Monetary policy

Monetary policy is a policy that aims to control the money supply in a national economy. It is used to regulate inflation and unemployment among other variables.

Generally, governments have two tools at hand to organize the economy – fiscal policy and monetary policy. While fiscal policy relies on taxation, government spending and government borrowing, monetary policy focuses primarily on adjusting money supply or interest rates to manage business cycle phenomena, such as recessions.

While fiscal policy lies within the competence of the government, monetary policy is conventionally a responsibility of the central bank. There are two types of directions for monetary policy:

• Expansionary monetary policy whose goal is to boost the money supply in the economy
• Contractionary monetary policy that aims to curb the money supply in the economy

Tools of monetary policy

• Interest rates – in order to decrease the supply of money in the economy, the central bank can chose to increase its interest rates, so as to nudge people to save their money, rather than spend it
• Purchase or sale of government securities – central banks can purchase government bonds, thus banks will obtain more money to increase the lending and money supply in the economy
• Change reserve requirements – if monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients, and thus, money supply decreases
• Open market operations – the purchase and sale of government securities so as to control the amount of foreign reserves in the economy

Objectives of monetary policy

By adjusting either of the introduced tools, the central bank aspires to influence the following phenomena:

• Inflation
• Unemployment
• Currency exchange rates