From The Free Forex Encyclopedia
Monetary policy refers to the process by which a monetary authority controls the money supply in the economy. Usually it is the central bank that carries out the task, adjusting the amount of money available in order to spur economic growth, stabilize prices and exchange rates, and promote employment.
Primary Techniques To Control Monetary Policy
One common technique is by increasing/decreasing the country's monetary base. Usually central banks do this by buying or selling bonds in exchange for money to be deposited in the central bank. In this process, the liquidity in the economy is increased.
Another way to control money supply is to limit the amount of assets that banks must leave with the central bank as reserves. By increasing the reserve ratio requirement, banks have less liquid assets available for loans and more illiquid assets such as mortgages.
Discount window lending is also another way to control monetary policy. The central bank allows commercial banks to borrow reserves in exchange for collateral, making liquidity available for them in times of emergencies.
The fourth way in which money supply can be controlled is by adjusting interest rates. When the central bank raises interest rates, the money supply contracts because there is more money used to pay for borrowing costs and less money to go around the economy.
There is also the currency board or the option of pegging a country’s monetary base to another’s. Because for any change in the amount of money in circulation (domestic monetary base) there must be an equivalent change in the amount of reserves of the foreign currency, the monetary authority cannot just easily pump liquidity into the economy.
These are five among the most commonly used tools to control monetary policy. However, in times when interest rates are already near zero, central banks also resort to unconventional methods such as quantitative easing.
Effect on currency
Monetary policy can either be classified as expansionary or contractionary.
Central banks usually adopt an expansionary monetary policy to spur economic growth. With higher liquidity, there is more money to go around for consumers to access. However, increasing the amount of money in circulation devalues the currency because its purchasing power becomes lesser as prices of goods and services rise. And so, an expansionary monetary policy is bearish for a currency.
On the other hand, a contractionary monetary policy has a bullish effect on a currency. Usually, it is characterized by high interest rates which encourages investors to park their assets in the country, as high interest rates promise higher returns to their investments.