Definition
The term monetary policy refers to the process by which a central bank controls the supply of money into an economy. Monetary policy oftentimes attempts to control an overarching economic factor such as inflation or interest rates.
Explanation
A central bank is the financial institution that oversees monetary policy and regulates the commercial banking system of a country. In the United States, the Federal Reserve Act provides for a central banking system, which is ultimately established to serve and protect the public interest.
Monetary policy is the strategy used by the central bank to control economic influencers such as interest rates or inflation. While there are several strategies within monetary policy, the overall goal is to foster a healthy rate of economic growth while maintaining the exchange rate of local currency with that of foreign nations.
There are a number of monetary policy strategies a central bank can use including inflation targeting, price level targeting, fixed exchange rates, and even adopting a gold standard policy. Generally, all these strategies are to control the economy in one of two ways:
Expansionary: if the central bank would like to stimulate the economy of their country, they would increase the money supply, thereby boosting borrowing and consumer spending.
Contractionary: if the central bank would like to slow down their country's rate of growth, they would decrease the money supply, thereby decreasing borrowing and consumer spending.
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