Key points:

  • Monetary policy is the strategy adopted by central banks to regulate the money supply and economic growth. As a rule, monetary policy involves changes in interest rates and requirements for bank reserves. 

  • Monetary aims to achieve economic goals such as controlling inflation, managing employment and promoting economic growth.

  • Monetary policy can be both expansionary and restrictive. This affects the disposable income of individuals and companies, which can indirectly affect the cryptocurrency markets.

What is monetary policy?

Monetary policy refers to actions taken by a country's central bank to regulate the money supply and the cost of borrowing in the economy. Monetary policy is used to achieve specific economic goals, such as controlling inflation, managing employment, or encouraging economic growth.

To implement monetary policy, central banks can adjust interest rates, conduct open market operations (OMOs), and change reserve requirements for commercial banks. By affecting the supply and cost of borrowing money, they can either boost economic activity or cool an overheated economy.

How does monetary policy work?

Monetary policy can be both expansionary and restrictive.

Expansionary monetary policy

Expansionary monetary policy usually involves lowering interest rates while simultaneously increasing the money supply to stimulate economic growth. It is often implemented during recession or periods of low economic activity. The goal is to make borrowing cheaper, encouraging consumers to spend and businesses to invest, thereby boosting overall economic activity.

Imagine that the central bank of country X wants to stimulate the economy by lowering interest rates. Jane and John, residents of country X, notice that the cost of borrowing has decreased. Jane decides to take out a loan to start a new business, while John takes advantage of lower interest rates to buy a new house. Thus, demand for goods and services increases, which leads to the creation of jobs and further economic activity.

Example: the 2008 financial crisis

During the financial crisis of 2008, the US government implemented an expansionary monetary policy to revive the economy. They lowered interest rates and introduced quantitative easing (QE), that is, the purchase of government and mortgage-backed securities. This increased the money supply and made borrowing cheaper. As a result, consumers spent more, businesses invested more, and the economy began to recover.

Restrictive monetary policy

A tight monetary policy involves raising interest rates and reducing the money supply to slow economic growth and fight inflation. By making borrowing more expensive, the central bank seeks to reduce spending and investment, reducing aggregate demand and cooling the economy.

Imagine that the central bank of country Y wants to control rising inflation by raising interest rates. Sarah and Mike discover that the cost of the loan has increased. Sarah decides to postpone her plans to expand her business, while Mike puts off buying a new car. As a result, consumer demand falls and businesses experience lower sales, which helps reduce inflation and stabilize prices.

Example: the beginning of the 1980s

In the early 1980s, the Federal Reserve used monetary policy to combat high inflation in the United States. The Fed raised interest rates, which made borrowing more expensive. This successfully reduced inflation, but also led to a temporary rise in unemployment.

Monetary and fiscal policy

Tools

Monetary policy primarily involves adjusting interest rates, carrying out OMOs and changing the requirements for bank reserves. Fiscal policy uses government spending and taxation as the main instruments.

Flexibility

Monetary policy can be implemented relatively quickly, which provides an immediate economic effect. Fiscal policy changes usually take longer to implement because they require approval through the legislative process.

Scale

Monetary policy is mainly focused on achieving economic goals, such as controlling inflation or managing unemployment. Fiscal policy is often aimed at specific areas of the economy. Government spending can be targeted at specific projects, and tax policies can be tailored to specific groups.

Monetary policy in crypto markets

Monetary policy can also affect cryptocurrency markets. Although cryptocurrency prices can sometimes change independently of traditional financial systems, changes in monetary policy can significantly affect market sentiment and investor behavior.

The impact of expansive monetary policy

When a central bank pursues an expansionary monetary policy, more money flows into the economy. Lower interest rates and an increase in the money supply stimulate borrowing and spending, giving people more disposable income. This means that people are more likely to invest in bitcoin and other cryptocurrencies, potentially driving up prices.

The impact of restrictive monetary policy

When a central bank pursues an accommodative monetary policy, money is effectively withdrawn from the economy. Higher interest rates and a shrinking money supply discourage spending, resulting in less available income for investment. This means that fewer people may have the means to invest in cryptocurrency, potentially driving down prices.

Results

Monetary policy is the control by central banks of the money supply and interest rates to achieve various economic goals, such as controlling inflation, creating new jobs, and promoting economic growth. Since monetary policy affects disposable income, it can also indirectly affect cryptocurrency markets.

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