It is an economic policy using money as a control variable to ensure and maintain economic stability. To do this, monetary authorities use mechanisms such as interest rate fluctuations, and participate in the money market. The US Central Bank is formed by a decentralized system known by the Federal Reserve System. The Federal Reserve has three main instruments to conduct monetary policy. These are: (1) open market operations; (2) discount rate and (3) the legal reserve requirement (“FRB: What is the difference between monetary policy and fiscal policy, and how are they related?,” n.d.)
The instruments of monetary policy influences the economy through the effect they have on the interest rate. If you want to stimulate the economy, the FRS performs a monetary policy of cheap money, which is to increase the amount of money. This increase in the amount of money generally has the effect of lowering the interest rate on the market. Thus, private investment and personal consumption is stimulated, causing an increase in aggregate demand and the Gross Domestic Product (GDP). (Heakal, 2004; Timberlake, 1993)
On the other hand, if you want to slow down economic activity, in order to reduce inflation, FRS conducts monetary policy of expensive money, which is to reduce the amount of money. This reduction in the amount of money generally has the effect of increasing the interest rate on the market. Thus, it is decreasing private investment and personal consumption, causing a decrease in aggregate demand and the price level.
A rise in the interest rate encourages saving and discourages credit. Auto markets, new homes and mortgages are among the most sensitive to changes in interest rates.
An expansive monetary policy is monetary policy that seeks to increase the size of the money supply. As already we mentioned, in most countries, monetary policy is controlled by a central bank.(“Current U.S. Monetary Policy and Interest Rates,” n.d.)
Actions they can take the authorities to increase the money supply:
· Buying government bonds and other financial assets and so the payment to private agents inject more money into the system liquid. This is called open market operations.
· Lace reduce banks: Reducing the amount of cash that banks must have to cover deposits, they will get increase the amount of money because with the same amount of coins and bills may attract more deposits.
· Reduce the types of intervention which favors banks borrow more on the central bank and offer cheaper loans and rates to customers who also are more likely to borrow at lower interest be injecting money into the system.