How the mechanisms of monetary policy work in the economy

Monetary policy is the set of tools used by financial authorities to manage the amount of money available in an economy and control interest rates. Generally, this accountability falls on the central bank or established convertibility systems. The fundamental purpose is to maintain economic balance by controlling inflation and ensuring adequate credit conditions.

Two opposing approaches: contraction and expansion

Policymakers have two fundamentally different strategies at their disposal. When they need to curb economic growth and control inflation, they implement restrictive measures. A practical example is when the central bank raises interest rates for commercial banks, thereby reducing the volume of money in circulation. This compression of the monetary supply typically leads to a decrease in inflation levels.

The Federal Reserve and other similar institutions can also implement this contractionary approach by selling securities and treasury bonds to financial entities. The direct result is that banks have less capital to lend to the public, which increases credit interest rates. Although this approach manages to contain inflation, it can also slow down investment and private consumption, negatively impacting growth.

The alternative path: stimulus and growth

In contrast, when the objectives include reviving the economy, authorities adopt an accommodative stance. Central banks may lower short-term interest rates, reduce liquidity requirements, and purchase securities in the open market. These actions generally accelerate economic growth and mitigate unemployment. Additionally, they favor a depreciation of the local currency, which enhances the competitiveness of exports and increases attractiveness for foreign investors.

However, this approach comes at a cost: it typically generates upward pressure on inflation levels, creating an uncomfortable balance between growth and price stability.

The reserve requirement instrument

A critical mechanism in the arsenal of monetary policy is the adjustment of reserve requirements. These represent the minimum percentage of total deposits that commercial banks must hold in available cash. This standard protects the ability of institutions to meet customer withdrawals.

When the central bank seeks to expand the monetary circulation, it lowers these ratios, allowing banks to lend larger volumes. Conversely, when it needs to restrict the supply, it increases these ratios, limiting the available credit.

Impact on the economic cycle

Central banks use these mechanisms to regulate the flow and ebb of liquidity in the national economy. The importance of these adjustments lies in their ability to generate expansive or recessive economic cycles, significantly affecting the well-being of the population and the stability of financial markets.