Monetary policy is the process a government, central bank, or monetary
authority of a country uses to attain a set of objectives
oriented towards the growth and stability of the economy and to control
(i) the supply of money
(ii) availability of money
(iii) cost of money or rate of interest
Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation.
Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.
Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard.
Trends in central banking
The central bank influences interest rates by expanding or contracting
the monetary base, which consists of currency in circulation and banks'
reserves on deposit at the central bank.
The primary way that the central bank can affect the monetary base is by open market operations or sales
and purchases of second hand government debt, or by changing the reserve
If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets.
A central bank can only operate a truly independent monetary policy when
the exchange rate is floating.If the exchange rate is pegged or managed
in any way, the central bank will have to purchase or sell foreign exchange.
These transactions in foreign exchange will have an effect on the monetary
base analogous to open market purchases and sales of government debt; if
the central bank buys foreign exchange, the monetary base expands, and vice
But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile.
Accordingly, the management of the exchange rate will influence domestic monetary conditions. To maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate.
The contraction of the monetary supply can be achieved indirectly
by increasing the nominal interest rates. Monetary authorities in
different nations have differing levels of control of economy-wide
interest rates. In the United States, the Federal Reserve can set the
discount rate, as well as achieve the desired Federal funds rate by
open market operations.
This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool — open market operations; one must choose which one to control.
In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.