Expansionary and contractionary monetary policy: impact on the economy and crypto markets

What is monetary policy really?

Monetary policy refers to the decisions made by central banks to control the money supply and the cost of money in the economy. Through adjustments in interest rates, open market operations, and modification of bank reserve requirements, central banks seek to achieve fundamental macroeconomic objectives: maintaining inflation under control, reducing unemployment, and sustaining economic growth.

These measures are not just numbers in financial reports. They directly affect how much money you have available to invest, how much it costs to take out a loan, and ultimately, your purchasing power in the markets, including the cryptocurrency markets.

Two opposing paths: expansion vs. contraction

Expansive monetary policy: injecting liquidity

Expansive monetary policy acts as an economic stimulus. Central banks lower interest rates and increase the money supply to make credit more accessible and cheaper. This strategy is typically implemented during recessions or periods of low economic activity.

The mechanism is straightforward: lower interest rates mean that loans cost less. People are more willing to borrow money to start businesses, buy homes, or make investments. Companies are encouraged to expand. Consumption increases, jobs are created, and the economy starts to move.

A classic example is the U.S. government's response to the financial crisis of 2008. The Federal Reserve implemented an aggressive expansionary monetary policy: it reduced interest rates to near-zero levels and introduced quantitative easing, buying government securities and mortgage-backed securities. This massive injection of liquidity increased the available money supply, significantly lowered borrowing costs, and allowed consumers to start spending again and businesses to invest. Gradually, the economy recovered.

The contractionary monetary policy: slowing down growth

When inflation skyrockets, central banks apply the brakes through contractionary monetary policy. They raise interest rates and reduce the available money supply. Money becomes more expensive to borrow, discouraging both spending and investment. Aggregate demand falls, prices stabilize, and inflation moderates.

In the early 1980s, the United States faced uncontrolled inflation. The Federal Reserve responded with aggressive interest rate hikes, making credit more expensive. Although this effectively reduced inflation, it also led to a temporary increase in unemployment. The trade-off is part of economic reality.

Monetary policy vs. fiscal policy: distinct tools

Although both seek to influence the economy, they operate in different ways. Monetary policy primarily uses interest rate adjustments and bank reserve requirements. Fiscal policy, on the other hand, uses direct public spending and taxes.

The advantage of monetary policy is its speed: it can be implemented relatively quickly. Fiscal policy requires slower legislative processes. However, fiscal policy can target specific sectors of the economy, while monetary policy tends to affect broader economic objectives.

How monetary policy impacts the crypto markets

Although cryptocurrencies sometimes operate independently of traditional financial systems, they are not immune to changes in monetary policy. In fact, the sentiment of the crypto market is significantly linked to these macroeconomic decisions.

When monetary expansion prevails

During periods of expansive monetary policy, money flows more freely through the economy. With low interest rates, investors have greater disposable income and seek investment alternatives that offer better returns. Cryptocurrencies, especially bitcoins and other digital assets, benefit from this increased availability of capital. Historically, these phases coincide with rises in cryptocurrency prices, as more people have access to funds to invest.

When contraction monetary policy is applied

The opposite occurs when central banks tighten monetary conditions. Higher interest rates mean less capital available for speculative investments. People prioritize consumption of necessities over investments in volatile assets. Cryptocurrency prices tend to fall under these pressures, reflecting lower demand and less disposable income for this type of investment.

Summary

Expansive and contractive monetary policy are the main tools that central banks use to manage economic growth, control inflation, and maintain financial stability. Although they seem like remote concepts, they have a cascading effect: they influence your access to credit, how much money you have left to invest, and thus, your ability to participate in the cryptocurrency markets.

Understanding how expansive monetary policy works and its alternatives helps you anticipate movements in the markets and make more informed investment decisions. In an ecosystem like that of cryptocurrencies, where liquidity cycles are crucial, this understanding is especially valuable.