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Monetary policy is the regulation of interest rates and the availability of money in order to provide sustainable growth and prevent hard crashes in the market. In the United States, it is set by an agency known as the U.S. Federal Reserve. Other countries may use a similar system or some other sort of centralized agency, up to and including the federal government itself. The value of this policy is somewhat debatable, but is used in many free market economies as a way for the government to provide some oversight in the market.
When an institution is in charge of monetary policy, it is usually done in one of two ways. It may buy securities back from banks, which will increase the bank's reserves, stimulating them to lend to other institutions. The other way the do that is to set interest rates at a certain level, which can also affect the economy.
In the United States, the Federal Reserve executes monetary policy through a board and a chairman, who is appointed by the president. The Federal Reserve has a committee that usually meets eight times every year to set interest rates. They may raise them, lower them, or keep them the same, depending on the analysis presented. The overall goal is to keep the economy sound. Other than making some appointments, the U.S. federal government has no other say. This is an independent model that many other countries choose not to follow.
Monetary policy works by first considering how the economy is performing. In more difficult times when the economy is down, a lowering of interest rates may be needed in order to stimulate borrowing. As borrowing increases, so will economic activity associated with that borrowing, which will create jobs and provide money for others. If the economy is going well, the Federal Reserve or other governing body may become concerned there is too much growth, which could set the economy up for a hard crash. To try to avoid that, there may be an increase in interest rates to try to gently cool off the economy.
Any institution that controls this policy needs to be aware that interest rates are tied to inflation to a great degree. As interest rates are lowered, money becomes cheaper to borrow and more is passed around. This devalues the currency by leading to an oversupply, which causes inflation to increase. If interest rates are raised, then inflation may decrease because there is less money flowing through the system and it, therefore, becomes more valuable.
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