Monetary Policy

by Stephan Smith on November 30, 2010

Central bankers throw the phrase ‘monetary policy‘ out all the time, but they never take the time to explain what it means. The term may be somewhat intimidating, but I assure you that it isn’t at all difficult to understand. If you are unclear as to what the term ‘monetary policy’ means, then allow me to explain it to you.

Monetary policy is an applied strategy taken to affect the availability of money and credit in a society. Currently, monetary policy is typically conceived and implemented by a country’s central bank. No other institution, whether it be in government or not, has a say on a country’s monetary policy besides the country’s central bank. Some monetary policies that are commonly implemented by various central banks are quantitative easing, quantitative tightening, choosing whether or not to reinvest earnings received from assets and setting a target overnight interest rate. Those are only a few strategies. All of these monetary policies affect a society’s money supply and the cost and the availability of credit.

Expansionary and Contractionary Monetary Policies

Now that you have a good understanding of what monetary policy is, I would like to talk about the two categories of monetary policy that are generally implemented by central banks. Those two categories are called expansionary monetary policy (also known as easing monetary policy) and contractionary monetary policy (also known as tightening monetary policy). These two categories have opposite effects on a society. Expansionary monetary policy’s main effect is to make money more available by expanding the money supply of a society. It also aims to make credit more accessible and affordable by flooding local commercial banks with money and thus makes loans more attractive. Contractionary monetary policy has a completely opposite effect.

Contractionary monetary policy involves removing money from a society by contracting the money supply. It also makes credit less accessible and more expensive to borrowers because local commercial banks have less money to lend. Now here’s the million dollar question. What economic conditions prompt a central bank to implement expansionary monetary policies and what economic conditions prompt a central bank to implement contractionary monetary policies. What’s the ‘why’ behind implementing expansionary monetary policies and contractionary monetary policies. Keep on reading to find out.

Price Stability

If you’ve read my article about central banks, you would have learned that a central bank’s primary goal is to ensure that the prices of goods and services remain stable in the country in which the central bank has power. A central bank has to make sure that the currency it issues maintains its value. That is its number one objective of a central bank. But what happens when prices for goods and services become unstable? That’s when central banks would start making changes to monetary policy so that they can rectify the price instability. There are only three scenarios regarding prices of goods and services that can occur in an economy. The three scenarios are called inflation, deflation and price stability (when there isn’t either inflation or deflation; where overall prices for goods and services don’t change over a period of time).

Let’s cover inflation first. When a country experiences inflation, overall prices for goods and services start to increase over time. That means the currency or whichever type of money that is being used is becoming less valuable over time. If that continues to happen at too great of a scale and money is becoming less valuable while prices are increasing, that means that the prices of goods and services are becoming unstable. When that occurs, the central bank has to intervene, for it is their top priority to ensure that prices remain stable (well, at a stable rate of inflation – more on this later). So, in an economic environment where inflationary pressures are running rampant, the central bank in charge of that economic environment must make a change to its current monetary policy in order to counter the price instability.

In an high inflationary environment, money is becoming less valuable because either demand for money has decreased or to much money has been created and injected into circulation. So to counteract the high inflationary pressure, a central bank must enact contractionary monetary policies. Why? Remember, contractionary monetary polices involves removing money from a society and thus make money more difficult to obtain and make credit harder to acquire. Removing money from a society will lower the supply of money and thus deflate it. A central bank usually considers implementing contractionary monetary policies when an economy starts suffering from great inflationary pressures.

Now let’s look at the flip side. If inflation is too low, where it borders on deflation, then a central bank is going to have to consider implementing expansionary monetary policies. Just for a quick review, deflation is when overall prices for goods and services decrease over time. When prices for goods and services decrease over time, that means the money over time is becoming more valuable. Though it may sound like a good thing, check out my article about deflation to learn why it isn’t. When an economy is suffering from deflationary pressures, a central bank must do what it can to counteract those pressures. That is usually done by implementing expansionary monetary policies. Now you know when a central bank should start considering to implement expansionary monetary polices and contractionary monetary polices. Just think of it like this: great inflation should be met with contraction and deflation should be met with expansion.

Now before I continue, I want you to take notice of one thing. Remember when I said: ‘well, at a stable rate of inflation – more on this later’? Also, did you notice that every time I talked about inflation, I just don’t say inflation but rather I say high inflation or great inflation? Whenever an economy suffers from high inflation, or high inflationary pressures, a central bank should start to consider implementing contractionary monetary polices. I want you to know why I specifically said high inflation. Let me explain…

Central banks want moderate levels of inflation in an economy. That’s right. Central banks don’t want price stability (when there is no inflation or deflation). They rather have moderate inflation and by wanting moderate levels of inflation they essentially want their currencies to become slightly less valuable over time. Only when inflation becomes too high, is when central banks take action. So that they’re not swinging in the dark, central banks usually have a target annual inflation rate they try to meet. This target annual inflation rate can be anything from 1 to 2.5 percent (please note: the target annual inflation rate really can be anything). If the annual inflation rate drops too low, like 0.1 – 0.9 percent, central banks get nervous because that means the economy is moving closer to deflation. Deflation is one monster that central banks don’t want any parts of.

Promote Maximum Employment and Economic Growth

Now there are some central banks out there in the world that have two purposes. The first purpose shared by all central banks is to ensure price stability of the country the central bank has power in. The second purpose shared by fewer central banks is to promote maximum employment, which would result in economic growth. The Federal Reserve and the Reserve Bank of Australia are two central banks that currently have the responsibility of ensuring price stability and promoting economic growth by implementing monetary policy that will encourage maximum employment. The European Central Bank, for example, is a central bank whose only role and task is to ensure price stability.

Let me clear the air now. The most important purpose of a central bank is to ensure price stability for goods and services. Any other purpose or role is secondary. Got it? Good. Now let’s bring it back to the topic of expansionary and contractionary monetary policies. If a central bank’s purpose includes encouraging maximum employment for its country, then that central bank would first have to assess its country’s rate of inflation or deflation and then assess the employment situation.

If an economy is suffering from a low rate of inflation and low employment, there is a strong chance that a central bank in that position would implement expansionary monetary polices. Expansionary monetary policies would increase the amount of money in circulation which would increase the rate of inflation and increase the availability and affordability of credit. With credit being easier to obtain, businesses and individuals will find it easier to get a loan. With more money in the hands of businesses and individuals, employment should theoretically improve. If an economy is suffering from moderately high inflation and low employment, then a central bank would be less likely to implement expansionary monetary policies simply because inflation is too high. Remember what I said? Ensuring price stability for goods and services is the top priority. Everything else is secondary. If an economy is experiencing very high employment and moderate inflation, then a central bank would sit back and enjoy, for it is fulfilling its dual purposes.



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{ 2 comments… read them below or add one }

yolanda little December 20, 2012 at 4:05 PM

I have enjoyed reading your article. It was very insightful, precise, and thorough. I am doing research for school and your article was right on target!

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Anonymous April 12, 2012 at 11:52 PM

nice article and site, it helped me with studying for my economics class. i still don’t get how to do those assets and liabilities charts though, that make another useful article!

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