Expansionary vs. restrictive monetary policy: definition and how do they work

Central banks influence the economy. But how? By adopting these two strategies: expansionary or restrictive monetary policy
expansionary restrictive monetary policy

Central banks influence the economy and the cost of money. But how? By adopting, depending on the short- and medium-term scenario, these two strategies.

A currency, just like any other asset, has no fixed value. It fluctuates every day, following supply and demand. Central banks, however, can have a profound effect through their decisions. These represent monetary policy, i.e. the choices an institution makes to influence the cost of money and its availability.

Objectives and instruments of monetary policy

The main instrument a central bank has at its disposal is the key interest rates. These are the official rates at which the ECB or Fed lend to banks. They are a kind of ‘valve’ that indirectly acts on the real economy. The reference rate, as the European Central Bank itself explains, ‘affects, in turn, the interest rates that commercial banks charge on loans to customers. In other words, it affects consumer spending and business investment‘.

But why is the need of central bank intervention? Monetary policy aims at price stability. In particular, to maintain positive but moderate inflation, which is considered essential to boost business, consumption and employment. To achieve this goal, a central bank can modulate its actions and use different instruments, but – basically – it adopts two types of monetary policy: expansionary or restrictive.

Expansionary monetary policy: when and why

Expansionary monetary policy intervenes when the economy is in trouble. That is, in times of crisis or recession, usually accompanied by low inflation rates. The central banks then intervene by reducing reference rates and – as has been the case in recent years – with soft loan schemes and open market operations, i.e. with the purchase of securities to boost the economy and shelter states from an excessive rise in government bond rates.

Expansionary monetary policy thus aims to encourage consumption and investment, but must be carefully modulated. If it is pushed too hard, it could have good results in the short term but excessively inflame inflation in the medium term, in fact going against its main objective (price stability).

Restrictive monetary policy: when and why

Restrictive monetary policy, on the other hand, aims to ‘cool’ the economy. It manifests itself through an increase in interest rates, a reduction in the amount of money in circulation and a reduction in the direct purchase of securities.

The restrictive monetary policy intervenes when excessive and prolonged inflation occurs. Too pronounced an increase in prices squeezes the purchasing power of households and weighs on businesses. Here too, interventions must be modulated so as not to have the opposite effect to the objective. Excessive monetary tightening, in addition to dampening inflation, could penalise economic growth, triggering a downward spiral.

The ECB’s monetary policy

This is a particularly eventful time for monetary policy. Grappling with two crises in a few years, the ECB has actually had one top priority for years: to push the economy. The main downside, as excessive inflation, was not a concern: despite the interventions, the price index remained below the European optimum (set at 2%). This is why European monetary policy was very expansionary for a long time. Reference rates were kept at historic lows, supported by less conventional instruments, such as long-term refinancing operations and massive bond purchases.

This orientation was first halted and then reversed in 2022. The rapid post-pandemic recovery and (among other things) the war in Ukraine inflamed inflation, bringing it back into focus. During 2021, the ECB preferred not to intervene, in the belief that inflation was not structural and fearing that a restrictive monetary policy would weaken the recovery. As the months went by, moreover, one of the rarest and most complicated scenarios for a central bank to handle emerged: stagflation, i.e. a scenario characterised by economic stagnation and sharply rising prices.

In the end, the persistence of inflation approaching double digits convinced the Eurotower to intervene, initiating a restrictive monetary policy. Last July, purchases of government bonds were halted and interest rates were raised (for the first time in over a decade). In September, another, decidedly sharper intervention (+75 basis points) and the prediction of further rises at the next meetings. The objective: to bring inflation as close to 2% as possible, so as to stabilise prices and encourage more sustainable growth.

Read also: World stock market indices: what they are and what they measure

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