Understanding how monetary policy works

Presented by the community - Author: Allister Davis

What is monetary policy?

Monetary policy is the set of instruments that central banks use to control the money available in an economy. Its fundamental objective revolves around maintaining economic stability by regulating both the money supply and the interest rates that govern the market. In most countries, these decisions are made by the central bank or executed through predefined convertibility regimes.

When we talk about what monetary policy is in practical terms, we refer to the concrete actions that central banks implement to influence economic behavior. These measures can be divided into two categories based on their objectives: policies that contract the economy or policies that expand it.

Contractionary monetary policy: slowing down the economy

When inflation rises uncontrollably, central banks resort to restrictive mechanisms. Contractionary monetary policy aims to slow economic growth by maintaining moderate rates of increase. One of the most common tools is to raise interest rates for commercial banks, which reduces the amount of circulating money.

How does it work in practice? The central bank or the Federal Reserve can sell government securities to financial institutions. This action drains resources from the banks, leaving them with less capital available to lend to businesses and consumers. As a result, financing costs rise. Although this strategy controls inflation, it has a cost: it slows down consumption, reduces investments, and can limit job opportunities.

Expansionary monetary policy: stimulating growth

The opposite scenario is expansionary monetary policy, a macroeconomic strategy designed to inject money into the economy. Central banks can lower interest rates, decrease reserve requirements, or acquire market securities. The result is more money circulating and easier access to credit.

This approach generates economic dynamism: it increases employment, boosts investment, and improves consumption. Additionally, when the value of the local currency falls, domestic products become more competitive in international markets. However, there is an inevitable consequence: inflation tends to rise when there is more money chasing the same amount of goods.

Booking Requirements: The Key to Monetary Control

A central mechanism in monetary policy is the reserve requirement, which represents the minimum percentage of deposits that banks must hold in cash. This requirement ensures that financial institutions can handle customer withdrawals smoothly.

When the central bank needs to boost the money supply, it lowers these reserve requirements. Banks can then lend a greater proportion of their funds. Conversely, if it needs to restrict the money supply, it raises the required reserve ratios, thus limiting the capital available for loans.

The impact on economic cycles

Understanding what monetary policy is essential for anyone who invests or does business. Central banks, like the Federal Reserve in the United States, use these tools to regulate the flow of capital in their economies. These decisions generate fluctuations in economic cycles, affecting prices, employment, and the availability of credit. That is why they are so relevant to the financial market and asset behavior in any economic context.