Economics Terms A-Z - The most important terms in economics.

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Economics Terms A-Z

Monetary Policy

Monetary policy refers to the set of policies that monetary authorities such as central banks use to control the money supply of a country and thereby the economic activity. According to economic theory, changes in the money supply - i.e., in the amount of money (in cash and deposits) that is provided by the central banks and can be used in economic transactions - affect investment and consequently economic growth. Increases in the money supply foster investment and spending which results in higher production and lower unemployment, while at the same time raising inflation. Decreases in the money supply, on the other hand, dampen investment and spending which leads to a decrease in production and higher unemployment, while at the same time lowering inflation.

So, how does the central bank control the money supply? The central banks have different instruments available to control the money supply of a country: the discount rate, open market operations and the reserve requirement. The discount rate is the interest rate at which the commercial banks can take out a loan at the central bank. At a lower discount rate borrowing money from the central bank is more attractive (less to pay back) and hence the demand for loans increases. The money borrowed by the commercial banks from the central bank in turn is made available to private households and business (also in the form of loans) that use this money to consume goods and services. At the same time, a lower interest rate makes saving money less attractive for households and they might consume a larger share of their income and save less. Hence, by lowering the discount rate, the central bank can increase the money supply. Similarly, a higher interest rate makes borrowing less attractive, the commercial banks will borrow less money from the central bank, and consequently there is less money available for loans for private households and firms. Thus, if the central bank wants to decrease the money supply, it can raise the discount rate.

Another instrument to control the money supply are open market operations. Open market operations refer to the purchase or sale of government bonds by the central bank. If the central bank decides to buy government bonds which are held by private households, companies or commercial banks this increases the amount of money that's circulating in the economy. By selling government bonds the central bank exchanges some of the government bonds it holds for money held by households, firms and commercial banks and thereby reduces the amount of money that circulates in the economy.

Theoretically, the central bank has a third instrument to control the money supply – the reserve requirement. For every Euro/Dollar/Pound that is deposited in a bank account the bank loans out a certain fraction to a third party and keeps a certain fraction of the deposit in their vaults as a reserve. The reserve requirement is the fraction of each deposit that the bank is legally obliged to keep as a reserve, i.e. that they are not allowed to lend.  The reserve requirement is set by the central banks. By increasing the reserve requirement, the central bank decreases the money supply as the commercial banks have less money to give out in the form of a loan. If the central bank wants to increase the money supply, it can decrease the reserve requirement. While changes in the discount rate and open market operations are commonly used to alter the money supply, changes in the reserve requirement are rare in practice.

Now let's turn to expansionary and contractionary policies. Depending on whether the central bank increases or decreases the money supply, it is said to either employ a expansionary or contractionary monetary policy. Expansionary monetary policy describes monetary policies that lead to an increase in the money supply, like, for example, decreasing in the discount rate or central bank purchasing of government bonds through open market operations. According to economic theory, expansionary monetary policies will stimulate investment and consumer spending which leads to an increase in production. This also decreases the unemployment rate and stimulates consumption. Therefore, expansionary policies are deemed appropriate to stimulate growth during recessions when unemployment is high and production low.

One problem that comes along with expansionary monetary policies is an increase in the price level. In other words, an increase in the money supply will lead to higher inflation rates. There is widespread agreement among economists that stable economic growth is best achieved when inflation rates are low to moderate and steady. High inflation is problematic as the value of money decreases and consumers may prefer to keep their wealth in the form of goods rather than money. In extreme cases very high inflation can cause consumers to hoard certain goods which may create shortages. Investment and saving are discouraged, which also slows down economic growth. In times of high inflation contractionary monetary policies can be used to lower inflation and stabilise the economy. Contractionary monetary policies are policies that decrease the money supply, like increasing interest rates or the selling of government bonds through open market operations by the central bank. A higher interest rate makes saving more attractive than spending and therefore 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. The price level will decrease.

Further Reading

The main objective of monetary policies is to ensure steady, long-term economic growth and to stabilise the economy in times of a crisis. Many economists 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, and 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 2008/09 help explain differences in the macroeconomic performance of different countries after the crisis.

Good to know

During the COVID-19 pandemic many countries have reacted with severe lockdown measures to stop the spread of the virus that at the same time have severe economic consequences such as rising unemployment and decreasing production. The measures to prevent COVID-19 from spreading differ from country to country as do the public policies to protect the economy. The International Monetary Fund (IMF) provides on its website a policy tracker with information on the main economic responses governments are taking to limit the economic impact of the COVID-19 pandemic. In this tracker, which includes 196 countries, you can have a look at the monetary policies different countries have taken in response to the crisis.