Meaning of Monetary Policy

Acronyms Business

The term “monetary policy” always refers to the actions of central banks. Monetary policy encompasses all measures taken by banks that aim to stabilize the financial market. Various tools are available to central banks to achieve this.

  • With their monetary policy, central banks should, among other things, ensure price stability.
  • An expansionary monetary policy leads to an increase in the amount of money available. It is used to stimulate the economy in a recession.
  • The restrictive monetary policy leads to a reduction in the amount of money available on the market and serves to prevent the economy from overheating.
  • In order to achieve the monetary policy goals, central banks can fall back on various instruments – for example the minimum reserve policy, the interest rate policy, the open market policy and foreign exchange market interventions.

The objectives of monetary policy

The ultimate monetary policy objectives of a central bank result from its statutes. Usually – as is the case with the ECB’s monetary policy – the primary goal of the central banks is to ensure price level stability. On the one hand, it is important to prevent excessive inflation (i.e. a rise in prices) and, on the other hand, deflation (a fall in prices). In addition, the central banks have subordinate goals: These have to do with economic growth or exchange rates , for example . Ensuring the proper functioning of the financial markets is also an important goal of monetary policy. According to abbreviationfinder, MPR stands for Monetary Policy Rate.

Since most measures take a long time to take effect, central banks cannot implement their ultimate goals directly. For this reason, the institutions develop monetary policy strategies that conceptually define the central bank’s approach. Corresponding strategy papers refer to both monetary policy impulses and operational goals, interim goals and the central bank’s ultimate goals. Most intermediate targets mostly relate to factors such as the money supply, interest rates or the inflation rate.

Expansive monetary policy

The expansionary monetary policy refers to the increase in the amount of money or its money supply initiated by a central bank. Usually, the central bank cuts key interest rates as part of an expansionary monetary policy . As a result, the supply of credit increases while the associated interest burden decreases. This in turn leads to an increased demand for credit, which usually also increases spending on consumer and capital goods. It is also possible that the central bank buys securities from the banks as part of an expansionary monetary policy.

Usually, central banks operate an expansionary monetary policy to the economy in times of recession to relaunch. However, the measures mentioned only have a short-term effect. In the long run, such a monetary policy will only result in an increase in the price level. In addition, doing this increases inflation, which in many cases is the goal. The rise in the price level can, however, also damage an economy, which is why it is important to weigh this means of monetary policy carefully.

Restrictive monetary policy

The restrictive monetary policy – also known as contractionary monetary policy – is the counterpart to expansionary monetary policy. It includes all monetary policy measures that result in a reduction in the amount of money available. A restrictive monetary policy causes interest rates to rise, as a result of which credit utilization decreases, which leads to a decline in production and investment. A restrictive monetary policy can mitigate inflationary tendencies, increase price stability and prevent the economy from overheating.

The instruments of monetary policy

In order to be able to implement the desired goals, central banks use various monetary policy instruments. The following tools, among others, are available to the ECB and other central banks:

  • Minimum reserve policy: The minimum reserves represent the mandatory deposits that credit institutions must have with a central bank such as the ECB. By increasing or decreasing the amount, the central bank can influence the banks’ free liquidity reserves, which affects the credit leeway of financial institutions.
  • Interest rate policy: The key interest rates are an important tool of monetary policy. With the help of interest rate policy, a central bank determines the conditions under which banks are allowed to borrow money or hold deposits. A change in the key interest rate usually also affects the market interest rate and the general interest rate trend.
  • Open market policy: These are monetary policy operations in which the central bank acts specifically as a buyer or seller of securities and claims. Purchases lead to an expansion of the money supply. Sales, on the other hand, reduce the money supply.
  • Foreign exchange market intervention: Central banks can also act as buyers or suppliers of the domestic currency. In a currency system with fixed exchange rates, the central bank is even obliged to intervene if there is a certain deviation from the standard value.