How central banks manipulate the economy: understanding monetary policies

Have you ever wondered why interest rates go up or down? The answer lies in the decisions made by central banks regarding the amount of money circulating in the economy. Monetary policies are the mechanism through which authorities precisely control that: the money supply and interest rates of a country.

The economic dilemma: less money or more money?

Most central banks face a constant dilemma. If they inject too much money into the economy, inflation skyrockets and your purchasing power decreases. If they withdraw money, loans become more expensive, people consume less, and layoffs may increase. Both options have consequences.

Expansionary monetary policy: stimulating at any cost

When a central bank decides to expand the money supply, it aims to boost economic growth. How does it do this? By lowering interest rates, purchasing government securities, and reducing the reserve requirements that commercial banks must maintain. The result: more money available for banks to lend, which stimulates consumption, reduces unemployment, and improves the competitiveness of exports by devaluing the local currency. The dark side: inflation increases significantly.

Contractionary monetary policy: brake to avoid chaos

The opposite occurs when the central bank implements a contractionary policy. It sells government bonds, raises interest rates, and increases reserve requirements. The goal is clear: to reduce the amount of circulating money to keep inflation under control. However, this economic brake slows down growth and can increase unemployment.

The reserve coefficient: the invisible lever

A key instrument that central banks control is the reserve ratio, the percentage of deposits that commercial banks must hold in cash. When this percentage decreases, banks have more money to lend. When it increases, the opposite occurs. It is a subtle but powerful tool for adjusting the flows of money in the economy.

Why Monetary Policies Matter

In the end, understanding how monetary policies work helps you anticipate changes in the economy. Central banks constantly calibrate these decisions to maintain balance: enough growth without falling into rampant inflation. Every move that governments and their monetary authorities make generates waves that directly affect economic cycles and your wallet.