Monetary Policy

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What is Monetary Policy?

Monetary policy is a series of actions taken by a country’s central bank to maintain a stable economy and employment with the use of various tools such as interest rates and asset purchasing.


What is Monetary Policy?

Key Takeaways

  • Monetary policy is managed by a country’s central bank.
  • Interest rates can be increased to support economic growth and decreased to manage inflation.
  • In the United States, the Federal Reserve manages the country’s monetary policy.
  • Monetary policy can help stabilize the economy without the need for legislative changes.
  • Policy changes can take months or years to be fully felt in the economy.

Types of Monetary Policy

Based on the monetary policy definition, there are two main types of policies: expansionary and contractionary.

Expansionary monetary policy is used to stimulate an economy that is slowing down or in a recession.

On the flipside, contractionary monetary policy is used to cool down an overheated economy that is running high inflation.

Monetary Policy Goals

The main goal of monetary policy is to balance full employment and inflation. When monetary policy is used to grow the economy, there’s a risk of increasing inflation.

On the other side, when monetary policy is used to manage inflation, it can slow the economy and risk a recession. Therefore, monetary policy decisions must balance these two opposing forces to maintain economic stability.

Tools of Monetary Policy

Tools of Monetary Policy

The main tool of monetary policy is interest rates, which central banks use to increase or decrease the cost of borrowing money. As interest rates rise, it becomes more expensive to borrow, and instead, businesses slow down their growth. This also incentivizes more savings and reduces economic growth. When interest rates are lowered, businesses are incentivized to borrow and grow and, in turn, hire more employees, which helps reduce unemployment and grow the economy.

Monetary policy can be used to buy and sell government securities such as bonds, known as open market operations. When a central bank purchases securities, it injects capital into the economy to spur growth. When it sells securities, it removes money from the economy to help manage inflation.

A final tool that central banks can use is to change the reserve ratio required for banks. The reserve ratio is the percentage of deposits that banks must hold as reserves. If this ratio is lowered, banks can lend out more capital and jumpstart economic growth. When the reserve ratio is raised, banks must hold more cash, taking it out of the economy and lowering growth as a result.

Expansionary Monetary Policy vs. Contractionary Monetary Policy

Expansionary Monetary PolicyContractionary Monetary Policy

What is it? Actions to increase the money supply and reduce interest rates

Goals: Stimulate economic growth and reduce unemployment

Money supply: Increases

Interest rates: Decrease

When is it used? A slowing economy facing a recession

Risks: Currency devaluation and rising inflation

What is it? Actions to decrease the money supply and increase interest rates

Goals: Manage rising inflation and stabilize the local currency value

Money supply: Decreases

Interest rates: Increase

When is it used? An overheated economy with rising inflation

Risks: Rising unemployment and slower economic growth

Monetary Policy vs. Fiscal Policy

Monetary PolicyFiscal Policy

What is it? Decisions to control the money supply and interest rates

Managed by… Central banks

Goals: Manage inflation and employment

Main tool: Interest rates

In a recession… Reduce interest rates and purchase securities

In an inflationary environment… Increase interest rates and sell securities

What is it? Decisions to manage taxes and government spending

Managed by… Governments and legislatures

Goals: Redistribute income and stimulate economic growth

Main tool: Government spending and taxes

In a recession…  Increase spending and decrease taxes

In an inflationary environment… Decrease spending and increase taxes

Monetary Policy Pros and Cons


  • Can be helpful to curb inflation and stabilize the economy
  • Monetary policy changes can be enacted fairly quickly
  • Central banks are usually independent of the political system and can make unbiased decisions
  • Economic stability can be gained from predictable monetary policy changes


  • May not be enough to control economic problems
  • It can take months or even years for monetary policy changes to impact the economy
  • When interest rates are already low, central banks are limited in what they can do to spark economic growth
  • Inflating asset prices with economic stimulus can disproportionately benefit financial asset owners, leading to greater financial inequality

The Bottom Line

Monetary policy actions can help central banks maintain economic stability. Monetary policy, meaning the management of interest rates and money supply, is a crucial tool in this effort. Because central banks are generally independent from political parties, they can operate without bias and in the best interest of the economy as a whole.

While monetary policy changes aren’t a cure-all for economic issues and can take months or even years to take full effect, they are often useful tools to manage inflation, employment, and keep the economy running smoothly.


What is monetary policy in simple terms?

What is an example of a monetary policy?

What is the main goal of monetary policy?

What is a monetary policy for dummies?

What are the 4 monetary policies?


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Daniel Pelberg
Financial Journalist
Daniel Pelberg
Financial Journalist

Dan has been a content and copywriter in the financial services and fintech industries for over a decade where he has seen firsthand the evolution of financial services and helped many companies convey complex information to a wide audience, both in the B2B and B2C markets. Dan has an affinity for all types of content in the financial sector, whether it’s writing an educational script for a new financial product video, a monthly newsletter for a financial advising firm, or a blog post for a new Bitcoin service. As a digital freelancer, Dan has had the opportunity to work with…