Monetary policy

Monetary policy is how a central bank — the Federal Reserve in the United States — influences the economy by controlling the money supply and the cost of borrowing. Its goals are commonly summarized as the dual mandate: stable prices (controlling inflation) and maximum employment.

The Fed's primary tools are open market operations (buying or selling government securities to add or drain bank reserves), the discount rate (the rate at which the Fed lends directly to banks), and reserve requirements. Buying securities injects money into the banking system and pushes interest rates down; selling securities does the opposite. The Federal Open Market Committee (FOMC) directs these operations and sets the target for the federal funds rate.

Policy comes in two flavors. Expansionary (loose) policy — lower rates, securities purchases — stimulates borrowing, spending, and hiring during a slowdown. Contractionary (tight) policy — higher rates, securities sales — cools an overheating economy and restrains inflation. Monetary policy is distinct from fiscal policy, which is the taxing and spending power of Congress and the president; the two can work together or in opposite directions.

Monetary policy is core material on the AP Macroeconomics exam, which tests the money market, policy tools, and their effects on output and the price level, and on the SIE and Series 65 exams, which test the Fed's tools, the difference between monetary and fiscal policy, and how rate changes ripple through securities markets.