Srading.com

Menu
  • Home
  • Markets
    • Forex
    • Stock
  • Fundamental Analysis
    • Economics
    • Money & Banking
  • Technical Analysis
    • Drawing Tools
    • Chart Patterns
  • Tools
    • Online Charts
    • Economic Calendar
    • Interest Rate Today (Live Widget)
    • Forex Market Hours
    • Currency Indexes Chart
    • National Holiday Calendar
    • CoT Chart
    • Quotes

RISK WARNING: Trding financial assets come with a high risk of losing money. So, everything you read on this website is for educational purposes or personal opinions only

Read our DISCLAIMER
Home
Fundamental Analysis
Money & Banking
What Is Monetary Policy? Types, Tools, Objectives & Examples
Money & Banking

What Is Monetary Policy? Types, Tools, Objectives & Examples

October 11, 2022 Zafari

Monetary policy refers to the money supply plan adopted by the central bank to influence economic activities.

The general monetary policy aims are macroeconomic stability such as inflation, currency stability, and employment.

A government needs to adjust constantly its policies because no policy is perfect, and the economy is evolving. Additionally, competitors and market forces in the free market often create imbalance. That is why monetary authorities should step in to solve the problems.

Generally, there are two types of monetary policy, expansionary and contractionary.

Tools of Monetary Policy

Central banks have authority powers and tools to implement their policies to fix economic problems.

In “relatively stable” and stable economies, primary tools are interest rates, market operation, required reserved ratio (RRR), collateral policy, and credit quotas.

Interest Rate

The overnight interest rate is the most powerful tool of the central bank.

It is the interest that commercial banks receive for their deposits in the central bank. When the central bank changes its interest rate, other banks follow by raising or cutting the interest rate that charges their customers.

A higher interest by the central bank (Ex: Fed in the USA and Bank of England in the UK) increase borrowing cost and decrease the money supply. A fall in the money supply lowers the inflation rate and investment.

Contrarily, a lower interest rate decreases borrowing cost and increase the money supply.

Discount Rate

It is the rate of interest that central banks charge other banks for lending them for short terms.

Required Reserve Ratio (RRR)

The required reserve ratio (RRR) is the percentage of deposits by customers that a commercial bank should keep in cash.

A higher RRR enables banks to loan more and causes an increase in the money supply. On the other hand, a lower RRR forces banks to loan less and decreases the money supply.

Market Operation

The central bank may enter the market as a participant, known as market operation.

Market operation is effective when the exchange rate is not in the target range.

The central bank sells foreign currencies when the domestic currency exchange rate is lower than the target and buys if the exchange rate is higher than the target. Moreover, it can buy debt securities to increase the money supply, and sell to decrease it.

Credit Quota Policy

Credit quota is a policy by the center that defines for every bank the amount of money that can lend.

This policy is not very common. However, the State Bank of Vietnam still uses it.

Collateral Policy

Collateral is a guarantee that the lender will receive if the borrower fails to pay the loan.

For example, a borrower may provide his home as collateral. If he fails to pay the loan, the lender can sell it to receive his money.

And central banks decide which assets qualify to be collateral.

Types of Monetary Policy

There are two types of monetary policy: expansionary and contractionary.

Expansionary Monetary Policy

Expansionary Monetary Policy means an increase in the money supply to increase economic activities.

Expansionary Monetary Policy

A central bank increases the money supply by combining multiple or using one of its tools. It can cut the interest rate, lower Required Reserve Ratio (RRR), or buy foreign exchanges from the domestic market.

How does it work?

The expansionary policy lowers the financing costs of businesses and investors and enables them to increase their borrowings. And lowering financing costs increase economic activities.

Objectives of Expansionary Monetary Policy

Economic problems can be many, and an expansionary policy can solve them. 

And some of them are the followings:

  1. Increase economic growth: Central banks take expansionary monetary policy to increase the money supply to make it cheaper by lowering the interest rate and the required reserve ratio (RRR) or buying foreign currencies. Central banks hope that the decisions lead to economic growth by boosting consumption and more investment.
  2. Reduce the unemployment rate: The central bank can help unemployment reduction by making available money to companies. The central bank may directly buy companies’ bonds or help get a loan from commercial banks by lowering interest rates. Low-interest rates encourage firms to borrow more, invest more, and finally will hire more.
  3. Increase inflation: One of the primary jobs of the central bank is to manage the inflation rate. Generally, in developed countries, the central banks target about a two percent inflation rate. Economists believe that a 2% inflation rate helps the economy to become stable. If the inflation rate is below the targeted rate, the central bank increases the money supply. Pouring money into the economy will diminish its value relative to other assets and raise the inflation rate.
  4. Boost Exports: The job of the central bank is not only to control money supply and demand but also to help exports and the economy. The central bank can help boost exports by weakening the exchange rate of a national currency relative to foreign currencies. If the value of a national currency is lower than the trading partners of a country, the cost of goods and services produced is lower than trading partners. The government can weaken the exchange rate by simply printing money or buying foreign currencies.

Example of Expansionary Monetary Policy

In December of 2007, the 2008 recession started. And the Fed Reserve started cutting the interest rate to encourage borrowing and investment.

Moreover, the Fed bought a huge amount of debt and mortgage-backed securities to inject money into the market.

The following is the chart of interest rates showing it through the years.


source: tradingeconomics.com

Contractionary Monetary Policy

Contractionary Monetary Policy means reducing the money supply in the economy to decrease economic activities. In other words, governments take contractionary monetary policy to cool the overheating economy.

Contractionary Monetary Policy

The central bank can raise the interest rates and reserve requirements and enter the open market to cut the money supply.

Central banks also may limit credit provisions to risky projects and people who are not likely to pay back by setting quotas and changing collateral policy.

Objectives of Contractionary Monetary Policy

Investors do not like contractionary monetary policy. However, sometimes it is a must.

Here are some contractionary monetary policy objectives.

  1. Reducing inflation: A higher inflation rate for savors is problematic. It makes it difficult for them to adjust to the new situation where the prices continue to rise. It is difficult for savors to save enough to buy a house, cars, and other things. There are many ways to control inflation. However, monetary policy tools are more effective in reducing the inflation rate.
  2. Preventing bubble: An economic bubble is a market condition when prices are too high without justifications. The contractionary monetary policy reduces the money supply making people unable to push prices higher, or creating a bubble. Some economists believe that it is the only money supply that creates a bubble and can avoid it.
  3. Strengthening national currency: A stable currency is a sign of a healthy economy. No one likes an unstable currency that is not trustable. And a central bank can strengthen a currency by cutting the money supply by raising the interest rate and RRR or selling foreign currencies in the free market.

Example of Contractionary Monetary Policy

The inflation rate in the united states started to rise above the Fed target in early 2021.


source: tradingeconomics.com

To control the inflation rate, the Fed began taking contractionary monetary policy by raising the interest rate in late Feb of 2021.


source: tradingeconomics.com

Moreover, the Fed started shrinking its balance sheet by selling debt securities that had amassed over time.

What Is the Difference Between Fiscal Policy and Monetary Policy?

Both of these policies’ goals are to manage the macro economy. 

So, here are the difference in bullet points. 

  • Fiscal policy is the spending and revenue plan of the government. But the monetary policy is about the money supply in the economy.
  • The fiscal policy tool is the budget. And the monetary policy tools are interest rates, RRR, market operation, collateral policy, and credit quota. 
  •  The office of the leader of a country (president or prime minister) and the congress (parliament) decide about the fiscal policy. However, the central bank takes the monetary policy.
  • Fiscal policy’s key targets are macroeconomic stability or growth, such as employment, building infrastructure, and a higher GDP growth rate. On the other hand, the fiscal policy’s key targets are to control inflation and the financial market. 
  • The monetary policy impacts the currency exchange rate. However, the fiscal policy has no or minor impacts on the currency exchange rate. 

Bottom Line

Monetary policy is an ever-changing central bank program and is reactive. The central bank responds to the inflation behavior of the goods market and the financial market.

Monetary policy goals are stability in the macro economy, mostly money, and the financial market.

Share
Tweet
Linkedin
Pinterest
Reddit
Email
Prev Article
Next Article
Tags:Banking Forex Fundamental Analysis

Related Articles

What Is a Central Bank, and What Does It Do?
What Is a Central Bank? A central bank is the …

What Is a Central Bank, and What Does It Do?

Money Supply: Types and its Management
What is the Money Supply? The money supply (MS) is …

Money Supply: Types and its Management

What Is Interest Rate? A Definitive Guide
The interest rate is a percentage of the loan (principal …

What Is Interest Rate? A Definitive Guide

What is Banking & What Are Commercial and Investment Banking?
What is banking that makes bankers rich? Bankers may not …

What is Banking & What Are Commercial and Investment Banking?

What Is Money? Features, Types, Money Market
What is money that has become the main thing almost …

What Is Money? Features, Types, Money Market

How Do Banks Make Money And What Are They?
How do banks make money? They make money in various …

How Do Banks Make Money And What Are They?

About The Author

Zafari

Zafari is a professional trader and has been in the financial market since 2014. He has a bachelor of public economics and an MBA. For some reason, he does not show his face. And he loves you all!

Leave a Reply Cancel Reply

  • Recent
  • Popular
  • Comments
  • Tags

Srading.com

QUICK LINKS

  • About
  • Cookies Policy
  • Terms & Conditions
  • Disclaimer
  • Privacy Policy
  • Contact Us

LATEST POSTS

  • Elliott Wave Theory Guide for Beginners
  • Top Continuation Candlestick Patterns
  • Top Reversal Candlestick Patterns
  • 6 Popular Continuation Patterns & How to Trade
  • 8 Popular Reversal Patterns and How to Trade Them

FOLLOW US ON SOCIAL MEDIA

  • Facebook
  • Twitter
  • LinkedIn
  • Instagram
  • Pinterest
  • Telegram
  • Reddit
  • YouTube

Trading financial assets are risky. Everything you read on this website is just for educational purposes or personal opinions only. Read our DISCLAIMER!

Copyright © 2023 Srading.com

Ad Blocker Detected

Our website is made possible by displaying online advertisements to our visitors. Please consider supporting us by disabling your ad blocker.

Refresh
We use cookies on our website to give you the most relevant experience by remembering your preferences and repeat visits. By continuing this website or clicking “Accept”, you consent to the use of ALL the cookies.
Do not sell my personal information.
Cookie SettingsAccept
Cookies Policy
Manage consent

Privacy Overview

This website uses cookies to improve your experience while you navigate through the website. Out of these, the cookies that are categorized as necessary are stored on your browser as they are essential for the working of basic functionalities of the website. We also use third-party cookies that help us analyze and understand how you use this website. These cookies will be stored in your browser only with your consent. You also have the option to opt-out of these cookies. But opting out of some of these cookies may affect your browsing experience.
Necessary
Always Enabled
Necessary cookies are absolutely essential for the website to function properly. These cookies ensure basic functionalities and security features of the website, anonymously.
CookieDurationDescription
cookielawinfo-checkbox-analytics11 monthsThis cookie is set by GDPR Cookie Consent plugin. The cookie is used to store the user consent for the cookies in the category "Analytics".
cookielawinfo-checkbox-functional11 monthsThe cookie is set by GDPR cookie consent to record the user consent for the cookies in the category "Functional".
cookielawinfo-checkbox-necessary11 monthsThis cookie is set by GDPR Cookie Consent plugin. The cookies is used to store the user consent for the cookies in the category "Necessary".
cookielawinfo-checkbox-others11 monthsThis cookie is set by GDPR Cookie Consent plugin. The cookie is used to store the user consent for the cookies in the category "Other.
cookielawinfo-checkbox-performance11 monthsThis cookie is set by GDPR Cookie Consent plugin. The cookie is used to store the user consent for the cookies in the category "Performance".
viewed_cookie_policy11 monthsThe cookie is set by the GDPR Cookie Consent plugin and is used to store whether or not user has consented to the use of cookies. It does not store any personal data.
Functional
Functional cookies help to perform certain functionalities like sharing the content of the website on social media platforms, collect feedbacks, and other third-party features.
Performance
Performance cookies are used to understand and analyze the key performance indexes of the website which helps in delivering a better user experience for the visitors.
Analytics
Analytical cookies are used to understand how visitors interact with the website. These cookies help provide information on metrics the number of visitors, bounce rate, traffic source, etc.
Advertisement
Advertisement cookies are used to provide visitors with relevant ads and marketing campaigns. These cookies track visitors across websites and collect information to provide customized ads.
Others
Other uncategorized cookies are those that are being analyzed and have not been classified into a category as yet.
SAVE & ACCEPT