Monetary policy

Monetary policy is one of the most important tools central banks use to influence the economy. It helps regulate inflation, employment and economic growth by setting interest rates, managing the money supply and other mechanisms. How does it work, what tools does it use and how does it affect everyday life? Discover why monetary policy is key to the stability of the modern economy.

What is monetary or monetary policy?

Monetary or monetary policy is the way a central bank (such as the European Central Bank in the euro area) influences the amount of money in the economy and sets interest rates to ensure the stability of the economy. The aim is to keep prices stable (prevent high inflation), promote economic growth and ensure that there are enough jobs.

Imagine the economy as a car and the central bank as the driver. If the car (the economy) is going too slowly (the economy is declining), the driver can step on the gas, for example, to lower interest rates or “print” more money into circulation, which will encourage spending and investment. However, if the car is going too fast (inflation is rising), the driver can apply the brakes, for example, by raising interest rates to curb spending and bring inflation down.

Monetary policy therefore helps to keep the economy in balance, so that it is neither overheated nor slowed down. It has a huge impact on ordinary people because it affects mortgage interest rates, the prices of goods and services and the overall cost of living.

Is monetary policy good?

Monetary policy is an essential tool for managing the economy, but its effectiveness and “goodness” depend on how it is applied and on specific economic conditions. It has its advantages but also its limitations:

Benefits of monetary policy:

• Flexibility: central banks can react quickly to changes in the economy, for example by cutting interest rates during crises.
• Stabilising inflation: monetary policy helps to keep inflation under control, which is important for people’s purchasing power.
• Promoting economic growth: the right instruments (e.g. expansionary policies) can stimulate investment and consumption.
• Independence: central banks are often independent of political influences, allowing them to make decisions that are beneficial in the long term.

Disadvantages of monetary policy:

• Uneven effects: not all sectors or social groups feel its impact equally. For example, low interest rates may favour investors at the expense of savers.
• Delayed effects: the effects of changes in interest rates or other measures take time to materialise, which can be a problem in rapidly changing conditions.
• Limited impact in certain situations: if interest rates are already very low (the zero lower bound), further reductions may not stimulate the economy (the liquidity trap).
• Dependence on correct forecasts: estimation errors and wrong central bank decisions can worsen the economic situation.

An alternative to monetary policy

Monetary policy, although a key instrument for managing the economy, has its limitations. There are alternative approaches and instruments that can serve to stabilise and promote economic growth. The main alternatives include:

• Fiscal policy: is managed by the government and includes public spending and tax policy.
• Modern Monetary Theory (MMT): argues that governments that issue their own currency can finance spending by printing new money without worrying about deficits, as long as inflation remains under control.
• Automatic stabilisers: mechanisms built into the economic system that are activated automatically without the need for government intervention (progressive taxation, social benefits, etc.)
• Cryptocurrencies and decentralised finance (DeFi): a system in which money and financial services operate without central management (e.g. bitcoin or Ethereum).
• Regional and local currencies: the use of specific currencies within regions to support the local economy.
• Monetary-fiscal policy mix: the simultaneous use of monetary and fiscal policy to comprehensively manage the economy.

Monetary policy and the price of bitcoin?

Monetary policy implemented by central banks has a significant impact on the price of bitcoin. When central banks pursue expansionary monetary policies, for example by lowering interest rates or increasing the money supply, investors often look for alternative assets to protect their capital from inflation. Bitcoin, due to its limited supply and decentralised nature, is becoming an attractive store of value, which can drive up its price.

Conversely, restrictive monetary policy, characterised by rising interest rates and a reduction in the money supply, may reduce the attractiveness of bitcoin as an investment. Higher interest rates increase the yields on traditional financial instruments, which may lead to a shift of capital from bitcoin back into traditional assets and a consequent fall in its price. In addition, monetary policy uncertainty may increase volatility in cryptocurrency markets. A 2023 study found that increased monetary policy uncertainty leads to a decline in bitcoin yields, suggesting a negative impact on bitcoin’s price during periods of uncertainty.

Overall, central banks’ monetary policy decisions can significantly affect the demand for bitcoin and its price in the market.

Monetary policy vs. fiscal policy

Monetary policy and fiscal policy are the two main tools that governments and central banks use to manage the economy. Although they share the common goal of promoting economic stability and growth, they work differently and use different mechanisms.

Monetary policy

It is managed by a central bank (e.g. the European Central Bank). The aim is to maintain price stability (control inflation), promote economic growth and employment, and ensure the stability of the financial system.

Fiscal policy

It is managed by the government through the national budget. It also aims to promote economic growth. But also to redistribute income (through taxes and social benefits) and, most importantly, to ensure the financing of public services (health, education, infrastructure).

Monetary and fiscal policy should be coordinated. For example: during a recession, the government may increase public spending (fiscal policy) while the central bank lowers interest rates (monetary policy), thereby jointly stimulating demand. Conversely, during an economic overheating, the government can cut spending and the central bank can raise interest rates to prevent inflation.

Monetary and fiscal policy are two key tools for managing the economy. While monetary policy regulates money flows and interest rates, fiscal policy influences the economy through public spending and taxes. Their effective combination is essential for stable and sustainable economic growth.

Monetary policy mechanisms

Monetary policy mechanisms are the tools that a central bank (e.g. the European Central Bank) uses to influence the amount of money in the economy and the level of interest rates. The aim is to keep the economy in balance, prices stable, jobs plentiful and growth reasonable.

Simply put, a central bank can:

• Set interest rates: if the central bank lowers interest rates, it is cheaper to borrow money, which encourages spending and investment. If it raises them, borrowing becomes more expensive, which dampens inflation. For example, cheap mortgages during low rates can increase demand for property.
• Manage the amount of money in the market: by printing new money (quantitative easing) or withdrawing it from circulation, the central bank influences how much money is available to spend. More money in the market reduces its value, which can lead to inflation.
• Reserve requirements for banks: the central bank can tell commercial banks how much money they must keep as reserves and how much they can lend. More reserves means less lending, less reserves means more lending. If banks have to hold less reserves, they can lend more and boost the economy.
• Open market operations: the central bank buys or sells securities (e.g. bonds) to influence the money supply. Buying bonds adds money to circulation, selling withdraws it.

These mechanisms act as a “gas and brake” for the economy to prevent it from overheating (high inflation) or slowing down (economic contraction).

Monetary policy objectives

Monetary policy has several main objectives, which the central bank pursues to ensure the stability and prosperity of the economy. These objectives are interlinked and often depend on the current state of the economy:

• Price stability: the main objective is to keep inflation low and stable. If prices rise too fast (high inflation), the purchasing power of money is reduced. Conversely, falling prices (deflation) can slow down the economy as consumers postpone purchases in anticipation of further price falls.
• Full employment: the aim is boost job creation and keep unemployment as low as possible Expansionary monetary policy, such as interest rate cuts, encourages firms to invest and create new jobs.
• Stability of the financial system: the objective is making sure the banking and financial system runs smoothly. If the financial system gets into trouble, it can cause a crisis (e.g. the 2008 financial crisis). The central bank supervises the liquidity of banks and intervenes when necessary.
• Promoting economic growth: the objective is to achieve sustainable economic growth. Getting monetary policy right stimulates investment, innovation and consumption, leading to improved living standards.
• Balancing foreign trade: the objective is to maintain a stable exchange rate of the domestic currency against other currencies. If the currency is too strong or weak, it can affect exports and imports, which has an impact on the economy.
• Inflation and deflation control: the aim is to prevent extreme price fluctuations. Too high inflation causes uncertainty and a fall in the value of money. Deflation can lead to a slowdown in the economy and higher unemployment.

Monetary policy aims to maintain balance in the economy. Price stability is often seen as the main objective, but it is closely linked to the promotion of employment, economic growth and the stability of the financial system. Successful monetary policy ensures a sound economic environment for firms, households and investors.

Types of monetary policies

Monetary policy is divided into two main types according to the objective it pursues: expansionary and contractionary. Both types are aimed at influencing economic activity, inflation and employment.

Expansionary monetary policy

It is used to stimulate the economy during an economic downturn or recession. The aim is to increase economic activity, reduce unemployment and boost growth. Cheaper credit encourages firms and households to spend and invest more. The central bank “prints” more money into circulation through asset purchases (e.g. quantitative easing). Banks can lend more money. Used during economic recessions when inflation is low or even deflation is imminent. Risk is inflation is too high and can encourage financial bubbles (e.g. in the housing market).

Restrictive monetary policy

This type of policy is used to curb excessive growth in the economy, which could lead to high inflation. The aim is to cool economic activity and stabilise prices. They make credit more expensive by slowing down consumption and investment. The central bank can sell assets or reduce the money supply. Banks have to hold more reserves, which limits the amount of credit they can provide. It is used in times of economic overheating when inflation is too high. Doing so risks slowing economic growth and higher unemployment.

Monetary policy rules

Monetary policy is guided by a set of rules and principles that ensure the efficient functioning of the economy and the achievement of its objectives, such as price stability, economic growth and employment. These rules are important to minimise the risk of errors in the management of the economy and to enhance the credibility of the central bank.

Price stability rule

The main priority of monetary policy is to maintain price stability, which means low and predictable inflation. The European Central Bank (ECB) aims to keep inflation close to, but below, 2%. Stable prices protect the purchasing power of the population and provide a favourable environment for investment and economic growth.

Taylor’s Rule

This is a mathematical model that helps the central bank set interest rates based on the current state of inflation and economic growth. If inflation is above target, interest rates should be increased. If the economy is in recession, interest rates should be lowered. This approach improves the predictability and transparency of central bank decisions.

The money neutrality rule

In the long run, monetary policy should be neutral, which means that changes in the money supply should not affect real economic growth, but only the price level. This principle emphasises that economic growth should be achieved by real factors such as innovation and productivity, not by printing money.

Transparency and communication rule

The central bank should clearly communicate its objectives, decisions and the reasons behind them to ensure public and financial market confidence. Press conferences after ECB meetings or publication of inflation projections. Transparency reduces uncertainty and increases the effectiveness of monetary policy.

Central bank independence rule

The central bank should be independent of the government so that it can take the right decisions in the long term without political pressures. Political interference could lead to excessive money printing or inappropriate interest rate cuts, which would destabilise the economy.

Inflation expectations rule

Monetary policy should be predictable and consistent to prevent unexpected jumps in inflation. By maintaining a clear target for inflation and minimizing sudden changes in policy.

Flexible Shock Response Rule

The central bank should be able to react quickly to unexpected events (e.g. economic crises, pandemics) by adjusting interest rates or other measures. E.g. quantitative easing during the 2008 financial crisis. This principle ensures stability even in the event of unforeseen fluctuations in the economy.

Financial market stabilisation rule

Monetary policy should promote the stability of the financial system and prevent crises that could threaten the economy. For example, by providing liquidity to banks during crises or by regulating the credit market.

In conclusion

Monetary policy, while it may seem like an abstract economic tool, has a direct impact on all of our lives. It controls interest rates, which affect mortgages, loans or savings, and also price stability, which determines how much we pay for food, housing or energy. Getting monetary policy right helps to create a stable and predictable economic environment in which not only firms but also households thrive. Understanding the basic principles of monetary policy allows us to better understand why interest rates, inflation or economic growth change. Although we do not directly manage it, its impact on our finances is undeniable. That is why it is important to follow the decisions of central banks and understand how they can affect our everyday decisions about investing, borrowing or saving.