Monetary policy refers to the course of action a central bank or government agency takes to control the money supply and interest rates in the national economy. Effective monetary policy supports actions that lead to the best possible standards of living for a nation's populace. This means attempting to control interest rates, levels of inflation and employment levels.
When the Fed lowers the federal funds rate, which is the rate banks pay to borrow from each other, you see the decrease in other interest rates such as the prime rate for commercial banks' best clients and the prevailing interest rates on consumer loans. When interest rates are lowered, the ripple effect goes across the economy. Consumer spending increases as individuals and couples become more willing to borrow. The increased spending leads to a demand for more consumer goods, which in turn leads to an increase in production. An increase in production creates an increase in employment levels and wages, which leads to a further increase in consumer spending, and the cycle then repeats.
If the demand for goods and services continues to increase, prices may increase for supplies and materials needed to meet the demand. A sustained upward increase in prices causes inflation. The Federal Reserve attempts to limit inflation through monetary policy by adjusting the federal funds rate upwards, which in turn affects interest rates lenders charge consumers. As a result, monetary policy reflects a balancing act of moderation, with the Fed trying to avoid extreme measures in either direction.
The Fed controls, to some extent, the money supply in the economy. This aspect of monetary policy plays less of a role than it once did in influencing current and future economic conditions, according to the Federal Reserve publication "Monetary Policy and the Economy." This is because the money supply once was aligned with the gross domestic product. However, as the financial system has become more complex, this money supply measure has diminished in importance.