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You’ve probably heard of this term if you’ve taken any economic course or been keeping up with the news lately. Monetary policy refers to the tools used by a central bank in order to control the overall money supply, to either promote economic growth (expansionary) or slow it down (contractionary).

For example in the United States, the Federal Reserve uses monetary policy such as revising interest rates or changing bank reserve requirements, to achieve maximum employment while keeping inflation in check.

Understanding Money Supply

Money supply is defined in various ways - and according to some definitions it includes all the currency (cash) and other liquid instruments circulating through a country’s economy at a measured time. As of December 2021, the Federal Reserve reported that the approximate money supply was ~$20.5 trillion.

Changing the money supply through monetary policy has a snowball effect: an increase typically lowers interest rates, which in turn generates more investment, puts more money into the hands of consumers and therefore stimulates spending. As a result, businesses respond by ramping up production to meet the rising demand, more materials and labour is needed too. With more demand, prices rise from luxury cars all the way down to a pack of bananas.

On the other hand, decreasing the money supply results in the opposite, decreasing growth and taking money away from consumers. Currently, in order to give suppliers breathing room to catch up on unmet demand and stop prices from rising any higher, the federal bank is attempting to restrict the money supply by aggressively raising interest rates.

Monetary Policy Tools

1. Open Market Operations In the open market, the FED buys or sells bonds to change the number of outstanding government securities in the market and thus money available to an economy. Government bonds are a preferred investment over other bonds or equity because they are essentially risk-free assets. The objective is to manipulate short-term interest rates, which affects longer term rates. You might be more familiar with the terms quantitative easing and tightening. Easing relates to selling more bonds to the economy while tightening refers to buying back bonds from the economy.

2. Interest Rates In the U.S, interest rates are known as discount rates and are the rate used by banks to lend money. Higher interest rates means that it's more expensive to borrow money while lower interest rates makes it cheaper to borrow. You still need to pay back the full borrowed amount - but if your debit is “floating rate” then your payment will adjust according to the movements of interest rates . For example, in order to ramp up the economy post the slowdown due to COVID, interest rates were set at nearly 0%, meaning that borrowing money was extremely cheap, which eventually led to the accelerated growth of businesses and the global economy.

3. Reserve Requirements One of the rules big banks are legally required to follow is the reserve requirement - how much money (from deposits) they must retain in their vaults. This number has always been less than 100% - meaning that a bank can only lend out reserves excess of the requirement, to other banks, business or consumers. Historically, the reserve requirement has been ~10%. Lowering this requirement means banks can lend more reserves which releases more capital into the economy, thus increasing the supply. Increasing the requirement means banks can lend out lesser money, which reduces supply and therefore slows growth.

Essentially, central banks will assess the economy under the lens of their mandate (usually the mandate is to maintain price stability) and use all tools at their disposal to achieve these goals.

Monetary policy usually works in accord - or at least with consideration for - fiscal policy.