What Is Discretionary Monetary Policy?

by Robert Shaftoe ; Updated July 27, 2017

Monetary policy refers to the Federal Reserve Bank's mandate to influence the economy by manipulating currency levels and the amount of Treasury securities in the market, which in turn affects interest rates. Discretionary monetary policy refers to the Fed's ability to react dynamically to economic conditions and make quick decisions, as opposed to only using the tools at its disposal when prearranged thresholds are reached. This latter approach is called committed, or sometimes constrained, monetary policy.

Technological advances along with an environment that more greatly values transparency has led to greater communication between the Fed and the public. The Fed makes available via its website a large number of inflation reports detailing projections and economists' expectations. This environment is more conducive to discretionary monetary policy.

Some of the perceived advantages of nondiscretionary monetary policy include:

  • Simplicity
  • Predictability
  • Credibility
  • Insulation from political pressures.

Monetary Policy

The four primary goals that motivate Fed policy are:

  1. Minimizing inflation
  2. Maintaining full employment
  3. Promoting significant and stable economic growth
  4. Maintaining an optimal level of exchange with respect to American companies' positions within the global trading market for goods and services

Treasury Market Operations

The Fed, or central bank, has a number of tools available to effectuate monetary policy, including the buying and selling of Treasury securities, adjusting the interest rates it uses to lend money to member banks and adjusting reserve requirements, which refers to the actual cash on hand that banks must retain in their vaults relative to their overall investments. The buying and selling of Treasury securities is the most commonly employed tool used by the Fed, because the huge amounts of money involved make it an effective tool. Moving so much money in and out of the economy influences interest rates and reserve requirements in its own way. This allows the Fed to influence the economy, but with a minimum level of perceived intervention.

Money Supply and Liquidity

By buying Treasury securities on the open market, the Fed can inject liquidity, or cash, into the economy. This works by providing cash to the banks and other investors in exchange for their Treasury investments. This cash then works itself into the wider economy in the form of loans, stock purchases and other actions that benefit companies and individuals. This can be an important catalyst for growth when the economy is not performing well and lenders tighten standards, making it especially difficult for smaller companies to obtain money to fund growth. However, when the money supply increases too quickly, this leads to a higher risk of inflation, which is one of the Fed's primary concerns.

Managing Inflation

The U.S. central bank and other central banks seem to have adopted a constrained, discretionary policy of inflation targeting. The Fed uses monetary policy to boost employment and income levels -- but in a way that doesn't cause a general rise in the prices of goods and services. The Fed monitors commodity prices and international exchange rates to measure inflationary pressures. When inflation is viewed as ticking upward, the central bank will combat this by reducing interest rates. This is done primarily to lower the cost of borrowing, which stimulates individual and corporate spending. This supports higher employment levels by creating opportunities to meet the greater demand for goods and services.