Monetary Policy – Definition and Types

Monetary policy is the discipline of economic policy that controls monetary factors to ensure price stability and economic growth.

It brings together all the actions that the monetary authorities (central banks) have to adjust the money market. Through monetary policy, central banks direct the economy to achieve specific macroeconomic objectives. To do this they use a series of factors, such as the money supply or the cost of money (interest rates). Central banks use the amount of money as a variable to regulate the economy.

Definition of monetary policy

Monetary policy objectives

Through the use of monetary policy, countries try to influence their economies by controlling the money supply and thus meet their macroeconomic objectives, keeping inflation, unemployment and economic growth at stable values. Its main objectives are:

  • Control inflation: Maintain the price level at a stable and low percentage. If inflation is very high, restrictive policies will be used, while if inflation is low or there is deflation, expansionary monetary policies will be used.
  • Reduce unemployment: Ensure that there are a minimum number of people unemployed. For this, expansionary policies will be used to promote investment and the hiring of employees.
  • Achieve economic growth: Ensure that the country’s economy grows in order to ensure employment and well-being. For this, expansive monetary policies will be used.
  • Improve the balance of payments: Monitor that the country’s imports are not much higher than exports because this could cause an uncontrolled increase in debt and an economic decrease.

The objectives of monetary policy can hardly be achieved with the use of monetary policy alone. To achieve them, usually, it is necessary to implement fiscal policies that are coordinated with monetary policy. In fact, monetary policies have multiple limitations, and for this reason, many economists are against the use of these policies, assuring that they pronounce business cycles. Furthermore, many times the monetary policy mechanisms do not achieve the desired objectives but alter other factors. For example, if we increase the money supply of an economy to achieve economic growth, the only thing we can achieve is an increase in prices.

Types of monetary policy

Depending on its objective, we can separate monetary policies into two types:

  • Expansive monetary policy: It consists of increasing the amount of money in the country to stimulate investment and thereby reduce unemployment and achieve economic growth. Its use usually causes inflation.
  • Restrictive monetary policy: It tries to reduce the amount of money in the country in order to reduce inflation. When restrictive policies are applied, there is a risk of slowing economic growth, increasing unemployment and reducing investment.

Expansive monetary policy

Expansive monetary policy is a type of monetary policy that is mainly characterized by trying to stimulate the size of a country’s money supply. Those responsible for their control are generally central banks or other similar economic power.

When individuals prefer to save money rather than spend or invest it, aggregate demand is very weak, which can lead to recessions. Through actions in the financial markets with expansive monetary measures, those responsible for the country’s economy seek to move towards economic growth and job creation by companies in the country.  This makes the use of expansive monetary policies frequent in situations of economic crisis or recessions. Through various stimuli, on the one hand, the objective is to stimulate the production of goods and services and, therefore, the level of income of citizens. On the other hand, another important objective is to influence the markets so that banks grant more credit to families and companies.

Situation of economic recession and expansive monetary policy

  • GDP growth below potential.
  • “Technical recession”: two consecutive quarters of negative growth.
  • Investment in capital goods in minimums.
  • Unemployment rate rebound.
  • Inflationary pressures are very weak.
  • Business profits in losses.

As explained in the concept of monetary policy, the points to keep in mind when considering monetary policies are the financial variables: price level (inflation) and interest rates. Through their management, those responsible for monetary policy seek to increase the money supply of a specific country. These variables are reflected in the mandate of each central bank.

There are situations in which in a country there is a low level of money in circulation. Governments or central banks often try to remedy this situation through expansive monetary policies that can increase the amount of money in these territories through various tools at their disposal.

Common mechanisms for expansive monetary policies

Monetary policy mechanisms are the tools that central banks have to carry out their monetary policies. In the case of expansive monetary policies, central banks can use these measures:

  • Reduction in interest rates.
  • Cash ratio reduction.
  • Operations in the open market.

It is important to differentiate the concept of expansionary monetary policy from that of economic growth since the relationship between economic policy and reality does not always go hand in hand. The effects that monetary policies actually cause are not always direct or immediate, in addition to being subject to other types of variables and involving various secondary effects on the economy, such as the appearance of inflation.

Restrictive monetary policy

Restrictive Monetary Policy is a type of monetary policy that seeks to reduce the money supply in a country or territory. By definition, it seeks the opposite effect of expansionary monetary policy by reducing the size of the money supply or, in other words, reducing the amount of money in circulation in a country’s economy.

There are times when there may be some excess money in circulation in the market. When that happens, the country’s monetary policy makers will try to reduce the amount of money in circulation through a restrictive or contractive monetary policy.

Alternatively, restrictive monetary policies are frequently used in situations where there is a high level of inflation, as the price level is one of the variables most used to measure the economic health of a country and, together with interest rates, they are used as a reference to apply a restrictive or expansive monetary policy. These variables are reflected in the mandate of each Central Bank.

Situation of expansion or economic boom and restrictive monetary policy

  • GDP growth above potential.
  • Investment in capital goods at maximums.
  • Unemployment rate decreasing.
  • Inflation at maximums.
  • Maximum business benefits.
  • High interest rates.

Common mechanisms for restrictive monetary policies

  • Increases in interest rates.
  • Increase in the cash ratio.
  • Operations in the open market.

The use of restrictive monetary policy measures also tends to lead to negative effects on the economy. Beyond controlling the rise in price levels as the main objective, sometimes it may happen that a decrease in the level of production in the country and the level of employment develops in response to the restrictive policies employed.

Mechanisms of monetary policy

There are several mechanisms of monetary policy to carry out this type of expansionary or restrictive policies, such as varying the cash ratio, modifying permanent facilities or carrying out operations in the open market. For example, buying gold or debt to introduce money into the market.

Depending on the aggressiveness of the mechanism used, we can distinguish two types of monetary policies:

  • Conventional monetary policy: It is one that uses traditional mechanisms. When we talk about traditional mechanisms, we are referring to official interest rates and the level of liquidity (for example, the cash ratio).
  • Unconventional monetary policy: When conventional monetary policy does not work, unconventional tools are used. In other words, non-traditional measures. The objective is to inject or drain liquidity into the economy through more aggressive mechanisms.

Example of monetary policy

If a Central Bank wanted prices to be lower, it would only have to decrease market money. Imagine a fictional country, where the only products out there are 100 oranges that are worth $2 each. The speed at which money circulates we have discovered to be 1 and in total there are 200 coins of one dollar (M = 200). If the Central Bank of this country wants prices to be half, it will withdraw 100 coins from the market. Since there are now only 100 coins, but there are still 100 oranges, each orange will have to be worth $1.

Before restrictive monetary policy: 200 x 1 = 2 x 100

After: 100 x 1 = 1 x 100

Product prices are now worth $1.

In reality, the problem with this restrictive monetary policy, in particular, is that it can also cause the volume of a country’s income to decrease.



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