What is Monetary Policy?

Monetary policy refers to processes or procedures used by the central bank or monetary authority to control the amount of money available in the economy, money supplied in an economy and how they are effectively channeled. The central bank of every country take specific actions to regulate how money is supplied and circulated within the economy. 

Monetary policy entails the act of planning and implementing a stream of actions to manage money supply in an economy. Central banks have the responsibility of managing the money supply of a nation to ensure the stability of the economy through adequate supply and circulation of money. 

The major takeaways of monetary policy are:

• Monetary policy refers to processes used by the central bank to regulate the supply and circulation of money in the economy.
• Monetary policy also entails the management of interest rates to control inflation and deflation in an economy.
• Central banks enhance economic growth and boost the liquidity of an economy through monetary policy.
• The specific actions used in monetary policy include the use of interest rates, bank reserve requirements and regulation of the amount of money banks should hold in their reserve.

Back to:ECONOMIC ANALYSIS & MONETARY POLICY

How to decide on Monetary Policy?

Central banks and monetary authorities in different countries often hold a series of meetings to decide on the monetary policy tools that will be used, these include open market operations, interest rates, direct lending to banks, bank reserve requirements, among others. Central banks formulate monetary policy based on data gathered from different sources, including economists, investors, financial experts and analysts. Decisions reached by central banks, currency board and monetary authority have significant impacts on the economy at large. 

There are many factors that are considered when monetary policy is to be made in a country, these include the GDP, growth rates of the country, inflation, industries, sectors and businesses and other factors. The objective of monetary policy is to stabilize economic growth through adequate supply and circulation of money in the economy which influence economic inputs, improve employment rate, and others. In some countries, monetary policy can be used instead of fiscal policy while some countries use both monetary policy and fiscal policy. In the United States, the body in charge of monetary policy is the Federal Reserve Bank.

Types of Monetary Policies

There are two major types of monetary policies, these are:

• Expansionary monetary policy: When this monetary policy is used, it is aimed at enhancing economic growth by offering lower interest rates which reduces money saving, thereby increasing spending. When interest rates are lower, individuals and businesses are discouraged from saving their money in the bank but they can conveniently take loans for their business. The expansionary monetary policy is often used when there is a recession or high rate of unemployment in a country.
• Contractionary monetary policy: This type of policy entails increasing interest rates which will reduce the growth of money supply in an economy and ultimately reduce inflation. Contractionary monetary policy tackles inflation in an economy.

Tools to Implement Monetary Policy

There are several measures or approaches through which the central bank implements monetary policy, these are often called monetary policy tools. The major monetary policy tools include the following;

1. Interest rates: Central banks modify or change interest rates to suit the economic need, when interest rates are low, it means lower collateral and many individuals and institutions can take as much loan as they want. Lower interest rates encourage spending and discourage saving, it is used when there is limited money in the economy. Higher interest rates also means that banks will demand more collateral.
2. Open market operations: this is an approach used by central banks to pump money into or remove money from the economy through the purchase of assets and selling of assets. When this tool is used, buying and selling of short term bonds such as the federal funds rate are done on the open market. The buying and selling occurs until the benchmark or target of the central bank is met and the economy made better.
3. Reserve requirements: This is another monetary policy through which central banks ensure that banks have the required amount of cash in their reserve and also retain the level of required deposits.

Difficulties in Monetary Policy

In the real world, effective monetary policy faces a number of significant hurdles. Monetary policy affects the economy only after a time lag that is typically long and of variable length. Remember, monetary policy involves a chain of events: the central bank must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy. The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates. When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars. Then it takes time for these changes to filter through the rest of the economy.

As a result of this chain of events, monetary policy has little effect in the immediate future. Instead, its primary effects are felt perhaps one to three years in the future. The reality of long and variable time lags does not mean that a central bank should refuse to make decisions. It does mean that central banks should be humble about taking action, because of the risk that their actions can create as much or more economic instability as they resolve.

Related Topics

• Legal Tender
• Numismatics
• Gresham's Law
• Barter
• Double Coincidence of Wants
• Parity
• Functions of Money
• Medium of Exchange
• Unit of Account
• Store of Value
• Time Value of Money
• Standard of Deferred Payment
• Liquidity Preference Theory
• National Savings and Investment Identity
• Circular Flow of Money
• Commodity Money
• Gold Exchange Standard
• Bretton Woods System
• Fiat Money
• Money Supply
• M1 and M2 Money Supply
• Monetary Base
• Savings, Demand, and Time Deposits
• Banks
• How Do Banks Create Money? 
• Financial Intermediary
• Bank Balance Sheet
• Money Multiplier Formula
• Velocity of Money
• Multiplier Effect
• Quantity Equation of Money
• McCallum Rule
• Neutrality of Money
• Real Bills Theory
• Banking System?
• Central Bank
• Federal Reserve System
• Federal Open Market Committee (FOMC)
• Fed Balance Sheet
• Term Auction Facility
• Taylor Rule
• How is the Federal Reserve Bank Organized?
• What is Bank Regulation?
• CAMELS Rating
• FDIC
• CFPB
• Bank Supervision
• Bank Runs
• What is Deposit Insurance?
• Federal Deposit Insurance Corporation
• Lender of Last Resort
• Central Banks Carry Out Monetary Policy
• Open Market Operations
• Bank Reserve
• Discount Rate
• Federal Funds Rate
• Monetary Policy
• Contractionary and Expansionary Monetary Policy
• Loose vs Tight Monetary Policy
• Easy Monetary Policy 
• Accommodative Monetary Policy
• Dove & Hawk (Monetary Policy) - Explained
• Tight Monetary Policy - Explained
• Stabilization Policy
• Pushing on a String
• The Effect of Monetary Policy on Interest Rates
• Federal Funds Rate
• Gibson Paradox
• Vasicek Interest Rate Model
• Equation of Exchange (Economics)
• The Effect of Monetary Policy on Aggregate Demand
• Quantitative Easing
• Reserve Currency
• What are Excess Reserves?
• Unpredictable Movements of Velocity
• Central Banks - Unemployment and Inflation
• Inflation Targeting
• Fisher Effect
• Asset Bubbles and Leverage Cycles
• Countercyclical
• Money Capital Market
• Quantity Theory of Money
• Aggregate Expenditure Model
• IS-LM Model
• European Capital Market Institute