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  1. Fiscal policy
  2. Inflation
  3. Liquidity
  4. Purchasing power

Monetary policy - What is monetary policy?

Monetary policy refers to the control of money supply and interest rates by regulatory authorities

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Monetary policy is generally managed by the central bank, which plans, announces, and implements measures to help control inflation, as well as to improve employment rates. Monetary policy is closely tied to fiscal policy, however, it can be used on its own.

While fiscal policy refers to governmental control over tax and public spending by authorities, monetary policy refers more to the spending of individuals as influenced (primarily) by interest rates.

What is involved in monetary policy?

Monetary policy can encompass a variety of different elements that can be adjusted in order to exert a particular result on the economy. These results can involve:

The implementation of monetary policy can involve one or multiple elements intended to have an impact on the above.

Types of monetary policy

Like fiscal policy, monetary policy is used in two distinctive ways. It is used to encourage growth in an economy (expansionary) or to stem inflation (contractionary).

Expansionary monetary policy

Regulatory authorities might initiate expansionary monetary policies at a time when there is a slow down in the economy resulting in increased rates of unemployment. In an expansionary policy, interest rates are generally lowered, making spending money more appealing and saving money considerably less appealing.

Improved purchasing power leads to increases in consumer spending. More spending by consumers leads to greater money supply, which has several effects including:

  • Better loan conditions
  • Better funding for businesses to make investments
  • Reduced rates of unemployment

In some extreme cases, regulatory authorities might use more than just lowering interest rates to encourage economic growth. In times of severe recession, the money supply might be increased as well.

However, economic growth is not always considered positive if it is linked to inflation. This is when a different type of monetary policy is employed.

Contractionary monetary policy

When inflation becomes a problem, regulatory authorities will introduce contractionary monetary policy. The main tool for controlling inflation is to increase interest rates. This reduces the demand for money resulting in opposite effects of expansionary policy including:

  • Worse conditions for borrowing money
  • Better conditions for saving (instead of spending)
  • Increased unemployment

Because inflation can become damaging over time, it is sometimes necessary for contractionary measures to be taken. This can reduce inflation, and is necessary in times of increasing inflation rates, as these have a tendency to get out of control quickly.

Other types of monetary policy

While expansionary and contractionary monetary policy have been the tried-and-true methods for influencing the economy as necessary, recently, another type of monetary policy has gained notoriety: quantitative easing.

How quantitative easing is different

Quantitative easing has been used to increase the money supply, so has been considered an expansionary policy. However, it works differently from traditional expansionary monetary policy in that it involves the buying of government bonds and the money supply targets financial institutions. By doing so, these institutions have more capital in order to provide better lending terms and increased liquidity.