Monetary policy consists of actions taken by a central bank to manage the money supply and interest rates in pursuit of macroeconomic goals such as price stability and full employment. Expansionary monetary policy increases the money supply and/or lowers interest rates to stimulate borrowing, investment, and consumption, typically during economic downturns. Contractionary monetary policy does the opposite, reducing the money supply and/or raising rates to slow the economy and fight inflation.
Central banks have several tools at their disposal. Open market operations, the most frequently used, involve buying and selling government securities: purchases inject reserves into the banking system and expand the money supply, while sales withdraw reserves and contract it. The federal funds rate, the interest rate at which depository institutions lend reserves to one another overnight, is the primary policy lever of the U.S. Federal Reserve. The discount rate is the rate the central bank charges commercial banks for short-term loans from its discount window, serving as a ceiling for short-term rates. The reserve requirement sets the minimum fraction of deposits that banks must hold in reserve; lowering it frees up funds for lending and expands the money supply, while raising it does the reverse. The money multiplier, equal to 1 divided by the reserve requirement ratio, indicates the maximum amount of money the banking system can create from each dollar of reserves.
When conventional tools lose effectiveness, typically because interest rates have fallen to near zero, central banks may resort to quantitative easing (QE), an unconventional policy in which they purchase longer-term securities such as government bonds or mortgage-backed securities to inject liquidity directly into financial markets. Beyond policy tools, central banks perform core institutional functions: they conduct monetary policy, act as lender of last resort during financial crises, supervise commercial banks, manage foreign exchange reserves, and issue the national currency.
The Federal Reserve System, established in 1913, serves as the central bank of the United States and comprises a Board of Governors in Washington, twelve regional Reserve Banks, and the Federal Open Market Committee (FOMC), which sets interest rate policy. The European Central Bank (ECB) plays a similar role across the eurozone, with price stability as its primary mandate. Central bank independence, the ability of central banks to set policy free from direct political pressure, has been widely adopted because it helps anchor inflation expectations and preserve credibility. The Taylor Rule offers a guideline for how policy rates should respond to deviations of inflation from target and output from potential, expressed as \( i = r^* + \pi + 0.5(\pi - \pi^*) + 0.5(y - y^*) \), where r* is the equilibrium real rate, π is inflation, π* is the inflation target, and (y − y*) is the output gap.