Monetary policy refers to the set of policies that monetary authorities such as central banks use to influence the money supply of a country and thereby economic activity.

According to some economic theories, changes in the money supply affect investment and consequently economic growth. Economists who subscribe to Keynesian or monetarist theories believe that increases in the money supply foster investment and spending, which results in higher production and lower unemployment.

At the same, though, increases in money supply raise inflation. The same is true in reverse for the opposite situation: a decrease in the money supply dampens investment and spending, which leads to a decrease in production and higher unemployment, while at the same time lowering inflation.

Students should note that classical economists, however, may disagree with these views and assert that the money supply does not affect real economic variables, a theory known as monetary neutrality. This article ignores the classical viewpoint and considers monetary policy as it is typically introduced in macroeconomics courses.

The role of the central bank

So, how does the central bank influence the money supply? Central banks directly control the monetary base. But, they cannot completely control the entire supply of money since the monetary base only forms part of the money supply.

Central banks have three main instruments available to influence the money supply of a country: the discount rate, open market operations, and the reserve requirement.

The discount rate

Readers may already be familiar with the idea that central banks “set” interest rates. But, central banks cannot do this directly; rather, they use the discount rate to influence interest rates in the economy. The discount rate is the interest rate at which commercial banks can take out a loan from the central bank. It is an important macroeconomic variable that has cascading effects for all other interest rates in the economy.

Banks typically borrow money from the central bank when they don’t have enough liquid assets on hand to pay some unexpected obligation (i.e., withdrawal requests from customers) or to satisfy increased reserve requirements.

At a lower discount rate, borrowing money from the central bank is more attractive for commercial banks (as there is less to pay back) and hence the demand for those loans increases. The same is true for the reverse; a higher discount rate increases the cost of borrowing from the central bank and decreases the demand for loans.

Money borrowed by commercial banks from the central bank is then made available to private households and businesses, also in the form of loans. So, central banks can increase the money supply by reducing the cost of banks borrowing from them.

Similarly, a higher interest rate makes borrowing more expensive and less attractive, incentivizing commercial banks to borrow less money from the central bank. Consequently, there is less money available for the bank to give out as loans for private households and firms. So, if the central bank wants to decrease the money supply, it can raise the discount rate.

Open market operations and reserve requirements

Open market operations refer to the purchase or sale of government bonds “on the open market” by the central bank. In other words, when the central bank buys and sells securities like a normal individual or firm, it’s called open market operations.

If the central bank decides to buy government bonds that are held by private households, companies or commercial banks, it increases the amount of money that's circulating in the economy. This is because the central bank can simply create the money used to buy the security, adding it to the economy during the purchase. Similarly, by selling government bonds, the central bank reduces the money supply as individuals or firms give the central bank their money to purchase the asset. Then, the central bank can take that money out of circulation, reducing the money supply.

The central bank has a third main instrument to control the money supply: the reserve requirement. The reserve requirement is the fraction of each unit of money deposited in a bank that the bank is legally obliged to keep as a reserve. In other words, the bank must have some amount of cash on hand that they are not allowed to use for anything except meeting their obligations (such as fulfilling withdrawal requests).

The reserve requirement is set by the central bank. By increasing the reserve requirement, the central bank decreases the money supply because commercial banks must hold more of their money in the form of cash that is sitting “unused”. Therefore, they have less money to give out in the form of a loan.

Conversely, if the central bank wants to increase the money supply, it can decrease the reserve requirement, which frees up more of the bank’s “unused” reserves to be lent out. While changes in the discount rate and open market operations are commonly used to alter the money supply, changes in reserve requirements are rare in practice.

Contractionary vs. expansionary monetary policy

Expansionary monetary policy describes policies that lead to an increase in the money supply, like decreasing the discount rate or purchasing government bonds through open market operations. According to economic theory, expansionary monetary policies will stimulate investment and consumer spending, shifting aggregate demand to the right; this leads to an increase in production and a decrease in the unemployment rate. Therefore, expansionary policies are deemed appropriate to stimulate growth during recessions when unemployment is high and production is low.

But, an increase in the money supply will lead to higher inflation rates. Thus there is widespread agreement among economists that expansionary monetary policies should not be used when the economy is already performing well.

Conversely, contractionary monetary policy is policy that reduces the money supply and lowers aggregate demand. While this may seem like a bad thing,  in times of high inflation contractionary monetary policies are the main tool used to lower inflation and stabilize the economy.

Contractionary monetary policies include increasing interest rates or selling government bonds through open market operations. A higher interest rate makes saving more attractive than spending and decreases the demand for loans as borrowing becomes more expensive. Consequently, investment and consumption decrease, and so does production. Lower production in turn will lead to higher unemployment, which may further dampen consumption.

Other interest rate targets

When a bank needs cash, it generally has two options for borrowing: from the central bank and from other commercial banks. The “discount rate” sets the cost of borrowing from the central bank, which was discussed above.

But when commercial banks borrow from other commercial banks, they don’t use the discount rate. The interest rate at which banks borrow from each other is very important, though it can have different names depending on the country and the context. It’s important because this interest rate often sets a benchmark by which other interest rates are determined. So, if this interest rate increases, borrowing generally becomes more expensive across the whole economy. Thus, central banks may want to influence (or outright set) the interest rate that banks face when they borrow from each other.

For example, in the United States, this rate is known (somewhat confusingly) as the “federal funds rate”. The U.S. Federal Reserve sets a target interest rate range, and commercial banks can borrow money from each other at an interest rate within this range. This rate is one of the key subjects of the widely-referenced “Taylor Rule”, a rule of thumb posited by an American economist that describes optimal monetary policy responses. It has often been used by analysts to predict future monetary policy.

Although the federal funds rate may be used as a benchmark by financial institutions around the world, it’s specific to the US. Other countries and other financial institutions around the world may reference other rates. For example, the London Interbank Offered Rate (LIBOR) played a similar role until 2023, where it began to be replaced by the Secured Overnight Finance Rate (SOFR).

These interest rates in turn influence the “prime rate” in different regions, which is the interest rate that banks give to high-quality borrowers. If you have a good financial history and healthy credit score, you’ll likely be offered the prime rate for many financial products.

Further Reading

The main objective of monetary policy is to ensure steady, long-term economic growth and to stabilize the economy in times of a crisis. Many economists have studied the reactions of governments during financial crises to assess the effects of monetary policies on production, inflation and unemployment.

Jannsen et. al. show in their article “Monetary policy during financial crises: Is the transmission mechanism impaired?” (International Journal of Central Banking, 2019) that the effects of monetary policy on production and inflation depend on the timing of their implementation. They also show that these policies have greater effects during financial crises. The authors found that the differences in the timing and size of the monetary policies taken during the financial crisis of 2008-2009 helped explain differences in the macroeconomic performance of different countries after the crisis.

Good to Know

Because contractionary monetary policy can increase unemployment and slow economic growth, it can be very unpopular with individual voters. Thus, politicians may be reluctant to implement contractionary policy even during times of high inflation, to avoid becoming unpopular.

Similarly, because expansionary policy encourages growth while lowering the unemployment rate, it can be tempting for politicians to implement expansionary monetary policy during an election year – even if the economy doesn’t need it. In this case, expansionary policy can lead to very high inflation that will ultimately harm the economy.

These are two major reasons why most countries today keep monetary policy in the hands of a central bank that is not beholden to political leadership. This allows the central bank to conduct monetary policy that is right for the economy without interference from political pressure.

Of course, this is a simplification. In the real world, different central banks may feature different levels of actual independence in practice. As research from Caixa Bank shows, central banks in many Western countries have been becoming more independent over time. In many of these countries, historical episodes of inflation or stagflation demonstrated the need for an independently operating central bank, causing the nation to be more inclined to increase central bank independence.

However, while independence has proven useful, if the central bank makes mistakes or fails to react to the economy appropriately or in a timely fashion, it may cause additional hardship. This type of situation has led Australia, for example, to attempt to increase accountability for central bank officials. For more on this topic, visit Caixa Bank’s article about central bank independence.