How Central Banks Control the Economy: Everything You Need to Know About Monetary Policy

The Fundamental Role of Monetary Policy in the Global Economy

Monetary policy is the set of decisions made by central banks to influence the money supply and interest rates in the economy. Although it sounds technical, these decisions directly affect your wallet, the prices you see in stores, and surprisingly, also the behavior of the crypto markets.

Central banks primarily use three tools to implement monetary policy: adjusting interest rates, conducting open market operations ( by buying and selling securities ), and modifying the reserve requirements that commercial banks must maintain. All these actions have a common goal: to regulate how much money circulates in the economy and at what accessible cost it is for citizens and businesses.

The Two Faces of Monetary Policy: Expansionary and Contractionary

When Money Is Injected: Expansive Monetary Policy

During times of economic crisis or recession, central banks opt for expansionary monetary policy. This strategy involves lowering interest rates and increasing the amount of money available in the economy to stimulate economic activity.

Imagine this scenario: the central bank of a country lowers interest rates. Suddenly, loans become cheaper. María, an entrepreneur, who could not finance her business before, now applies for a loan with affordable interest rates. Carlos, a worker, decides to take advantage of the low rates to refinance his mortgage. At the same time, consumption increases, businesses receive more investment, jobs are created, and the economy begins to grow.

A crucial historical example is the United States' response to the financial crisis of 2008. The U.S. government implemented an aggressive expansionary monetary policy that included near-zero interest rates and a program called quantitative easing. This program involved purchasing large volumes of government bonds and mortgage-backed securities. The result was a massive injection of liquidity into the economy, allowing credit to flow again and consumers to start spending, facilitating a gradual economic recovery.

When Withdrawing Money: The Contractionary Monetary Policy

On the opposite end, when inflation skyrockets and prices rise uncontrollably, central banks implement a contractionary monetary policy. This measure increases interest rates and reduces the money supply to slow down the economy and curb inflation.

Consider this example: the central bank of a country significantly raises interest rates because inflation reaches alarming levels. Loans become expensive. Patricia, a small business owner, decides to postpone the expansion of her facilities because financing is now prohibitively expensive. David delays the purchase of a new car. With less spending and investment, demand decreases, which eventually puts downward pressure on prices.

A relevant case occurred in the early 1980s in the United States. The Federal Reserve faced very high inflation and decided to implement a severe contractionary monetary policy, drastically raising interest rates. This measure was effective in controlling inflation, although it had a social cost: unemployment temporarily increased. However, it was necessary to restore price stability in the economy.

Monetary Policy vs Fiscal Policy: Different Tools, Similar Objectives

It is common to confuse monetary policy with fiscal policy, but they are different instruments:

Tools: Monetary policy focuses on interest rates and money supply through central bank operations. Fiscal policy, on the other hand, uses public spending and taxation, decided by governments through the legislative process.

Implementation Speed: Monetary policy can be adjusted relatively quickly. A central bank can change interest rates within a matter of weeks. Changes in fiscal policy require political negotiation and legislative approval, making them slower.

Focus: Monetary policy pursues general macroeconomic objectives such as controlling inflation or managing employment. Fiscal policy can target specific sectors of the economy, allocating funds to particular projects or groups.

The Surprising Impact of Monetary Policy on Cryptocurrency Markets

Although cryptocurrencies were conceived as an alternative and independent financial system, reality shows that traditional monetary policy exerts a significant influence on the price behavior of Bitcoin, Ethereum, and other digital currencies.

When There Is More Money: Effects of Monetary Expansion

When a central bank implements an expansionary monetary policy, it literally injects more money into the economy. Lower interest rates make savings in bank accounts unattractive. Investors, with more liquidity available and seeking higher returns, often turn to alternative assets like Bitcoin and other cryptocurrencies. This flow of capital into the crypto markets tends to put upward pressure on prices.

Additionally, periods of monetary expansion generally coincide with greater confidence in the markets and a higher risk appetite among investors, factors that additionally favor digital assets.

When There Is Less Money: Effects of Monetary Contraction

Conversely, when a central bank contracts the money supply through higher interest rates, money becomes more expensive to obtain and more profitable to save in traditional low-risk instruments. Investors have less capital available for speculation in high-risk assets like cryptocurrencies. This scarcity of liquidity and the higher cost of capital typically pressure the prices of Bitcoin and other crypto assets downward.

During these periods, investors tend to seek refuge in safer and more predictable assets, reducing their exposure to volatile markets such as that of cryptocurrencies.

What You Need to Understand: Key Summary

Monetary policy represents the mechanism through which central banks regulate the circulation of money and interest rates in order to achieve price stability, full employment, and sustainable economic growth. Even if you operate in the crypto markets, you cannot ignore what is happening in central banks.

Changes in monetary policy —whether expansive to stimulate the economy or contractionary to control inflation— modify the amount of money available for investment. This change in liquidity and market sentiment inevitably translates into pressure on cryptocurrency prices.

As a participant in digital markets, understanding monetary policy provides you with crucial context to comprehend market cycles, anticipate changes in investor sentiment, and make more informed decisions about when and how to allocate your capital in the crypto markets.