Guide to Monetary Policy
Intro to Monetary Policy
What is monetary policy?
Monetary policy is how central banks influence the economy by raising or lowering the money supply. This is in contrast to fiscal policy, which is how the government uses its taxes and spending to affect the economy.
What are the tools of monetary policy?
Monetary policy has a few main tools—reserve requirements, discount rates, open market operations (OMO), and quantitative easing (QE).
How does monetary policy affect markets?
Monetary policy affects markets in many ways, however, two main ones include boosting or dampening the economy as a whole, and raising or lowering bond yields. First, as expansionary monetary policy can boost the economy as a whole, investments more sensitive to the business cycle will usually benefit and vice versa with contractionary policy. Secondly, monetary policy’s effect on interest rates causes yields to rise and fall, which changes the relative value of existing interest-bearing investments.
What is the difference between expansionary monetary policy and contractionary monetary policy?
Expansionary monetary policy is when a central bank increases the money supply which fights recessions and increases economic growth. Contractionary economic policy pulls money out of the economy in order to fight inflation.
Tapering is the process of gradually decreasing the size of an expansionary monetary policy. This can include any form of monetary policy but is most often applied to quantitative easing (QE).
Foreign Exchange Reserves
Foreign exchange reserves, also called Forex reserves, are stores of foreign currencies held by central banks. The central banks use these to purchase their own currency to carry out monetary policy.
M2 is one way to measure the money supply. It includes all cash and checking deposits, referred to as M1, as well as savings deposits, money market securities, and certificates of deposit (CD).
International Monetary Fund (IMF)
The IMF is a multinational organization meant to promote economic growth, ensure the stability of the world financial system, and lower poverty. It offers grants, loans, and other financial assistance to countries to accomplish these goals.
A liquidity trap is when cash savings rates are high and interest rates are low. This combination makes it difficult for monetary policy to affect the economy.
Economic stimulus refers to policies undertaken by a government or central bank to increase economic growth and counter recession. These can be either fiscal or monetary in nature.
A currency is anything that serves as a medium of exchange, a store of value, and a unit of account. Most countries have a standard currency to serve these functions in that country.
The monetary policy trilemma is the inability to simultaneously have a fixed currency exchange rate, allow capital to flow in and out of a country freely, and maintain an autonomous monetary policy. A country can only have two of the above and the decision as to which two is a critical part of monetary policy.