Monetary Policy

What monetary policy is - and what it is not

Monetary policy is a central bank's management of the money supply and short-term interest rates to pursue its macroeconomic goals. It works on the cost and availability of credit across the whole economy. This lesson is about the actions and tools of monetary policy - what a central bank does and how it works. Neighboring topics own the surrounding pieces: the institutional structure of the Federal Reserve System, what money is and how it is measured, how commercial banks create deposits through fractional-reserve lending, and the general definition of an interest rate. Here we take those as given and focus on how the central bank pulls its levers.

The two directions of monetary policy are the heart of the subject. Expansionary policy (also called loose or easy money) lowers interest rates to stimulate borrowing and spending; a central bank uses it when the economy is weak, unemployment is high, or a recession threatens. Contractionary policy (tight money) raises interest rates to restrain borrowing and spending; a central bank uses it when inflation is running above target. The two are mirror images: one adds fuel, the other removes it.

The traditional tools

Historically, central banks have had three main tools. First and most important are open-market operations: the central bank buys or sells government securities (in the U.S., Treasury bonds) to change the quantity of bank reserves and the level of interest rates. When the Fed buys bonds, it pays banks with newly created reserves, so reserves rise, credit becomes cheaper, and policy eases. When the Fed sells bonds, reserves flow back to the Fed, credit tightens, and policy contracts. Open-market operations have been the workhorse tool since the 1920s because they are precise and reversible.

Second is the discount rate - the interest rate banks pay to borrow directly from the Fed's 'discount window.' Raising it makes emergency borrowing more expensive and signals a tighter stance; lowering it does the reverse. Third are reserve requirements - the fraction of customer deposits a bank must hold rather than lend out. Raising the requirement shrinks the amount banks can lend; lowering it expands lending capacity. Reserve requirements are now a minor tool: in March 2020 the Fed reduced U.S. reserve requirement ratios to zero. The operating target these tools aim at is the federal funds rate, the interest rate banks charge one another for overnight loans of reserves.

The modern approach: a target range and administered rates

Modern central banking no longer relies on making reserves scarce. Because the banking system now holds ample reserves, the Fed announces a target range for the federal funds rate - a band 25 basis points (0.25 percentage points) wide - and steers the actual rate inside that band using administered rates it sets directly. The most important is the interest rate on reserve balances (IORB), the rate the Fed pays banks on the reserves they hold with it. A bank has little reason to lend reserves overnight at a rate below what it can earn risk-free from the Fed, so IORB acts as a floor that pulls the funds rate up toward the range. A second tool, the overnight reverse repurchase (ON RRP) rate, extends a similar floor to financial firms that cannot earn IORB. Together these administered rates keep the effective federal funds rate within the FOMC's target range without needing large daily bond operations. As a concrete reference point, at its meeting on July 29, 2026 the Federal Open Market Committee held the target range at 3.50 to 3.75 percent, unchanged since December 2025.

Transmission: from the policy rate to jobs and prices

Changing a short-term rate matters only because the change ripples outward. When the Fed eases, borrowing becomes cheaper: firms are more willing to finance new equipment and buildings, and households borrow more readily for homes and cars. That extra investment and consumption raises aggregate demand, which pushes output and employment up. When the Fed tightens, the chain runs the other way: costlier credit discourages investment and big-ticket purchases, aggregate demand falls, and the reduced pressure on prices brings inflation down. This is why monetary policy is called countercyclical - it leans against the business cycle.

Two cautions matter. First, the effects arrive with a lag of many months, so central bankers must act on forecasts of where the economy is heading, not just where it is. Second, there is a danger of overreaction: ease too much and you can ignite inflation; tighten too much and you can trigger a recession. In the United States these choices are anchored by a dual mandate that Congress wrote into law - the Fed is directed to promote maximum employment and stable prices (it interprets 'stable prices' as 2 percent annual inflation). Monetary policy is distinct from fiscal policy: monetary policy is run by the central bank through interest rates and the money supply, while fiscal policy is run by the government through its taxing and spending budget.