Monetary policy is the process by which a country’s central bank controls the supply of money and interest rates to influence economic conditions.
It is one of the main tools used to manage inflation, control unemployment, and stabilise economic growth.
You can easily tell the difference between fiscal policy and monetary policy by remembering that monetary policy refers to central banks' decisions and fiscal policy refers to Government decisions (spending a taxation).
There are two main types of monetary policy: expansionary and contractionary.
Expansionary monetary policy is used to stimulate economic growth, often by lowering interest rates and increasing the money supply. This makes borrowing cheaper, encourages businesses to invest, and boosts consumer spending.
Contractionary monetary policy is used to slow down an overheating economy, usually by raising interest rates and reducing money supply, which makes borrowing more expensive and helps control inflation.
Interest rates are one of the key tools in monetary policy. Central banks raise rates to slow down inflation and lower rates to encourage borrowing and spending. These changes affect everything from mortgage costs to business investment, influencing overall economic activity.
Another tool used in monetary policy is open market operations, where the central bank buys or sells government bonds to adjust liquidity in the banking system. Buying bonds injects money into the economy, making borrowing easier, while selling bonds reduces the money supply and tightens credit conditions.
Monetary policy decisions are influenced by economic indicators such as inflation, GDP growth, employment levels, and exchange rates. Central banks aim to maintain stability by adjusting policies based on these factors, ensuring the economy does not overheat or fall into recession.
The effectiveness of monetary policy depends on how quickly changes in interest rates and money supply influence the economy. While lowering rates can boost spending and investment, it may take months for the effects to fully show. Similarly, raising rates to control inflation may take time to slow down demand.