Monetary Policy is the attempt at affecting the economy by altering short-term interest rates or changing the monetary base. This is done by the monetary authority, which is commonly the central bank.
The focus of this policy is always upon high economic growth, achieving full employment, and maintaining price stability. Deviations from these will cause the central bank to adjust the policy in an effort to get these back in alignment.
Set of Tools
Monetary policy is a set of tools the authority can turn to.
It typically starts with open market operations where the central bank, such as the Federal Reserve, buys or sells bonds in an effort to alter the supply of government securities. The goal is to affect interest rates through policy that is either expansive or contractive.
Quantitative easing and tightening are operations that are in alignment with reaching the target of the policy. Under this, reserve balances are altered. When the policy is expansive, the central bank will swap reserves for securities which end up on the balance sheets of the commercial banks. This can be either mortgage backed securities (MBS) or sovereign debt. When the policy is contractive, the opposite happens.
The value of quantitative easing is hotly debated.
In addition to bond purchases/sales, the central bank can raise or lower interest rates. This is done by moving the rate banks charge each other with inter-bank lending. In the United States, this is called the discount rate. It is what banks will basically use to lend upon.
Another tool is the altering of reserve requirements. This is the amount of deposits that commercial banks are required to hold in order to meet their liabilities. The idea is that less reserve should allow for the creation of more loans. This is believed to be the basis for stimulating economic activity.
Under fractional reserve banking, the central bank lacks the ability to directly inject money into the economy. All expansion of the money supply is handled by the commercial banks. Even the demand for banknotes, which is central bank money, is dictated by the banks.
Trying to affect interest rates is done with the intention having an impact upon lending. By trying to lower rates, the goal is to increase the number of loans made. The challenge is that central banks cannot force lenders to issue out more loans. There are various components that factor into lending decisions.
Interest rate policy has mixed effectiveness. The rate on inter-bank lending can change. That does not mean the market agrees. Interest charged on mortgages and car loans can vary. We also see differing impact upon bonds. This denotes how the yield curve is shaped.
The short end of the curve is more affected by the monetary policy of the central bank when it comes to interest rates. Longer dated bonds will not be aligned to the same degree. Many use this as a way to judge the market view of the monetary policy of the central bank.