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What Is Monetary Policy?

By Inyoung Hwang · May 11, 2021 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is Monetary Policy?

Monetary policies are how a central bank or similar government organization manages the supply of money—as well as the interest rates—in an economy.

In the U.S. the central bank is known as the Federal Reserve. The Fed has a dual mandate: first, to maintain stable prices, and second, to promote full employment.

Read on to learn more about monetary policy and the integral role that the Fed plays.

Overview of Fed Monetary Policy

The U.S. Federal Reserve sets the level of the short-term interest rates in the country, which then has an impact on the availability and cost of credit. We’ll discuss how the short-term rates the central bank sets has a direct impact on a key interest rate for banks.

The Fed also has an indirect effect on longer-term interest rates, currency exchange rates, and prices of bonds and stocks, as well as other assets. Through these channels, monetary policy can influence household spending, business investment, production, employment, and inflation.

A country’s economy sometimes experiences inflation, which is when the prices of goods and services overall are rising. The central bank can use monetary policy to tame inflation, mainly by raising interest rates. In the U.S., inflation was rampant in the 1970s and early 1980s. Since then, consumer prices have stayed relatively stable.

In more rare instances, the economy has been in a period of deflation when overall prices have fallen. Then the central bank typically responds by loosening monetary policy, either by lowering interest rates or the more extreme measure of buying assets directly. A sharp period of deflation occurred after World War I, as well as during the first several years of the Great Depression.

Recommended: What Is Fiat Currency?

What Is the Fed Funds Rate?

The Federal Reserve System has a committee, the Federal Open Market Committee (FOMC), which meets several times a year to review key economic factors. The FOMC watches for signs of recession or inflation. It then sets what’s called the federal funds rate–what banks charge one another on an overnight basis.

It may seem counterintuitive that banks would loan money to each other, but here’s why they do. Banks are required to meet the reserve requirement set by the Fed. This is the smallest amount of cash a bank must have on hand, either in its own vault or in one of the regional Fed banks.

For example, the Fed, in the era of the housing bubble of 2008, lowered the federal funds rate to 0.25% to encourage banks to lend. This was part of the Fed’s strategy to mitigate the expanding financial crisis. In contrast to that rate, in 1980, the federal funds rate was 20%, the highest in our nation’s history.

Rates set by the Fed have an impact on the overall financial market. For example, when rates are low, it’s less expensive and easier to borrow, which can boost the market’s liquidity. Overall, when rates are low, the economy grows. When high, it typically retracts.

Recommended: Federal Reserve Interest Rates, Explained

How Monetary Policy Can Affect You

If a bank doesn’t have enough to meet its reserves, it borrows the funds from a bank with excess cash. The lending bank can benefit financially because it would earn interest in the amount of whatever the federal funds rate is that day.

This system helps ensure that each bank has enough cash on hand for its business needs that day, and it also caps that bank’s lending ability because the bank needs to keep a certain amount of cash in a vault, rather than lending it out.

Then, banks can decide to set their prime interest rates, or the rates that they charge their best customers—those who are considered low risk. So, if the federal funds rate goes up, your bank may decide to charge a higher interest rate on loans—if it goes down, a lower rate.

Moves made by the Fed can have a significant impact on the personal finances of people in the U.S. As the federal funds rate changes, it’s likely that banks’ prime rates will change in response—which in turn affects what consumers are likely to be charged on mortgage loans, car loans, personal loans, credit cards, and so forth.

This can affect consumers who owe money on a variety of loan types, but this is often more the case for people who have short-term variable interest rate loans. As the federal funds rate and the prime interest rates at banks go up or down, so can the monthly loan payment. In addition, a credit card rate could be tied to the prime rate plus a certain percentage.

Famous Fed Decisions

If you want information in significant detail, you can see meeting minutes from the Federal Reserve going back to 1936. You can also see the entire history of rate changes since 1954.

An entire book could be written about Federal Reserve policies and the Great Depression —a decade-long, deep economic downturn when production numbers plunged and unemployment figures skyrocketed. It’s been acknowledged that mistakes the Fed made contributed to this economic disaster.

During this time period, the Fed was largely decentralized and leaders disagreed on how to address the growing economic challenges. Some policies were implemented that unintentionally hurt the economy. The Fed raised interest rates in 1928 and 1929 to limit securities speculation, and economic activity slowed. The Fed made the same error in judgment in 1931.

In 1973, President Richard Nixon stopped using the gold standard to support the U.S. dollar. When inflation rates tripled, the Fed doubled its interest rates and kept increasing them until the rate reached 13% in July 1974. Then, in January 1975, it was significantly dropped to 7.5%.

This monetary policy didn’t effectively address the inflation, and in 1979, then Fed Chairman Paul Volcker raised rates and kept them higher to end inflation. This might have contributed to the country’s recession, but the inflation problem was solved.

Recommended: History of Fed

Monetary Policy vs Fiscal Policy

Both monetary policy and fiscal policy are tools government organizations use to manage a nation’s economy. Monetary policy typically refers to the action of central banks, such as changes to interest rates that then affect money supply. As mentioned, in the U.S. that would be the Federal Reserve.

Meanwhile, fiscal policy typically refers to tax and spending by the federal government. In the U.S., fiscal policy is decided by Congress and the presidential administration.

For instance, when the Covid-19 pandemic wreaked havoc on the U.S. economy, forcing many businesses to shut down, U.S. fiscal policy put together stimulus packages that included supplemental unemployment benefits, stimulus checks, and small-business loans. These measures were intended to prop up the economy during a difficult time.

In recent years, the rise and popularity of digital currencies like Bitcoin have spurred central banks to explore virtual money of their own. Central bank digital currencies (CBDC) are digital versions of the fiat currency issued by a sovereign nation. While such money is still in its early stages, the emergence of CBDC could give central banks a more direct way of implementing monetary policy in an economy.

Recommended: What Is a CBDC?

The Takeaway

Monetary policies are a key way that central banks try to influence a country’s economy. The main tools that central banks, like the U.S. Federal Reserve use are interest-rate levels and money supply.

On a macroeconomic level, monetary policy can be a powerful, important way to fend off recessions or tame inflationary pressure. On a more microeconomic level, the monetary policy interest rates that a central bank sets also affect loans that everyday consumers take from their banks.

Understanding how monetary policy works can help investors gauge the future of economic growth and consequently, the direction of financial markets. Central bank decisions and interest-rate changes have an impact on the prices of bonds, stocks and commodities. With SoFi Invest, investors can monitor price actions in all these asset classes using the Active Investing platform.

Get started investing with SoFi Invest today.


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