What Is the Role of Monetary Policy?

Micah MacBride

Governments have two kinds of regulations when it comes to managing money, fiscal policy and monetary policy. Fiscal policy determines how governments raise money through taxes and spend that revenue. The role of monetary policy is to manipulate the availability a nation's currency in order to keep both inflation and the national unemployment rate low.

American monetary policy involves decisions taken by the Federal Reserve to attempt to influence the economy by influencing the availability of money and the cost of credit.
American monetary policy involves decisions taken by the Federal Reserve to attempt to influence the economy by influencing the availability of money and the cost of credit.

Generally, if a country's economy is growing, then there will be a healthy supply of jobs for workers to fill and a low unemployment rate. A low unemployment rate helps keep an economy healthy, since those employed workers are also consumers with money to spend on the products and services different companies offer. When consumers are buying, the businesses are making money and can afford to continue employing — and hiring more — workers who, in turn, act as consumers as well.

Inflation refers to what occurs when the currency of a particular nation becomes so abundant that it begins to lose value. This results in rising prices, which means that the purchasing power of each unit of currency goes down. Governments want to keep inflation to a minimum because rising price levels hurt consumers' ability to buy goods and services. In addition to harming the standard of living of consumers, this, in turn, hurts the companies whose goods and services the consumers are not buying. This then hurts the economy.

The role of monetary policy in encouraging economic growth typically takes a form that makes it easier for businesses to get loans and credit to expand their operations, and for entrepreneurs to get money to start new businesses. A government's central bank can do this by lowering reserve requirements, or the percentage of liabilities that a bank must, legally, keep as liquid currency. This then allows banks to make more loans and issue more credit than they can with higher reserve requirements. Central banks can also encourage economic growth by increasing the money supply, or the total amount of a nation's currency that is in circulation.

To keep inflation low within the confines of the role of monetary policy, a government may constrict the amount of money that is in circulation, in order to preserve the value of each unit of currency. This involves steps that are opposite to those that encourage economic growth. These include raising reserve requirements for banks and decreasing the nation's money supply.

The challenge inherit in the role of monetary policy is that governments cannot encourage economic growth without risking inflation, and cannot take steps to keep inflation low without risking an economic slow down, and a corresponding increase in the unemployment rate. This requires governments to prioritize either economic growth or maintaining low inflation at any given point in time. Generally, central banks deal with this dilemma by taking modest steps to keep inflation low during times of economic growth, and risking inflation to focus on encouraging economic growth when economies are in recessions or depressions.

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Discussion Comments


The role of monetary policy is distinct from fiscal policy but I think they still rely on one another. If fiscal and monetary policies are contradictory, and if they don't support one another, I don't think either will be very effective.


@ZipLine-- The Central Bank or the Federal Reserve (Fed in short) is not independent. The Fed's Board of Governors is appointed by the President! The Central Bank is the government's bank. That's where the US Treasury is and where our taxes go. So the Federal Reserve is a government institution and accountable to other government institutions.

What you said about economic growth is true. Economic growth is good, but rapid economic growth can be bad because it leads to high inflation. The ideal economy is a stable one where employment, inflation, etc. are at optimal rates. For example, the ideal inflation rate is 2%. The target for unemployment rates is 5.5%. When inflation is too high or too low, it causes problems. That's why the Fed has different monetary policies like tight monetary policy or easy monetary policy to fix things.


Is the Central Bank mostly independent from the government? Does the Bank decide on the monetary policy simply by looking at inflation?

I can't believe that the economy is so volatile that it would require drastic changes in monetary policy frequently. I've always thought that economic growth is good but what I've understood from this article is that "some" economic growth is good.

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