Monetary Policy

What is Monetary Policy?

Monetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment.

These policies are implemented through different tools, including the adjustment of the interest rates, purchase or sale of government securities, and changing the amount of cash circulating in the economy. The central bank or a similar regulatory organization is responsible for formulating these policies.

Objectives of Monetary Policy

The primary objectives of monetary policies are the management of inflation or unemployment and maintenance of currency exchange rates.

1. Inflation

Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.

2. Unemployment

Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.

3. Currency exchange rates

Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.

Tools of Monetary Policy

Central banks use various tools to implement monetary policies. The widely utilized policy tools include:

1. Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.

2. Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients, and thus, money supply decreases.

Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).

3. Open market operations

The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.

Expansionary vs. Contractionary Monetary Policy

Depending on its objectives, monetary policies can be expansionary or contractionary.

Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy by decreasing interest rates, purchasing government securities by central banks, and lowering the reserve requirements for banks. An expansionary policy lowers unemployment and stimulates business activities and consumer spending. The overall goal of the expansionary monetary policy is to fuel economic growth. However, it can also possibly lead to higher inflation.

Contractionary Monetary Policy

The goal of a contractionary monetary policy is to decrease the money supply in the economy. It can be achieved by raising interest rates, selling government bonds, and increasing the reserve requirements for banks. The contractionary policy is utilized when the government wants to control inflation levels.

Related Readings

Thank you for reading CFI’s guide to Monetary Policy. To keep learning and advancing your career, the following resources will be helpful:

• Automatic Stabilizer
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• Market Economy
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