What Is Monetary Policy: Definition and Examples

Among the most influential institutions shaping a country’s economic health is the central bank. Despite its power, it often operates discreetly, remaining largely unnoticed by the public.

In this article, we will explain what central banks do, why their actions matter, and how they impact our standard of living. Understanding these mechanisms is essential, as they directly affect the economic well-being of every citizen.

Understanding Monetary Policy

Central banks, also known as monetary authorities, are government institutions responsible for implementing and managing monetary policy. But what exactly is monetary policy?

Governments can influence economic development through two main policy types: fiscal and monetary.

• Fiscal Policy: Managed by the Ministry of Finance, fiscal policy involves taxation and government spending. When the government needs funds, it raises taxes or borrows money, though tax cuts are rare.
• Monetary Policy: This refers to measures aimed at controlling inflation, interest rates, unemployment, and more.

According to the Bank for International Settlements, monetary policy involves issuing “money,” a state-backed obligation used as a means of payment. In essence, monetary policy determines the form and value of money, while fiscal policy dictates where that money should be allocated.

However, unchecked money creation can lead to inflation or even hyperinflation.

Monetary Policy Tools

To regulate money supply and maintain economic stability, central banks use various instruments:

1) Open Market Operations

Central banks engage in financial markets by buying and selling assets to influence liquidity and interest rates. Key operations in the financial sector include:

• Repurchase Agreements (Repos): Central banks lend money to commercial banks against collateral, with an agreement to repurchase it later.
• Reverse Repos: Commercial banks lend to the central bank under similar terms.
• Deposits and Lending: Central banks accept deposits from commercial banks to absorb market liquidity or lend funds without transferring collateral ownership.
• Currency Swaps: Central banks exchange currencies to stabilise foreign exchange markets.

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2) Monetary Policy Interest Rate

By adjusting interest rates, central banks control the cost of borrowing. Lower rates stimulate borrowing and spending but can cause inflation if money supply outpaces economic output. Raising rates curbs inflation but increases borrowing costs.

3) Reserve Requirement Ratio

This ratio dictates how much of a bank’s deposits must be held in reserve. Lower ratios enable more lending, boosting economic activity but increasing risk. Central banks adjust this ratio to manage credit availability.

Objectives of Monetary Policy

Central banks typically pursue three key objectives over a period of time:

1. Price Stability: Most central banks target a 2% inflation rate, though the rationale behind this specific figure is debated.
2. Low Unemployment: While some central banks focus solely on price stability, the United States Federal Reserve has a dual mandate to maintain both stable prices and low unemployment.
3. Economic and Financial Stability: Central banks monitor and intervene in financial markets to prevent instability and global financial crisis. In some countries, this responsibility is shared with other regulatory bodies.

Conclusion

Monetary policy involves strategies designed to manage a country’s economy by influencing money supply, interest rates, and inflation. While these measures aim to reduce economic volatility, they can sometimes create unintended consequences.

For instance, during the pandemic, central banks slashed interest rates to near-zero levels, spurring excessive borrowing and inflation. As history shows, when central authorities control money’s value, economic distortions often follow, sometimes with severe societal consequences, as seen during the 2008 financial crisis.