What is Monetary Policy?

A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services including economic research. Its main goals include stabilising the nation's currency, keeping unemployment low, and preventing inflation. Most central banks are governed by a board consisting of its member banks.

Central banks affect economic growth by controlling the liquidity in the financial system. They have three monetary policy tools to achieve this goal.

First, they set a reserve requirement. It's the amount of cash that member banks must have on hand each night. The central bank uses it to control how much banks can lend.

Second, they use open market operations to buy and sell securities from member banks. It changes the amount of cash on hand without changing the reserve requirement.

Finally, they set targets on interest rates they charge their member banks. That guides rates for loans, mortgages, and bonds. Raising interest rates slows growth, preventing inflation. That's known as contractionary monetary policy. Lowering rates stimulates growth, preventing or shortening a recession. That's called expansionary monetary policy.

Monetary policy is tricky. It takes about six months for the effects to trickle through the economy. But if central banks stimulate the economy too much, they can trigger inflation, something they avoid like the plague. Inflation destroys any benefits of growth. It raises prices for consumers, increases costs for businesses and eats up any profits. Central banks must work hard to keep interest rates high enough to prevent it.