Monetary policy involves the actions by central banks, such as the U.S. Federal Reserve, to regulate a nation’s supply of money. The Federal Reserve or the Fed, and other central banks, trade in government bonds, regulate banking reserve requirements, and set short-term interest rates to influence the money supply. They hope to foster sustainable economic growth and hold inflation to a minimum. Monetary policy carries its own set of strengths and weaknesses.
Inflation harms the value of money by reducing its purchasing power. When inflation rises faster than expected, the Fed may sell government bonds to take money out of circulation or raise short-term interest rates. According to The Federal Reserve Bank of San Francisco, these actions may lead banks and other lending institutions to increase long-term rates. This reduces access to credit and slows consumer spending, countering inflation.
The objectives of sustainable economic growth and low inflation often conflict. Greg Mankiw, a Harvard economist and author of “Principles of Economics,” writes that a short-run trade-off exists between unemployment and inflation. In a growing economy, with lower unemployment, inflation may increase temporarily. This triggers monetary policy action to slow growth and reduce inflation. When inflationary pressures decrease, the jobless rate may rise for a brief period as the pace of the economy slows.
Short-run action enables policy makers to assess economic conditions and promote sustainable growth and low inflation over the long term.
Monetary policy decisions by the Federal Reserve can take months or even a year or longer to have the intended effect.