What is the Central Bank Monetary Policy?

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What is the Central Bank Monetary Policy

Our job is to keep prices stable. This is the most that monetary policy can do for economic growth and job creation”. It is with this sentence that the European Central Bank responds on its website to the question “What is central monetary policy?“ 

What is the Central Bank Monetary Policy?

Imagine the economy is like a car, and the central bank is the driver. The central bank’s monetary policy is like the driver’s control over the car’s speed.

  1. Speeding Up (Expansionary Policy): When the economy is slow and needs a boost, the central bank can step on the gas pedal by:
    • Lowering Interest Rates: This encourages people and businesses to borrow money, spend, and invest, which stimulates economic activity.
    • Buying Bonds: This puts more money into the economy, making it easier for banks to lend and for people to spend.
  2. Slowing Down (Contractionary Policy): When the economy is overheating and needs to cool down to prevent inflation (usually measured by the Consumer Price Index), the central bank can hit the brakes by:
    • Raising Interest Rates: This makes borrowing more expensive, slowing down spending and investment.
    • Selling Bonds: This reduces the money supply, making it harder to borrow and spend.

So, the central bank’s monetary policy is all about managing the economy’s speed – trying to keep it steady, not too slow, and not too fast. It’s a bit like the car’s accelerator and brakes to ensure a smooth and safe ride for everyone in the economic vehicle.

In the United States, the central bank is the Federal Reserve (Fed). In Europe, it is the European Central Bank (ECB). Here in Nigeria, it is the Central Bank of Nigeria (CBN).

Although the control of the markets is not one of the objectives of these institutions, their actions have direct effects and consequences on investments.

How central banks implement monetary policies

To implement its monetary policy, a central bank uses various tools, among which, the best known, is that of interest rates

The latter represents the cost of money at a given moment and, therefore, by acting on them, it is possible to control the demand and supply of money in the area of ​​interest of the central bank. What a central bank puts in place in its monetary policy, therefore, has a high specific weight, given and considering that its moves also influence the Forex market.

Read also! Who Controls the Forex Market?

Types of Central Bank Monetary Policy

The monetary policy implemented by a Central Bank can be mainly of two types, ie expansionary or tight. 

Expansionary monetary policy

Which action taken by a central bank would reflect expansionary monetary policy?

An action taken by a central bank that reflects an expansionary monetary policy is when the central bank increases the money supply or makes it easier for people and businesses to borrow money. This typically involves:

  1. Lowering Interest Rates: The central bank may reduce interest rates, such as the key policy rate or the discount rate. Lower interest rates make it cheaper to borrow money, encouraging businesses and individuals to take out loans for investments, spending, and housing.
  2. Quantitative Easing (QE): The central bank can buy government bonds or other assets from the market, injecting money into the financial system. This increases the money supply and lowers long-term interest rates, stimulating economic activity.
  3. Lowering Reserve Requirements: The central bank can decrease the amount of money that banks are required to hold in reserve. This means that banks can lend out more of their deposits, increasing the amount of money circulating in the economy.
  4. Forward Guidance: The central bank can provide guidance about its future monetary policy intentions. If it signals that it will keep interest rates low for an extended period, it encourages borrowing and spending because people expect interest rates to remain favorable.

All of these actions are aimed at making money more accessible and affordable. They also encourage borrowing and spending, ultimately boosting economic activity and promoting economic growth.

Tight monetary policy

Opposed to the expansionary monetary policy is the tight one. A central bank takes actions to implement monetary policy, and when it follows a tight monetary policy, it typically does the following:

  1. Raising Interest Rates: One of the key actions in tight monetary policy is increasing the benchmark interest rates. This makes borrowing money more expensive for banks and individuals. As interest rates rise, people are less inclined to take out loans for things like homes or businesses, which reduces overall spending and slows down economic growth.
  2. Reducing the Money Supply: The central bank may also sell government securities or take other measures to reduce the amount of money circulating in the economy. When there’s less money available, it becomes harder for individuals and businesses to access credit, further curbing spending and economic activity.
  3. Increasing Reserve Requirements: Central banks can raise the amount of money that banks are required to keep in reserve, meaning they can’t lend out as much of their deposits. This reduces the amount of money available for loans and credit, contributing to a tighter monetary environment.

All of these actions aim to make it more expensive and less convenient to borrow money and spend, which helps control inflation but can also slow down economic growth. Tight monetary policy is often used when the central bank is concerned about rising inflation rates.

Tools of Monetary Policy

The tools that monetary authorities can use are money supply and interest rates.

  • Money supply: The money supply is influenced through the so-called “open market operations”, ie the purchase and sale of government bonds. By purchasing bonds, the central bank increases the money present in the system; selling reduces it. Open market operations are considered conventional instruments of monetary policy. Among the unconventional tools, one of the most important is quantitative easing.
  • Interest rates: The level of interest rates, on the other hand, is influenced by varying very short-term rates, typically the interbank rate, the one at which banks lend money. Changing this rate will then affect all the others.

Take Away

The main purpose of the central bank monetary policy is to ensure price stability and low inflation. The lower the inflation rate, the more favorable the conditions for living and doing business.

Maintaining price stability helps to solve several urgent problems for the state at once:

  • protect citizens’ savings in the national currency from depreciation;
  • increase the availability of credit financing for legal entities;
  • simplify strategic planning for business;
  • increase confidence in the national currency;
  • protect low-income citizens.