How monetary policy works: the key tool of central banks

Monetary policy is the set of decisions implemented by central banks to regulate the money available in the economy and interest rates. Its fundamental purpose is to maintain economic stability by controlling inflation and promoting sustainable growth. Although it sounds technical, understanding how these mechanisms operate helps us comprehend why markets fluctuate.

Two opposing strategies, different objectives

Central banks have two main paths: to contract or expand the economy. The difference between the two is crucial for understanding economic cycles.

The contractionary monetary policy seeks to curb economic growth when there is inflationary pressure. How? The central bank raises interest rates to discourage borrowing and reduces the amount of circulating money. This means that commercial banks have less capital available to lend, so they raise their own rates. Although it curbs inflation, it comes at a cost: it slows consumption, discourages investment, and can increase unemployment.

Another contraction tool is the sale of government bonds and Treasury bills. When the central bank or the Federal Reserve sells these securities to financial institutions, money is withdrawn from the economy, reducing the amount of cash available.

On the opposite pole is expansive monetary policy, which seeks to stimulate economic growth. Central banks lower interest rates, buy securities, and decrease reserve requirements. The result is more money flowing into the economy, greater incentives to invest and employ, and a weaker currency that makes exports more competitive. The downside: inflation tends to increase.

The reserve requirement: the silent regulator

A less visible but very effective mechanism is the reserve requirement. Central banks require commercial banks to maintain a minimum percentage of deposits in cash. If the central bank wants to inject more money, it reduces this percentage; if it needs to contract, it increases it. It is simple but powerful: small changes in this ratio can significantly alter how much money circulates.

The impact on economic cycles

Monetary policy is the tool that determines the rates of expansion and contraction of the economy. Central banks, such as the Federal Reserve in the United States, constantly use it to maintain the balance between growth and inflation. However, they do not always work as expected: policies designed to stimulate can generate uncontrolled inflation, while contractionary ones can lead to recessions.

Understanding these dynamics is essential for anyone looking to anticipate market movements, as monetary policy directly affects asset prices, exchange rates, and investment opportunities across all global economies.