Monetary policy, to a great extent, is the management of expectations.[4] Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at
which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control
one or both of these, to influence outcomes like economic growth,
inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority
has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals).
The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard.
A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases
the
size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.
There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the
1970s,
monetary policy
has generally been formed separately from fiscal policy. Even prior
to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.
Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, the Reserve Bank of New Zealand, and the Bank of Japan) exist which have the task of executing
the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.
The
primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial
instruments, such as treasury
bills, company bonds, or foreign currencies.
Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting
of a specific exchange rate relative to some foreign currency or else relative to gold.
The
other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open
Mouth Operations" (talking monetary policy with the market).