Monetary policy -- controlling the money supply and interest rates -- is the responsibility of the Federal Reserve, which executes its policies with three primary tools. The Fed sets the reserve requirement, the amount that banks must hold to back up their deposits. It sets the discount rate, the interest rate that banks must pay if they borrow money from the Fed. And it engages in open market operations, the buying and selling of government securities on the open market, to set interest rates and control the money supply. Through its policy decisions the Fed can pursue expansionary, contractionary or neutral monetary policy. Neutral monetary policy is effective and appropriate if the economy is at full employment with low inflation and steady sustainable growth.
The Federal Open Market Committee
The primary policy-making group in the Federal Reserve is the Federal Open Market Committee, or FOMC. This body is composed of the seven-member board of governors and the presidents of five of the 12 regional Federal Reserve Banks who serve on a rotating basis. Meeting eight times a year, the FOMC sets the federal funds rate, the interest rate that commercial banks charge each other on overnight funds. (Banks borrow from each other if their reserves fall short of the required level.) Each time it meets, the FOMC reviews economic developments from the previous meeting, examines the effectiveness of previous policies and sets a target range for the federal funds rate for the upcoming period.
Expansionary Monetary Policy
If the FOMC feels the economy is sluggish and needs a stimulus to keep unemployment in check, it will pursue an expansionary monetary policy. By lowering the target range for the federal funds rate, it increases the money supply. Easy money and lower interest rates stimulate borrowing, increase business investment and facilitate an economic expansion.
Contractionary Monetary Policy
If the economy is overheating with rising inflation, the FOMC may feel it necessary to slow economic expansion, in which case it will pursue a contractionay monetary policy. Decreasing the money supply and raising interest rates curtail borrowing and business investment, reducing inflationary pressure in the economy.
Neutral Monetary Policy
The range for the federal funds rate can go from low enough to stimulate economic growth to high enough to slow economic activity. Somewhere between the lows and the highs -- and economists do not all agree just where -- is a rate or range of rates that neither stimulates nor contracts the economy. Identifying that interest rate level and taking action to achieve it is neutral monetary policy.
The Fed would pursue neutral monetary policy if it wished to maintain the economic status quo.