What Is the Role of Monetary Policy?

Governments have two kinds of regulations when it comes to managing money, fiscal policy and monetary policy. Fiscal policy determines how governments raise money through taxes and spend that revenue. The role of monetary policy is to manipulate the availability a nation's currency in order to keep both inflation and the national unemployment rate low.

Generally, if a country's economy is growing, then there will be a healthy supply of jobs for workers to fill and a low unemployment rate. A low unemployment rate helps keep an economy healthy, since those employed workers are also consumers with money to spend on the products and services different companies offer. When consumers are buying, the businesses are making money and can afford to continue employing — and hiring more — workers who, in turn, act as consumers as well.

Inflation refers to what occurs when the currency of a particular nation becomes so abundant that it begins to lose value. This results in rising prices, which means that the purchasing power of each unit of currency goes down. Governments want to keep inflation to a minimum because rising price levels hurt consumers' ability to buy goods and services. In addition to harming the standard of living of consumers, this, in turn, hurts the companies whose goods and services the consumers are not buying. This then hurts the economy.

The role of monetary policy in encouraging economic growth typically takes a form that makes it easier for businesses to get loans and credit to expand their operations, and for entrepreneurs to get money to start new businesses. A government's central bank can do this by lowering reserve requirements, or the percentage of liabilities that a bank must, legally, keep as liquid currency. This then allows banks to make more loans and issue more credit than they can with higher reserve requirements. Central banks can also encourage economic growth by increasing the money supply, or the total amount of a nation's currency that is in circulation.

To keep inflation low within the confines of the role of monetary policy, a government may constrict the amount of money that is in circulation, in order to preserve the value of each unit of currency. This involves steps that are opposite to those that encourage economic growth. These include raising reserve requirements for banks and decreasing the nation's money supply.

The challenge inherit in the role of monetary policy is that governments cannot encourage economic growth without risking inflation, and cannot take steps to keep inflation low without risking an economic slow down, and a corresponding increase in the unemployment rate. This requires governments to prioritize either economic growth or maintaining low inflation at any given point in time. Generally, central banks deal with this dilemma by taking modest steps to keep inflation low during times of economic growth, and risking inflation to focus on encouraging economic growth when economies are in recessions or depressions.