Monetary policy is a form of economic policy that involves changing money supply in order to change cost of borrowing which in turn changes inflation rate, growth rate and unemployment rate. Together with fiscal policy, monetary policy is used to save the economy from severe ups and downs.
Monetary policy is implemented by the central banks (in US, the Federal Reserve). It is relatively more responsive than the fiscal policy because central banks can react to economic changes more quickly than the government and the legislature.
When the economy is under recessionary pressures, the central bank increases the money supply which in turn decreases the cost of borrowing. Low cost of borrowing stimulates consumption and investment which increases GDP. Higher investment by businesses reduces unemployment rate and all this helps the economy move out of recession. On the other hand, when the economy is under inflationary pressures, the central bank decreases money supply which increases cost of borrowing. Higher cost of borrowing dampens consumption and investment which reduces inflation.
Most common tools used by central banks in implementing the monetary policy include:
- Changing discount rate: discount rate is decreased to fight recessionary pressures and increased to fight inflationary pressures.
- Carrying out open market operations: government securities are bought to fight recession and sold to fight inflation.
- Changing the required reserve ratio: the reserve ratio is decreased to fight recession and increased to fight inflation.
Central banks widely use the Taylor's rule to set a target interest rate.
Manuel Castro is an economist with the Federal Reserve. He just finished his research showing that US unemployment rate is expected to surge by 3% and that GDP growth rate is expected to fall by 2%. What action he would most likely recommend?
High expected unemployment and low expected growth rate suggest that the economy is heading towards recession and the Federal Reserve needs to increase the money supply to lower the cost of borrowing. Lower cost of borrowing will help revive consumption and investment and decrease unemployment and sustain the growth rate. The Federal Reserve can achieve this objective by a combination of decrease in discount rate, purchase of government securities and decrease in required reserve.