Role of monetary policy
Monetary policy involves the management of money supply and interest rates by a country’s central bank to achieve macroeconomic objectives, particularly price stability and sustainable growth. In many countries, central banks operate independently from government to enhance credibility.
Tools of monetary policy
| Instrument | Description | Effect on the economy |
|---|---|---|
| Interest rate changes | The central bank sets a policy rate (e.g. the discount rate). Changes in this rate influence borrowing costs throughout the economy. | Higher rates reduce consumption and investment, lowering inflationary pressure; lower rates encourage borrowing and spending. |
| Open market operations | Buying or selling government bonds to adjust the amount of money in circulation. | Purchasing bonds increases the money supply and lowers interest rates; selling bonds does the opposite. |
| Reserve requirements | Rules requiring banks to hold a percentage of deposits as reserves. | Lower reserve ratios allow banks to lend more, expanding the money supply; higher ratios restrict lending. |
| Exchange rate intervention | Central bank buys or sells its own currency in the foreign exchange market to influence the exchange rate. | Buying domestic currency can support its value but reduces reserves; selling currency can cause depreciation to stimulate exports. |
Types of monetary policy
Like fiscal policy, monetary policy can be expansionary or contractionary. Expansionary policy involves lowering interest rates or increasing the money supply to stimulate spending and investment, used during recessions. Contractionary policy raises interest rates or reduces the money supply to curb inflation.
Strengths and limitations
- Interest rate changes are quick to implement and can influence borrowing and spending decisions across the economy.
- Monetary policy may be less effective if interest rates are already very low (liquidity trap) or if businesses and consumers are pessimistic about the future.
- There are time lags before changes in interest rates fully impact investment and consumption.
- Higher rates can appreciate the domestic currency, reducing exports and worsening the current account.
Examples and applications
When inflation surged in many countries in 2022, central banks such as the US Federal Reserve and the Bank of England raised policy interest rates. Higher borrowing costs cooled demand for mortgages and consumer credit, helping to slow price increases. However, higher interest rates also made it more expensive for businesses to invest.
During the global financial crisis of 2008 and the COVID‑19 pandemic in 2020, central banks cut interest rates close to zero and engaged in quantitative easing – purchasing government bonds to inject money into the economy. These measures aimed to support lending and prevent deflation. In some cases, rates were so low that monetary policy became less effective, illustrating the concept of the liquidity trap.
Exchange rate intervention is common in countries that peg their currency. For example, Hong Kong’s Monetary Authority buys and sells US dollars to maintain the Hong Kong dollar’s fixed exchange rate, influencing domestic interest rates and money supply.
