What is “Monetary Policy”?

The definition of monetary policy is the actions that central banks undertake in order to control the money supply and achieve its macroeconomic objectives.

Central banks have targets in controlling inflation at a certain level, for example, a 2% annual inflation target, as well as aim to promote sustainable growth and manage liquidity.

To achieve these objectives, central banks use two major mechanisms – they set the base interest rates (the rate they charge banks to borrow money from them) and quantitative easing (QE), also known as an asset purchase, which involves digitally creating money to fund government and corporate bond purchases.

Key Learning Points

  • Monetary policy is the actions central banks undertake in order to achieve their macroeconomic objectives and control the money supply.
  • The tools central banks use to achieve their targets include setting the base interest rate and asset purchasing or quantitative easing.
  • More broadly, monetary policy could be determined as either expansionary, which aims to increase economic activity, and growth or contractionary, which aims to bring down inflation levels.
  • Policymakers meet on a regular basis and the minutes from those meetings are widely anticipated by investors as they could give important indications about the economy and the markets.

The Basics of Monetary Policy

The usual macro goals of most central banks are achieving sustainable growth, maintain full employment and control the prices of goods and services. The actions undertaken by policymakers are defined as monetary policy – managing the money supply in the economy through setting interest rates at which banks could borrow money, purchasing or selling government or corporate bonds, setting and adjusting the cash reserves requirement for banks, and regulating foreign exchange rates.

Building the monetary policy relies on macroeconomic data from a variety of sources such as GDP (gross domestic product) growth, inflation (measured by the consumer price index and the producer price index) or sector-specific figures along with geopolitical and financial market developments.

Types of Monetary Policy

There are two major types of monetary policy – expansionary and contractionary. An expansionary policy has the objective of expanding economic growth by lowering interest rates and promote spending by making saving less attractive. This type of policy is usually adopted during a recession, economic slowdown, or period of high unemployment rate.

On the other hand, contractionary policy involves increasing interest rates in order to stabilize the money supply and control rising levels of inflation. It makes saving more attractive, which could slow down economic growth and have a negative impact on employment. However, this type of policy is often viewed as a necessity to cool down an “overheating” economy.


Monetary vs. Fiscal Policy

There is a distinct difference between monetary and fiscal policies. The first is aimed at addressing the macroeconomic stability and is undertaken by the country’s central bank, while the second refers to the tax and spending policies and is determined by the country’s government.