Monetary policy: Definition, types and tools

What is monetary policy?

Monetary policy refers to actions taken by a central bank or monetary authority to manage the supply of money and interest rates in an economy with the aim of promoting economic growth and stability. It may be necessary to change the money supply, set interest rates, or use other instruments to affect the price and accessibility of credit.

The ultimate goal of monetary policy is to achieve and maintain a healthy economy. This typically involves balancing multiple objectives such as:

To ensure economic stability, mitigate the impact of economic shocks, and promote sustainable economic growth, central banks carefully manage the money supply and interest rates. However, the exact goals and tactics of monetary policy may change depending on the unique circumstances and requirements of each economy.

type of monetary policy

There are two main types of monetary policy.

  • Expansionary monetary policy: The goal of expansionary monetary policy is to increase the money supply and promote economic expansion. Lowering interest rates, expanding the money supply, and relaxing reserves can all be used to achieve this.
  • Contractionary monetary policy: aims to reduce the money supply and keep inflation under control. Raising interest rates, reducing the money supply, and raising reserves can all be used to achieve this.

Different types of monetary policy tools

The tools used to conduct monetary policy can be broadly categorized into three types.

  • Open market operations: This involves central banks buying and selling government securities on the open market to increase or decrease the money supply.
  • Interest Rate: The central bank can change the benchmark interest rate, which is the rate at which banks can borrow from the central bank. This affects other interest rates in the economy, affecting borrowing and spending.
  • Reserve requirements: Central banks can change the reserve requirements of banks. This affects the amount of funds banks have to hold in reserves and can lend out.

Other less frequently used tools include discount window lending, moral persuasion, and direct bank lending management.

Monetary Policy of Fiat Currency and Monetary Policy of Virtual Currency

To achieve macroeconomic goals such as price stability, full employment, and economic growth, central banks such as the US Federal Reserve set and implement fiat monetary policies. To influence the supply and demand for money in the economy, central banks employ various monetary policy instruments, such as changing interest rates, conducting open market transactions, and introducing reserve requirements.

Related: Cryptocurrencies resonate better with the BIS vision of an ideal monetary system.

On the other hand, cryptocurrencies like Bitcoin (BTC) adopt a decentralized monetary policy. This refers to the approach of controlling the supply of cryptocurrencies based on decentralized algorithmic rules rather than centralized decision-making by a central authority. Or central bank.

In decentralized monetary systems, mathematical algorithms stored in cryptocurrency software control the creation and circulation of currency. This ensures that the money supply is stable and not subject to arbitrary changes by central authorities. Bitcoin, for example, is capped at 21 million and its creation rate will gradually decline over time.

Decentralized monetary policy, as opposed to centralization, has many advantages. Establishing a more stable and predictable monetary policy would reduce the need for trust in centralized authorities and reduce the risk of inflation. Moreover, it makes it more difficult for governments to manipulate the money supply for political or commercial purposes.

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But decentralized monetary policy also has its challenges. Not as flexible as centralized monetary policy, it may not be able to respond quickly to changing market conditions. In addition, deflationary pressures due to shortages of various cryptocurrencies may discourage people from investing and spending money.

What will be the CBDC monetary policy?

Central bank-issued CBDCs have a higher demand for money than cryptocurrencies because central banks can change the amount of Central Bank Digital Currencies (CBDCs) to meet macroeconomic goals, just like traditional fiat currencies. and supply may be more controllable. This shows that central banks can affect the amount of money in circulation and the demand for money in the economy by changing interest rates, conducting open market transactions and imposing reserves.

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However, the exact monetary policy of a CBDC depends on the individual design of the CBDC and the goals of the issuing central bank. Some CBDC monetary policies may be more liberal, while others may be more closely aligned with existing fiat or cryptocurrencies. The evolutionary nature of digital currencies and the need for central banks to adopt this new technology may ultimately influence CBDC monetary policy.