For Beginners … What Is Monetary Policy?

Monetary policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.

The central bank may force up interest rates on borrowing in order to discourage spending or force down interest rates to inspire more borrowing and spending. When it raises or lowers its rates, all financial institutions tweak the rates they charge all of their customers, from big businesses borrowing for major projects to home buyers applying for mortgages.

By managing the money supply, a central bank aims to influence macroeconomic factors including inflation, the rate of consumption, economic growth, and overall liquidity.

In addition to modifying the interest rate, a central bank may buy or sell government bonds, regulate foreign exchange (forex) rates, and revise the amount of cash that the banks are required to maintain as reserves.

Economists, analysts, and investors eagerly await monetary policy decisions and even the minutes of meetings in which they are discussed. This is news that has a long-lasting impact on the overall economy as well as on specific industry sectors and markets.

What Goes Into Policy Decisions

Monetary policy is formulated based on inputs from a variety of sources. The monetary authority may look at macroeconomic numbers such as gross domestic product (GDP) and inflation, industry and sector-specific growth rates, and associated figures.

Geopolitical developments are monitored. Oil embargos or the imposition (or lifting) of trade tariffs are examples of actions that can have a far-reaching impact.

The central bank may also consider concerns raised by groups representing specific industries and businesses, survey results from private organizations, and inputs from other government agencies.

Types of Monetary Policies

Broadly speaking, monetary policies can be categorized as either expansionary or contractionary:

Expansionary Monetary Policy

If a country is facing high unemployment due to a slowdown or a recession, the monetary authority can opt for an expansionary policy aimed at increasing economic growth and expanding economic activity.

As a part of expansionary policy, the monetary authority often lowers the interest rates in order to promote spending money and make saving it unattractive.

Increased money supply in the market aims to boost investment and consumer spending. Lower interest rates mean that businesses and individuals can get loans on favorable terms.

Many leading economies around the world have held onto this expansionary approach since the 2008 financial crisis, keeping interest rates at zero or near zero.

Contractionary Monetary Policy

A contractionary monetary policy increases interest rates in order to slow the growth of the money supply and bring down inflation.

This can slow economic growth and even increase unemployment but is often seen as necessary to cool down the economy and keep prices in check.

Monetary policy is enacted by a central bank with the mandate to keep the economy on an even keel. The aim is to keep unemployment low, protect the value of the currency, and maintain economic growth at a steady pace. It achieves this mostly by manipulating interest rates, which in turn raises or lowers borrowing, spending, and savings rates.

Source: Investopedia