Definition of monetary policy

Monetary policy is the process by which the monetary authority of a country, like the central bank or currency board, controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.

Further goals of a monetary policy are usually to contribute to economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies.

Monetary economics provides insight into how to craft an optimal monetary policy. Since the 1970s, monetary policy has generally been formed separately from fiscal policy, which refers to taxation, government spending, and associated borrowing.

Monetary policy is referred to as either being expansionary or contractionary. Expansionary policy is when a monetary authority uses its tools to stimulate the economy. An expansionary policy increases the total supply of money in the economy more rapidly than usual. It is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Also, this increases the aggregate demand (the overall demand for all goods and services in an economy), which boosts growth as measured by gross domestic product (GDP). Expansionary monetary policy usually diminishes the value of the currency, thereby decreasing the exchange rate.

The opposite of expansionary monetary policy is contractionary monetary policy, which slows the rate of growth in the money supply or even shrinks it. This slows economic growth to prevent inflation. Contractionary monetary policy can lead to increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession; it should hence be well managed and conducted with care.