How central banks control the money that circulates in the economy

Monetary policy is the main tool by which monetary authorities influence the flow of money in a country. In practice, central banks like the Federal Reserve use it to control inflation and interest rates, thereby ensuring economic stability. But how does this mechanism really work?

Two opposing strategies: restrictive and expansive

There are two completely different approaches. Restrictive monetary policy aims to slow down the economy by reducing the amount of money available. If the central bank raises interest rates, commercial banks tighten loans, money circulates less, and inflation decreases. It's like “pulling the brakes” on the economy.

The other approach is completely opposite: expansionary monetary policy. Here the central bank injects money into the economic system to stimulate growth. Interest rates fall, loans become easier, companies invest more, and consumers spend more. It sounds wonderful… until the other side of the coin arrives.

The effects of expansionary monetary policy: benefits and risks

The positive effects of expansive monetary policy are evident in the short term. The economy accelerates, unemployment decreases, exports become more competitive as the currency depreciates. Businesses hire, consumption rises, everything seems to be going well.

However, the effects of expansionary monetary policy come at a cost: inflation rises. The more money circulates, the higher prices increase. If left unchecked, the situation can spiral out of control, eroding people's purchasing power and creating economic instability.

The Concrete Tools of Central Banks

How do central banks implement these policies? They use three main levers:

1. Interest rates: the key rate is the main one. If the Federal Reserve or another central bank raises it, loans become more expensive; if it lowers it, loans become easier and more affordable.

2. Reserve Requirements: banks must hold a percentage of customer deposits as cash reserves. If the central bank lowers this requirement, banks can lend more money. If it raises it, banks lend less.

3. Open market operations: the central bank buys or sells government bonds and other financial instruments. When it buys, it injects money into the system; when it sells, it withdraws money.

The economic cycle depends on these choices

Monetary policy largely determines a country's boom-bust cycle. An overly aggressive restrictive policy stifles growth. An excessive expansive policy creates bubbles and inflation. Central banks must find the perfect balance: stimulate the economy without overheating it, control inflation without strangling it.

This is the constant challenge of modern policy makers.