Definition: Monetary policy refers to how the Federal Reserve uses interest rates and the money supply to guide economic growth. The Fed generally uses the Fed Funds Rate to impact all other interest rates, including bank loan rates and mortgage rates. The Fed can also use other tools to increase the supply of money in the economy.
The Fed's primary mandate is to manage inflation. The Fed reduces inflation by raising the Fed Funds rate or decreasing the money supply. This is known as contractionary monetary policy.
However, the Fed must be careful not to tip the economy into recession. To avoid recession, and the resultant unemployment, the Fed must lower the Fed Funds rate and increase the money supply. This is known as expansionary monetary policy.
Examples: The Fed must use monetary policy to offset the Federal Government's expansionary fiscal policy.
