Monetary policy is the process through which the federal government controls the amount of currency that is allowed to flow into the economy. Like fiscal policy, monetary policy can be intended to expand or contract the economy. While it is theoretically possible for monetary policy and fiscal policy to be employed together, in the United States they are usually employed separately.

Generally, expansionary monetary policy is used when the federal government wants to reduce unemployment during a recession. To accomplish this goal, more money is printed by the Treasury Department and released into the economy, and interest rates are lowered. With money or credit easier to access, companies are motivated to take on more projects, such as construction, and hire more workers to complete those projects. When they work, expansionary monetary policies increase the general demand for goods and services, which in turn leads to economic growth.

The federal government may use contractionary monetary policy to slow the rate of growth in the money supply or even take steps to reduce it. When less money is available in the economy, prices cannot rise as quickly, and inflation diminishes. Unfortunately, contractionary monetary policy can cause an increase in unemployment. Since money is less available or available only at higher interest rates, spending and borrowing are reduced. Businesses engage in fewer new projects and thus hire fewer workers, and consumers have less money to make purchases.

How well do you understand the principles behind monetary policy? Try answering each of the questions below in your own words. When you get to the end of the activity, compare your answers to the ones provided.