Monetary policies refer to the plan of action from central banks, currency boards, or other relevant monetary authority in a country to control the quantity of money in a country and the channels by which new money is supplied.
In general, there are two types of monetary policies: expansionary and contractionary policies.
If the economy is experiencing high unemployment rate during a slowdown or recession, the monetary authority can choose an expansionary policy.
The goal of this policy type is increase economic growth and expand the economic activity. With an expansionary monetary policy, the authority typically slashes interest rates via different ways that pomote spending.
Meanwhile, in the event of higher inflation and higher cost of living and doing business, a contractionary monetary policy may be more appropriate.
This type of policy typically uses higher interest rates that slow down the growth of money supply. It then ultimately brings down inflation.
Tools for Implementing Monetary Policies
Central banks around the world use different tools to create and implement monetary policy.
Bond Buying and Selling
Central banks may buy and sell short-term bonds on the open market using newly created bank reserves. This process is often called the open market operations.
Open market operations usually target short term interest rates like the federal funds rate. The central bank basically adds money into the banking system through the purchase of assets, and other banks react by loaning the money easier at lower rates.
The operation typically goes on until the bank reaches its target interest rate.
Changing Interest Rates
Another tool that the central bank can use is the interest rate. It may also tinker with the required collateral that it demands for emergency direct loans to banks (since it also serves as the lender of last resort).
The reserve requirement talks about the funds that banks must maintain as a proportion of the deposits made by customers in order to ensure that they are able to meet their liabilities.
Making this reserve requirement lower unleashes more capital for the banks to offer loans or to buy other assets. With higher reserve requirement, meanwhile, the opposite effect is true.
Apart from directly influencing the money supply and banking lending situation, central banks also use their public announcements as powerful tools to shape market expectations over the bank’s own future monetary policies. Statements from the central bank as well as policy announcements can move financial markets.
On the flip side, the policy announcements can only be effective to some extent. To put that more clearly, they are only effective depending on the credibility of the authority responsible for planning, announcing, and implementing the policies.
These monetary authorities must work totally independent of influence from the country’s government, politics, and any other policy-making authorities.
However, in reality, different governments may have different levels of interference with the monetary authority’s operations.
For instance, if the central announces a policy to curb increasing inflation, the inflation rate may still spike if the public has little to no trust in the monetary authority.