Definition of monetary policy
What is monetary policy?
Monetary policy is the action taken by a central bank to influence the money supply level of a country or geographical area. In the European Union, the ECB (European Central Bank) is in charge of monetary policy. In the United States, it is the FED.
Monetary policy can influence several elements:
- The price level of goods and services (inflation rate)
- Its currency's exchange rate level
- Economic growth level
Monetary policy objectives
The objective of monetary policy is to promote economic growth while maintaining a moderate level of inflation and a relatively stable exchange rate. To this end, the central bank influences the financing conditions of the economy through the money supply level.
The problem with monetary policy is that this equation is often impossible to solve. Effectively, economic growth generates inflation. If growth is too strong, the inflation rate becomes too high. This eventually leads to a decrease in purchasing power for households and therefore a decrease in consumption. Inflation also leads to devaluation of the currency, which has an impact on the external trade balance. If inflation is too high, it leads to a decline in economic growth and ultimately to recession.
The central bank must therefore constantly adjust its monetary policy to find the best compromise between growth, inflation and exchange rates. This is the great challenge for monetary policy and that is why the central bank meets monthly to decide on the strategy to be followed. Good monetary policy requires constant monitoring and the central bank must react quickly if economic conditions deteriorate.
Monetary policy instruments
- Interest rates: This is the central bank’s main monetary policy instrument. There are 3 policy rates, the refinancing rate, the deposit rate and the marginal lending rate. An increase in policy rates reduces the level of the money supply. Effectively, financing conditions are more expensive and economic agents borrow less. If this monetary policy is applied, it makes it possible to fight against too high a level of inflation and to avoid overheating the economy.
A reduction in policy rates increases the money supply level. Credit conditions are better and economic agents are more inclined to invest and consume. The central bank applies this monetary policy in order to stimulate economic growth or to emerge from recession.
- Minimum reserves: In its monetary policy, the central bank sets a percentage of the deposits that commercial banks must put in reserve. The higher this percentage, the more it reduces access to credit and thus limits economic growth. On the other hand, a small percentage helps to promote access to credit and thus increases the money supply.
- Open market operations: These are the central bank's direct interventions in the interbank market through the purchase or sale of securities (often treasury bills). This monetary policy instrument is widely used by central banks. The massive purchase of securities helps to support growth while the sale of securities helps to curb inflation.