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What is Monetary Policy?
Monetary policy is a series of actions taken by a country’s central bank to maintain a stable economy and employment with the use of various tools such as interest rates and asset purchasing.
Key Takeaways
- Monetary policy is managed by a country’s central bank.
- Interest rates can be increased to support economic growth and decreased to manage inflation.
- In the United States, the Federal Reserve manages the country’s monetary policy.
- Monetary policy can help stabilize the economy without the need for legislative changes.
- Policy changes can take months or years to be fully felt in the economy.
Types of Monetary Policy
Based on the monetary policy definition, there are two main types of policies: expansionary and contractionary.
Expansionary monetary policy is used to stimulate an economy that is slowing down or in a recession.
On the flipside, contractionary monetary policy is used to cool down an overheated economy that is running high inflation.
Monetary Policy Goals
The main goal of monetary policy is to balance full employment and inflation. When monetary policy is used to grow the economy, there’s a risk of increasing inflation.
On the other side, when monetary policy is used to manage inflation, it can slow the economy and risk a recession. Therefore, monetary policy decisions must balance these two opposing forces to maintain economic stability.
Tools of Monetary Policy
The main tool of monetary policy is interest rates, which central banks use to increase or decrease the cost of borrowing money. As interest rates rise, it becomes more expensive to borrow, and instead, businesses slow down their growth. This also incentivizes more savings and reduces economic growth. When interest rates are lowered, businesses are incentivized to borrow and grow and, in turn, hire more employees, which helps reduce unemployment and grow the economy.
Monetary policy can be used to buy and sell government securities such as bonds, known as open market operations. When a central bank purchases securities, it injects capital into the economy to spur growth. When it sells securities, it removes money from the economy to help manage inflation.
A final tool that central banks can use is to change the reserve ratio required for banks. The reserve ratio is the percentage of deposits that banks must hold as reserves. If this ratio is lowered, banks can lend out more capital and jumpstart economic growth. When the reserve ratio is raised, banks must hold more cash, taking it out of the economy and lowering growth as a result.
Expansionary Monetary Policy vs. Contractionary Monetary Policy
What is it? Actions to increase the money supply and reduce interest rates
Goals: Stimulate economic growth and reduce unemployment
Money supply: Increases
Interest rates: Decrease
When is it used? A slowing economy facing a recession
Risks: Currency devaluation and rising inflation
What is it? Actions to decrease the money supply and increase interest rates
Goals: Manage rising inflation and stabilize the local currency value
Money supply: Decreases
Interest rates: Increase
When is it used? An overheated economy with rising inflation
Risks: Rising unemployment and slower economic growth
Monetary Policy vs. Fiscal Policy
What is it? Decisions to control the money supply and interest rates
Managed by… Central banks
Goals: Manage inflation and employment
Main tool: Interest rates
In a recession… Reduce interest rates and purchase securities
In an inflationary environment… Increase interest rates and sell securities
What is it? Decisions to manage taxes and government spending
Managed by… Governments and legislatures
Goals: Redistribute income and stimulate economic growth
Main tool: Government spending and taxes
In a recession…? Increase spending and decrease taxes
In an inflationary environment… Decrease spending and increase taxes
Monetary Policy Pros and Cons
Pros
- Can be helpful to curb inflation and stabilize the economy
- Monetary policy changes can be enacted fairly quickly
- Central banks are usually independent of the political system and can make unbiased decisions
- Economic stability can be gained from predictable monetary policy changes
Cons
- May not be enough to control economic problems
- It can take months or even years for monetary policy changes to impact the economy
- When interest rates are already low, central banks are limited in what they can do to spark economic growth
- Inflating asset prices with economic stimulus can disproportionately benefit financial asset owners, leading to greater financial inequality
The Bottom Line
Monetary policy actions can help central banks maintain economic stability. Monetary policy, meaning the management of interest rates and money supply, is a crucial tool in this effort. Because central banks are generally independent from political parties, they can operate without bias and in the best interest of the economy as a whole.
While monetary policy changes aren’t a cure-all for economic issues and can take months or even years to take full effect, they are often useful tools to manage inflation, employment, and keep the economy running smoothly.
