Key takeaways

• Monetary policy is a set of actions a nation's central bank can take in order to control the overall money supply and achieve sustainable economic growth

• Monetary policy can be broadly classified as either expansionary or contractionary

• Three conventional tools to implement monetary policy include open market operation, changing bank reserve requirements and discout window lending

Understanding Monetary Policy

Monetary policy is a set of tools a central bank can adopt to promote sustainable economic development by controlling the overall supply of money that is available to the nation's banks, consumers, and businesses.

The goals of monetary policy include achieving a stable rise in gross domestic product (GDP), keeping unemployment low, and maintaining foreign exchange (forex) and inflation rates in a controllable range.

In the US, The Federal Open Market Committee of the Federal Reserve holds eight regularly scheduled meetings each year. After a couple of days of discussion, it will announce whether it will make any changes to the nation's monetary policies.

Moreover, the Federal Reserve may act in an emergency if it deems necessary. It has done so in recent crises including the 2007-2008 global financial crisis and the COVID-19 pandemic.

Types of Monetary Policies

Broadly speaking, monetary policies can be categorized as either expansionary or contractionary.

1.    Expansionary Monetary Policy

If a country is facing high unemployment due to an economic slowdown or a recession, the monetary authority of the country can adopt an expansionary policy to boost economic growth.

Expansionary Monetary Policy usually increases the money supply and lowers the interest rate, encouraging businesses to borrow more and expand production. From the perspective of investors, they may see the increased business activity as a good indicator, which in turn usually sends the stock price rising.

2.    Contractionary Monetary Policy

When the economy is overheating and inflation is out of control, a contractionary monetary policy is usually needed so as to cool down the economy and keep prices in check.

The primary purpose of contractionary monetary policy is to make it harder for companies and consumers to borrow and spend money and, in turn, control inflation. However, such a policy may lead to a market crash as struggling companies cut expenses and cut production.

Three Tools of Monetary Policy

There are mainly three instruments available for central banks: open market operations, reserve requirements and the discount window.

1.    Open market operations

Open market operations involve the buying and selling of securities on the open market.

Open market operations target short-term interest rates such as the federal funds rate. The central bank adds money into the banking system by buying assets—or removes it by selling assets. As a result, banks respond by lending money more easily at lower rates—or harder at higher rates—until the central bank's interest rate target is achieved.

Open market operations can also increase the money supply in a more targeted way by purchasing a specified quantity of assets. This is the process known as quantitative easing (QE).

Open market operations are flexible, so it is the most frequently used tool of monetary policy.

2.    Reserve requirements

Authorities can also change the reserve requirements. These are the funds that banks must retain from the deposits made by their clients in order to ensure that they are able to meet their liabilities.

Lowering this reserve requirement releases more capital for the banks to offer loans or to buy other assets. Increasing it curtails bank lending power.

3.    Discount window and Discount rate

The discount window is a central bank facility that offers commercial banks very short-term loans (often overnight).

Central banks can change the discount rates, the interest rates charged by central banks for offering such loans, or the required collateral for direct loans to banks in an emergency as lender-of-last-resort.

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