Monetary policy: what is it, types and objectives

Every sector has rules and policies that guide its successful operations. Likewise, central banks use monetary policy to control economic turbulence and attain price stability, which results in low and stable inflation. Let's take a closer look at what it's all about.
monetary policy

Every sector has rules and policies that guide its successful operations. Likewise, central banks use monetary policy to control economic turbulence and attain price stability, which results in low and stable inflation. Let’s take a closer look at what it’s all about.

What is monetary policy

Monetary policy refers to the actions and strategies undertaken by a central bank or authority to first and foremost manage or control the supply of money and credit in an economy to achieve specific economic objectives.

The main objectives typically include promoting price stability, maintaining full employment, and supporting economic growth.

The types of monetary policy

We have two main types, which includes:

1. Contractionary monetary policy

Contractionary policy, also referred to as tight monetary policy, is used to reduce a country’s money supply to tame excessive inflation and maintain economic equilibrium. An attempt will likely be made by a central bank to curb the increase in money and prices by raising interest rates. It is typically used to control inflation.

2. Expansionary monetary policy

As opposed to the contractionary policy, the expansionary one is targeted to increase the amount of money in the economy by lowering interest rates, reducing the number of reserves that banks must hold, and having central banks buy government assets. 

This strategy encourages consumer spending and business growth while lowering unemployment rates. This policy’s overarching objective is to support economic growth, but can also have unintended consequences, occasionally resulting in hyperinflation. It is typically used to combat a recession or to promote job creation.

What are the goals of monetary policy

The question of to what end this monetary policy is used might have crossed your mind, so here are a few among many other primary goals of monetary policy:

1. Price stability

The most important goal of is to maintain price stability, which means keeping inflation low and stable. Central banks usually target a specific inflation rate, such as 2%, and adjust their monetary policy tools to achieve that goal.

2. Full employment

Another important goal is to promote full employment or maximum employment. The central bank can influence the level of employment by adjusting interest rates and other monetary policy tools, which can affect the level of economic activity and the demand for labor.

3. Economic growth

Monetary policy can also be used to promote economic growth by making credit more readily available and lowering the cost of borrowing. Lower interest rates can stimulate investment and consumer spending, which can boost economic activity.

4. Stability of financial markets

Central banks also aim to maintain the stability of financial markets and prevent financial crises. They use this tools to manage liquidity in the banking system and prevent excessive risk-taking by financial institutions.

5. Exchange rate stability

Finally, central banks may also aim to maintain stability in the exchange rate of their country’s currency. This can help promote international trade and investment, as well as maintain the confidence of foreign investors in the country’s economy.

Read also: Svb and Signature Bank’s bankruptcy, Treasury and Fed intervene: customer deposits protected

What’s the difference between monetary and fiscal policy?

There’s a general misconception about monetary policy being the same as fiscal policy. But the two are different with unique purposes.

Fiscal policies are used by the government to regulate how money is spent in an economy and to establish targets for the amount of national spending. Governments might, for instance, lower taxes and increase expenditure to boost the economy if warranted; typically, they invest in social programs and infrastructure improvements that create revenue and jobs. Or, if such an economy is prospering, a government may decide to cut spending while raising taxes. 

On the other hand, it primarily serves as a tool for growth and inflation. It doesn’t affect the economy as much as fiscal policy. It majorly focuses on the precise steps the Central Bank takes to control the supply, demand, and value of money in the economy as a means of attaining the macroeconomic goals of the government.

Tools of monetary policy

The Federal Reserve has various tools at its disposal when determining monetary policy. Which includes:

1. Open market operations

This practically involves buying or selling government securities in the open market to influence the supply of money and interest rates.

2. Discount rate

This is the interest rate at which commercial banks can borrow from the central bank. By changing the discount rate, the central bank can affect the cost of borrowing for commercial banks and their willingness to lend to consumers and businesses.

3. Reserve requirements

By raising or lowering reserve requirements, the central bank can influence the amount of money that banks have available to lend and the overall supply of money in the economy.

Why it is crucial in shaping a country’s economy

It’s worth noting that the economic strategy of any country is built on its monetary policy. Anyone from part-time employees to enormous financial institutions, both local and foreign, is influenced when monetary policy changes because it is the cornerstone of any country’s economic strategy. 

Therefore, while different economists may argue on the benefits and drawbacks in certain circumstances, the majority will concur that it’s part of the crucial instruments in shaping the economy.

Read also: A guide to financial instruments: what they are and which are the most common today

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