MONETARY POLICY

It is a process through which authorities, such as a central bank, controls the amount of money in an economy with the aim of maintaining economic stability and growth. It is usually carried out by controlling interest rates.

There are expansionary monetary policies

  • If the monetary supply increases; contractive monetary policies
  • If the money supply decreases, and neutral policies
  • If the money supply is kept constant.

 

The monetary policy aims to:

  • Avoid inflation
  • Achieve the highest level of employment possible
  • Achieve economic growth
  • Avoid unbalances between the balance of payments, the maintenance of a stable exchange rate, and the protection of the international reserve position

EXPANSIONARY MONETARY POLICY

This policy has been used in times of crisis or economic stress. The central bank (or the fed in the US) can carry out liquidity injections by:

  • Open market Operations: the central bank buys national bonds or other financial assets. When payment is made by these bond investors, more liquid money is injected in the system.
  • Reduce the required-reserve ratio: the required-reserve ratio is the amount of money that banks must keep in their reserves. Therefore, if banks are allowed to decrease the amount of money destined to these reserves, they will have more money available.
  • Reduce the discount rate: if the central banks reduces the interest rates, banks will be able to apply for more loans because the money that is required to pay for them (payments of interests) will be less. Similarly, families and companies will also be able to apply for loans, causing an increase in consumption and along with it the circulation of capital.

CONTRACTIVE MONETARY POLICY:

This policy consists of taking money out of the system, which is carried out to control inflation, and it can be done in the following ways:

  • The central bank sells national bonds or other financial assets. The money it receives from its sale removes a certain amount of money from the system. Since there is less money circulating in the economy, the level of prices reverts back to where it used to be.
  • The central bank increases the required-reserve ratio: if banks are obliged to increase their required-reserves, this means that they must deposit more money into these reserves. That way the amount of money in the system is reduced.
  • Increase the discount rate: in this case, banks will apply for fewer loans to the central bank because the price that they have to pay for it (payment of interests) is higher. For the same reason, families and companies will also request for fewer loans.