 0.50%.

Monetary policy is a central bank's actions and communications that manage the money supply. Central banks use monetary policy to prevent inflation, reduce unemployment, and promote moderate long-term interest rates. 

Learn more about how monetary policy affects the economy, how it relates to fiscal policy, and which tools central banks use to manage it.

Definitions and Examples of Monetary Policy

Monetary policy increases liquidity to create economic growth. It reduces liquidity to prevent inflation. Central banks use interest rates, bank reserve requirements, and the number of government bonds that banks must hold. All these tools affect how much banks can lend. The volume of loans affects the money supply.

The money supply includes forms of credit, cash, checks, and money market mutual funds. The most important of these forms of money is credit. Credit includes loans, bonds, and mortgages.

In a recession, central banks might combat high unemployment by giving banks more money. Banks in turn lower interest rates, which allows businesses to hire more employees. This is an example of expansionary monetary policy.1

How Does Monetary Policy Work?

Central banks have three monetary policy objectives. The most important is to manage inflation. The secondary objective is to reduce unemployment, but only after controlling inflation. The third objective is to promote moderate long-term interest rates.2

The U.S. Federal Reserve, like many other central banks, has specific targets for these objectives. It wants the core inflation rate to be around 2%.3 Beyond that, it prefers a natural rate of unemployment of between 3.5% and 4.5%.4

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