Monetary policy is effective when it meets the issuing agency's goals for its effect on the economy. In the United States, the Federal Reserve handles money and credit tactics, with the stated goals of promoting maximum employment, keeping prices stable and securing moderate long-term interest rates.
Traditionally, the Federal Reserve has relied on three main approaches to influence the economy: open market operations, the discount rate and reserve requirements.
Open Market Operations
The Federal Reserve influences monetary policy by buying and selling securities in the open market. The historic goal has been to adjust the reserve balances to keep the federal funds rate at the desired target. If the rate is close to the target -- which was near-zero for an extended period beginning in 2008 -- the Fed will continue down the same path.
The Discount Rate
The discount rate represents the interest charged banks on loans they receive from their regional Federal Reserve Bank lending facility. This in turn influences other interest rates, increasing its effect on the economy. Lowering the discount rate encourages businesses and consumers to take out loans because it's cheaper to borrow money. Raising the rate has the opposite effect and can cool off an economy perceived to be in danger of overheating.
The Fed's Board of Governors uses reserve requirements to mandate how much of its deposits banks must set aside, either in their own branches or at a Reserve Bank. Decreasing the reserve requirements increases the amount a bank can lend; increasing them does the opposite.
How This Works
The Federal Reserve selects its tactics based on the primary needs for the economy at the time. For example, to promote a stronger job market, a successful monetary policy might include lowering interest rates. That decreases the cost of borrowing money, making it easier for businesses to expand and hire more workers. On the other hand, if that ultimately led to an increase in inflation, the Fed might then raise the rates. This could cause inflation to taper off and keep prices stable, but also cause employers to cut back on their budgets and shed workers, raising the unemployment rate.
In many cases, an action the Federal Reserve takes benefits one area of the economy, but has a negative effect on another. Balancing the diverse economic goals of the economy is one of the constant challenges the Fed faces.
A More Active Role
Though it is not a traditional use of monetary policy in the United States, in recent years monetary policy has had the effect of stabilizing key sectors of the economy. In particular, the Fed focused on stabilizing the housing market through the increased purchase of mortgage-backed securities that otherwise likely would have been considered toxic assets. It also chose to extend credit directly to institutions considered too big to fail, in some cases urging specific companies to participate. This expansion of the standard U.S. monetary policy toolkit hasn't been without its detractors, but it has had success in achieving those specific policy aims.