Key aspects

• Monetary policy refers to the strategies adopted by central banks to regulate the money supply and economic growth. It typically involves changes in interest rates and bank reserve requirements.

• The objective of monetary policies is to achieve economic objectives, such as controlling inflation, managing employment levels and promoting economic growth.

• Monetary policies can be expansionary or contractionary. They influence the disposable income of individuals and companies, which can indirectly affect crypto markets.

What is monetary policy?

Monetary policy refers to actions taken by a nation's central bank to regulate the money supply and cost of borrowing in the economy. Monetary policies are used to achieve specific economic objectives, such as controlling inflation, managing employment levels, 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 influencing the supply and cost of borrowing, they can boost economic activity or cool an overheated economy.

How does monetary policy work?

Monetary policies can be expansionary or contractionary.

Expansionary monetary policy

Expansionary monetary policies typically involve lowering interest rates while increasing the money supply to stimulate economic growth. They are often implemented during recessions or periods of slow economic activity. The goal is to make borrowing cheaper, encourage consumers to spend and businesses to invest, and thus boost 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 borrowing costs have decreased. Jane decides to take out a loan to start a new business, while John takes advantage of the lower interest rates to buy a new house. In this way, the demand for goods and services increases, leading to job creation and increased economic activity.

Example: The 2008 financial crisis

During the 2008 financial crisis, the US government pursued expansionary monetary policy to revive the economy. It lowered interest rates and introduced quantitative easing (QE), i.e. buying government securities 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.

Contractionary monetary policy

Contractionary monetary policy involves raising interest rates and reducing the money supply to slow economic growth and combat inflation. By making borrowing more expensive, the central bank aims to reduce spending and investment by lowering overall demand and cooling the economy.

Imagine that the central bank of country Y wants to control rising inflation by raising interest rates. Residents Sarah and Mike discover that the cost of borrowing has increased. Sarah decides to delay her plans to expand her business, and Mike postpones buying a new car. As a result, consumer demand falls and businesses see a decline in sales, which helps to reduce inflation and stabilize prices.

Example: Early 80s

In the early 1980s, the Federal Reserve used contractionary monetary policy to combat high inflation in the United States. The Fed raised interest rates, making borrowing more expensive. This succeeded in reducing inflation, but it also led to a temporary rise in unemployment.

Monetary policy versus fiscal policy

Tools

Monetary policy mainly involves adjusting interest rates, conducting open market operations, and changing reserve requirements for banks. Fiscal policy uses government spending and taxes as its main tools.

Flexibility

Monetary policy can be implemented relatively quickly, allowing for operational economic effects. Changes in fiscal policy often take longer to implement because they require approval through the legislative process.

Scope of application

Monetary policy focuses primarily on general economic objectives, such as controlling inflation or managing unemployment. Fiscal policy is often focused on specific areas of the economy. Government spending can be targeted at specific projects, and fiscal policies can be tailored to specific groups.

Monetary policy in crypto markets

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

Impact of expansionary monetary policy

When a central bank implements expansionary monetary policy, more money flows into the economy. Lower interest rates and a larger money supply encourage borrowing and spending, which provides more disposable income. This means that people are more likely to invest in bitcoins and other cryptocurrencies, which could push up prices.

Impact of contractionary monetary policy

When a central bank implements a contractionary monetary policy, money leaves the economy. Higher interest rates and a reduced money supply discourage spending, resulting in less income available for investments. This means that fewer people may have the means to invest in cryptocurrencies, which could drive prices down.

Conclusions

Monetary policy refers to the control of money supply and interest rates by central banks to achieve various economic goals, such as controlling inflation, creating more jobs, and encouraging economic growth. Since monetary policy influences disposable income, it can also indirectly affect crypto markets.

Further reading

• What is fiscal policy?

• What are economic models?

• What is quantitative contraction (QT)?

• What is stagflation?

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