Economic Control Instruments: How Monetary Policy Works in Practice

A monetary policy is the set of decisions made by the financial authorities of a country to regulate the circulation of money and control interest rates. These measures are typically implemented by the central bank or under a specific convertibility regime, and their fundamental purpose is to maintain economic balance by controlling both inflation and interest rates.

Two Paths to Manage the Economy

There are two main approaches when we talk about monetary policy. The first is the restrictive approach, designed to slow down economic growth and prevent overheating. When a central bank implements this strategy, it typically raises interest rates for commercial lenders, reducing the amount of money available in the economy. A complementary alternative is for the monetary authority to sell government bonds and treasury bills directly to financial institutions, thus limiting their credit capacity and raising their interest margins.

Although this mechanism slows down inflation, it also has a cost: it reduces private consumption and business investments, temporarily hindering economic development.

The second approach is completely opposite: the expansive monetary policy, which seeks to inject liquidity and stimulate economic activity. To achieve this, the central bank lowers short-term interest rates, reduces reserve requirements, and buys financial assets in the market. This type of intervention generates employment, increases spending, and causes the local currency to lose relative value, benefiting exporters. The downside is that it eventually raises inflation levels.

The Role of the Reserve Requirement

A key mechanism within any monetary policy is the reserve requirement, which establishes the minimum percentage of deposits that commercial banks must hold in cash. This requirement serves a protective function: it ensures that there is enough money to meet customer withdrawals.

When the central bank wishes to expand the money supply, it lowers this requirement, allowing banks to lend a greater proportion of their deposits. If it needs to contract the economy, it does the opposite: it raises the requirement, limiting the available credit.

Impact on the Economic Cycle

The importance of monetary policy lies in its ability to directly influence economic cycles. Both the Federal Reserve and other central banks around the world rely on these tools to regulate the flow of capital, prevent crises, and maintain growth within manageable ranges. Every decision regarding interest rates, reserve requirements, or open market operations generates waves that permeate the entire economic structure.