Monetary Policy

Monetary Policy refers to the process by which the Monetary Authority of a given country implements a variety of measures to control the supply of money.

At the forefront of Monetary Policy is the objective of managing and controlling the level of inflation, economic and employment growth.

This is often done by targeting a specific rate at which banks can borrow and lend (interest rate).

Monetary is different to fiscal policy, which refers to government spending and borrowing.

Some examples of Monetary Authorities are:

  • The United States Federal Reserve
  • Bank of England
  • Bank of Japan
  • People’s Bank of China
  • European Central Bank

 

Monetary Policy and the Monetary Authority

Successful monetary policy uses a combination of measures to control both the total supply of money as well as the price at which money can be lent.

A successful monetary policy can only exist when a country has only one issuer of currency, and when there is a regulated system of issuing currency through which banks are linked to the Monetary Authority.

The Monetary Authority has legal authority established by government laws to alter the money supply within the banking system.  The Monetary Authority can use two types of monetary policy.

 

Types of Monetary Policy

  1. Contractionary Monetary Policy: occurs when the Monetary Authority reduces the money supply, or raising the interest rate.

This directly reduces the total amount of money that is circulating in the economy.

In order to achieve this, the Monetary Authority simply sells bonds (government debt) in exchange for cash.

By collecting cash, the Monetary Authority is literary removing a certain amount of cash from the economy.

  1. Expansionary Monetary Policy: opposite of contractionary Monetary Policy.

An Expansionary Monetary Policy is implemented by increasing the money supply, thereby decreasing the rate of interest.

In order to achieve this, it is important to understand the concept of banking reserve requirements.

Banks are required by law to maintain a certain percentage of their client’s assets as cash available for immediate withdrawal.

The remainder of cash held by a bank is invested in other assets like loans and mortgages.

When a Monetary Authority allows the banking system to lower the reserve rate, this grants banks more cash available to loan out to customers.

 

Monetary Policy and Inflation

As mentioned, the main focus of a Monetary Policy is the control of inflation.

A reduction in interest rate (Expansionary Monetary Policy) boosts the total demand for goods and services because money is more readily available and cheaper to borrow.

On the other hand, if spending is too strong and the economy is growing at an unsustainable level, inflation is likely to occur.

The Monetary Authority will have to raise interest rates (Contractionary Fiscal Policy) in order to return spending to a more appropriate level and keep inflation within a desired range.

 

Conclusion

Changes in Monetary Policy, as a side effect can influence the prices of investments (such as stocks, bonds, real estate) thus increasing or reducing individual wealth, which may encourage or discourage spending based on the type of policy enacted.

At a macro-economic level, a change to the policy rate may make the nation’s assets more (or less) attractive to foreign investors, such as the demand to hold the currency in an investment portfolio.

Changes in Monetary policy can take up to two years to have the full effect on targeting inflation.

Monetary Policy must always be forward looking, and policy makers always need accurate information and forecasts for the activity in the next two years.

Typically, a Monetary Authority will meet eight times a year to decide what changes if any will be made.

Key Words: Monetary Policy, Central Banks, inflation, Employment, Interest Rate, Money Supply, Contractionary Monetary Policy, Expansionary Monetary Policy, Banks, Reserve Rate