Monetary Policy Tools, Examples, and Types

What is monetary policy?

Monetary policy is the process of managing money supply, interest rates, and exchange rates by the central bank of a country or any regulatory body empowered by the law. It is the machinery that is often combined with fiscal policies to maintain stability in an economy. The monetary policy is worked out by the central bank of a country which has powers to set interest rates, money supply, etc. for maintaining low inflation and high growth rate of an economy.

The central bank uses monetary policy to reduce inflation by making money less available, influencing the rate at which people want to borrow money for investments (interest rates) and how much currency is in circulation (money supply). Monetary policy is generally used when fiscal policy fails. The type of policy used by a government gives signals about the government priorities.

Types of monetary policies

  • Expansionary monetary policy
  • Contractionary monetary policy

Each type of monetary policy has advantages and disadvantages. Take, for instance, expansionary monetary policy can be risky for a country because it can cause hyperinflation if not kept under control while contractionary monetary policy is seen as less risky and more effective.

Expansionary monetary policy

Expansionary monetary policy is when a nation’s monetary authority such as the central bank, sets out to expand the money supply in an economy by either lowering interest rates or buying back assets; the objective is to control inflation, decrease unemployment, and increase economic growth.

Examples expansionary monetary policies

An example of expansionary monetary policy would be in 2016 when India’s Prime Minister Modi initiated a demonetization program where 500 and 1000 rupee notes were taken out of circulation. These rupee notes were replaced with new 500 and 2000 rupee notes. The reasoning behind this large monetary policy was that people were holding their money in cash (due to fears about the Indian economy) which created a liquidity trap. By taking out the 500 and 1000 rupee notes, people were now required to deposit them back into the bank which increased liquidity in India’s monetary system.

Another expansionary monetary policy example is when the United States Federal Reserve announced its Quantitative Easing program in 2008 after the recession of 2007-2009. The program was set out to increase inflation by buying mortgage bonds and treasury securities.

An expansionary monetary policy can also be performed via lowering interest rates. For example, before the Eurozone Sovereign debt crisis that started in 2010, most European nations operated with an expansionary monetary policy by using their national central banks to reduce interest rates below the European Central Bank’s (ECB) rate of 2%. However, once they realized they could not control their sovereign debts, they started to increase interest rates which led to a contractionary monetary policy.

Contractionary monetary policy

Contractionary monetary policy is when a nation’s monetary authority such as the central bank, sets out to reduce inflation and slow economic growth by increasing interest rates and/or selling assets. This monetary policy made it so that people were less likely to spend their money because the return on savings was now higher than spending money.

Examples of contractionary monetary policies

An example of this can be seen in Canada where after Stephen Harper became prime minister he wanted to cut down the deficit by lowering current expenditures and increasing taxes rather than cutting down future expenditures such as social services which led him towards contractionary monetary policy. This affected Canadians heavily by slowing down their spending which brought about high unemployment rates of around 8.7%.

Another example of contractionary monetary policy is when Russia raised interest rates to 17% in 2014 after Crimea voted to join the Russian Federation and sanctions were placed on them by the United States and the European Union. This monetary policy brought about a recession in Russia as their national currency fell from an inflation rate of 11.4% to 13.5%.

Monetary policy examples

In 2008, during the financial crisis in the US, expansionary monetary policy was taken up because there was a need to revive the economy and monetary easing provided a strong stimulus for economic recovery. Expansionary monetary policy can affect the worldwide economy as well; it depends upon how much impact needs to be made upon the local economy after gauging other economies across the world. During Fed meetings, monetary policy decisions are taken on many factors such as GDP figures from different countries, employment rates, inflation rate, etc., as all factors affect the borrowing power of consumers as well as investors.

During the monetary easing by European Central Bank in June 2014, it was decided to buy 60 billion Euros of public and private sector securities per month till September 2016. It was aimed at lowering interest rates for companies to borrow more money. This monetary policy had a positive impact on economic recovery in eurozone countries that were at risk of facing deflation.

Japan is another example where monetary easing policies have been taken during the last couple of decades but they have not produced results yet due to political issues there.

Expansionary monetary policies aim for increased spending on goods and services by the government, tax cuts to consumers for increasing their spending power. Monetary easing will devalue the currency of a country causing prices to rise; the downside is that it has a risk of hyperinflation due to increased money supply in the economy.

Monetary policy tools

Also known as monetary policy instruments; there are several tools that can be used by a central bank (or other agencies with similar functions) to help control inflation and liquidity, and thus guide the economy towards achieving high employment and price stability (balance of growth and low inflation). The list of all possible tools is quite long; however, most of them fit into one of two general categories:       

  • Interest rates  
  • Open market operations

The use of monetary policy tools can be restricted to financial institutions such as banks. However, such restrictions may raise the cost of borrowing for the economy as a whole, since fewer players will be able to access it (e.g., individuals & corporations). If monetary policy is used by the government itself (and not the central bank), this would likely result in high inflation rates and/or hyperinflation (currency devaluation).

Interest Rates

When using interest rates as a tool, central banks often use their control over short-term market rates as a way to guide inflation towards its target level. Interest rate outputs affect an economy through several channels:

  • Credit supply: interest rates affect the quantity of loans offered by the financial institutions, and hence inflationary pressures in an economy.
  • Assets prices: since important assets such as real estate and stocks depend on borrowing, they will be affected by changes in interest rates (e.g., low interest rates may encourage individuals to go on a buying spree).
  • Exchange rate: for countries with fixed exchange rate, monetary policy determines domestic currency value vis-à-vis other currencies whose values are allowed to fluctuate. Thus, a change in interest levels may affect the value of home currency and exports competitiveness

Central banks will use interest rates when they aim at tightening or loosening monetary policies. While not all situations allow for setting interest rate levels, this is the most widely used tool of monetary policy.

Open Market Operations (OMO)

Central bank open market operations (OMO) are one of the main tools that central banks use to shift money supply and interest rates in an economy. OMO takes further advantage of a central bank’s ability as a lender of last resort. It works by buying/selling securities from banks, thus expanding/shrinking their reserves at the central bank.  In turn, it leads to a contraction or expansion in spending because money supply increases with purchases and decreases with sales.

1. Central bank foreign exchange operations

Central bank foreign exchange operations are important tools of monetary policy. It involves buying/selling of foreign currencies in the forex market, which impacts the value of the home currency relative to other currencies. A strategy often used by central banks is to buy weak currencies and sell strong ones – this has a depreciating impact on the home currency. This decreases exports competitiveness and imports inflationary pressure into the local economy.  On the other hand, selling weak currencies and buying strong ones increases home currency value as well as decreases inflationary pressures from abroad.

2. Reserve requirements

Central banks use reserve requirements to manage liquidity in the system. By increasing/decreasing these, central banks can influence how much cash commercial banks will keep at the central bank. Thus increasing/decreasing liquidity and consequently inflationary pressures.  The latter works via a multiplier effect – an increase in cash deposits leads to a greater spending power of individuals and corporations which further increases demand for goods and services, thus leading to inflationary pressures.

3. Discount rate

Central banks can affect short-term interest rates by manipulating the discount rate. This is the rate at which commercial banks are allowed to borrow directly from the central bank. Thus an increase in this rate will make it more expensive for commercial banks to obtain funds – reducing demand. Given that inflationary pressures are mainly caused by increased demand for goods and services, lowering the discount rate has a contractionary effect on the economy.   

Central banks don’t just use monetary policy tools in isolation. Policymakers attempt to reduce or increase systemic liquidity by coordinating several tools together. For instance, central banks can use open market operations and change required reserves simultaneously. Or they can sell securities at one end and raise the discount rate on the other- thus having a contractionary effect on money supply and inflation.

The following table summarizes each tool according to its type and purpose, along with examples for illustrative purposes:

Type Of Monetary Policy Tools
Tool Definition
Example(s)
Interest Rates (I)
Used to control inflation and liquidity in the economy
Increased rate leads to a decrease in inflation or causes a tightened monetary policy; whereas a decreased interest rate leads to increase inflation or loosen monetary policy.
Open Market Operations (O)
Used to change the money supply under discretionary direct control by Fed
When the Fed buys bonds or US treasury bills, this expands the money supply and cheapens interest rates; whereas when the Fed sells bonds/US treasury bills, it causes a shrinkage of the money supply and increases the interest rates.
Bank Regulation (R)
Strict bank regulation aimed at controlling risk levels on bank’s balance sheet
Increased regulations cause decrease taking, thus leading banks to take less risk; whereas decreased regulations cause increase taking, thus leading banks to take more risk
Capital Controls (C)
Sets limits on the amount of money that can be taken out of or brought into a country.
They are sometimes imposed by the monetary authority to prevent excessive capital outflow/inflow that will cause unwanted fluctuations in currency value. Raised capital controls cause decreased capital inflow and decrease liquidity; whereas decreased capital controls cause increased capital inflow and increase liquidity.
Bank Recapitalization (B)
Must be coupled with strict bank regulation and is often implemented together.
Increase money supply via injecting cash into banks’ accounts for increased lending ability; Decrease money supply via withdrawing cash from banks’ accounts for lending ability
A table showing the different types of monetary policy tools, their uses, and examples when used in an economy

Functions of monetary policy

The functions of monetary policy are the primary goals that central banks attempt to accomplish in their policies. While there is no single unanimous agreement on what functions should be prioritized, most economists agree on the general functions which include interest rate targeting and inflation targeting. Monetary policy can also be used as a tool by governments for fiscal policy purposes, such as when it is decided whether to pursue expansionary or contractionary fiscal policies.

The functions of monetary policy can be generally categorized into two main functions: maintaining price stability and promoting economic growth. Price stability refers to keeping inflation within an acceptable range while promoting economic growth consists of ensuring maximum sustainable growth with low unemployment rates.

Maintaining price stability is considered one of the most important functions of any financial system. Not only is inflation one of the most important economic indicators, but it also becomes problematic when it becomes too high. When inflation is too high, individuals make rational choices to spend their money now before prices increase even further; this causes aggregate demand (AD) to drop. Aggregate demand refers to the market demand for all goods and services in an economy at a given price level. The drop in AD causes output to decline as businesses have lower sales volumes, unemployment rises because fewer jobs are being produced for existing workers, wages decrease because there is no need for employers to pay employees more if there are fewer opportunities available that can be filled with those higher wages.

As part of its functions to maintain price stability, monetary policy needs to ensure that inflation is kept within a small and acceptable range. This can be done by increasing interest rates when inflation begins to rise and decreasing interest rates after inflation begins to fall.

When the central bank raises interest rates, it makes borrowing money more expensive for individuals and businesses; this causes AD to drop because people have less disposable income, so they purchase fewer goods and services. The decrease in demand causes prices of goods and services to fall which lowers overall inflation levels. If the central bank decreases interest rates, consumers are able to borrow money at lower interest rates so they will spend more on goods and services, causing prices to increase.

Monetary policy functions in different ways depending on whether the economy is considered in a recession or an expansionary phase. An economic expansion occurs after an economic recession (or during times of growth), which causes the output gap to increase.

Monetary policy rate

The monetary policy rate is the most important monetary tool used by central banks to dictate short-term interest rates, which impact monetary and financial conditions for all market participants. As such, it will have huge implications on global stock markets and currencies as well as global commodities prices – including oil and gold and other precious metals and stones.

Under this, there are three key variables:

  • the monetary base;
  • reserve money;
  • and the monetary policy rate.

To control these variables, central banks implement certain specific policies based on their objectives.

What are the 3 main tools of monetary policy?

The 3 main tools of monetary policy are the Federal Funds Rate, the Discount Rate, and Open Market Operations.

The Federal Funds Rate is an extremely influential tool used by central banks to influence business activity and inflation. The target for this rate is usually around 5 percent in America, though it does change according to economic conditions. It’s kept at a very low level when demand is high so that businesses have money to hire people and invest in their companies. Additionally, it can be used as a preventative measure against inflation-if there’s concern about rising prices, the Fed will raise interest rates. On the other hand, if there’s concern that unemployment levels may rise due to insufficient demand or investment opportunities then they’ll lower rates to spur growth.

What is the monetary policy committee?

The monetary policy committee is entrusted with the responsibility of formulating the monetary policy and fixing the official interest rate.

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