Monetary policy refers to the measures adopted by a country’s central bank or currency board to control money supply (cash, checks, credit, mutual funds, etc.) within its economy by lowering or increasing interest rates; determining the minimum amount of funds banks must have in their vaults; and trading government securities such as bonds, bills and notes (to increase money supply). The broader objective is to maintain financial and economic stability, and make sure there are sufficient financial resources for the country or state’s development. In other words, monetary policies are supposed to help attain or sustain zero unemployment, achieve or maintain strong economic growth rate, and stabilize wages and prices. Like fiscal policy, monetary policy also contributes to a country’s economic activity.

Devising a Monetary Policy

To create a monetary policy, the central bank studies the economy’s inflationary trends – including consumer confidence (consumer perception about the economy), unemployment, exchange rate index, house prices, etc. If the various parameters indicate higher inflation and growth possibilities, the interest rates would be increased. Interest rates are cut down if little growth and a dip in inflation rate is expected. Theoretically, lower interest rates help stimulate economic activity as the costs of borrowing reduce, increasing consumers’ disposable income and encouraging spending. Interest rates go up if the rate of economic growth is too quick, which may lead to inflation issues.

Monetary Policy Types

Basically, monetary policy can be categorized as expansionary policy and contractionary policy. Also called easy monetary policy, expansionary policies entail increasing money supply to reduce unemployment, stimulating consumer spending and private-sector loans, and boosting overall economic growth. A contractionary policy, on the other hand, slows money supply or decreases its growth rate to control inflation. Such a monetary approach may also slow down economic growth, augment unemployment and reduce spending and borrowing by businesses and individuals. These may lead to a recession, but the inflation numbers would be under check.