Monetary Policy

What are the basics of monetary policy?

Monetary policy is the process of controlling the supply of money (the size and rate of growth of the money that circulates in the economy) in a given country. Usually, it is carried out by a monetary authority, such as a central bank or currency board appointed by the government.

Classic tactics of monetary policy are modifying the interest rate and the inflation rate, with the goal of securing price stability and creating general trust in the currency. It also includes the buying and selling of government bonds and the level of liquid reserves that private and commercial banks need to keep in the vault, commonly referred to as bank reserves.

Further goals of a monetary policy are usually in line with political targets, such as increasing economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies.

What are the different types of monetary policy?

Depending on the economic goals, monetary policy can be either expansionary or contractionary. If the goal is to stimulate the economy, it’s expansionary. An expansionary policy increases the total supply of money in the economy more rapidly than usual. It is traditionally used to try to combat unemployment in a recession by lowering interest rates to make the credit flow from the commercial banks to businesses. Also, this increases the overall demand for all goods and services in an economy (aggregate demand), which increases growth as measured by gross domestic product (GDP). Expansionary monetary policy usually devaluates the value of the currency, thereby decreasing the exchange rate.

The opposite of expansionary monetary policy is contractionary monetary policy, which slows, or even decreases, the rate of growth in the money supply. This tactic intends to prevent inflation by slowing economic growth. Contractionary monetary policy can result in increased unemployment as well as depressed borrowing and spending by consumers and businesses, which can eventually lead to an economic recession.

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Category: Financial Glossary

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