Types of Monetary Policy

Expansionary Monetary Policy Contractionary Monetary Policy

Expansionary Monetary Policy

Expansionary monetary policy

Expansionary policies are fiscal policies, like higher spending and tax cuts, that encourage economic growth.[1] In turn, an expansionary monetary policy is monetary policy that seeks to increase the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry. Neoclassical and Keynesian economics significantly differ on the effects and effectiveness of monetary policy on influencing the real economy; there is no clear consensus on how monetary policy affects real economic variables (aggregate output or income, employment). Both

economic schools accept that monetary policy affects monetary variables (price levels, interest rates). Monetary policy relies on a number of tools: monetary base, reserve requirements, discount window lending and interest rates. Monetary policy tools Monetary base Expansionary policy can be implemented by increasing the money supply relative to the quantity demanded - it will cause the equilibrium rate of interest to fall, all other things being equal. The monetary authority exerts regulatory control over banks. Expansionary policy can be implemented by allowing banks to hold a lower proportion of their total assets in reserve. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By requiring a lower proportion of total assets to be held as liquid cash the Federal Reserve increases the availability of loanable funds. This acts as an increase in the money supply. Discount window lending Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. The funds expands the monetary base. By extending new loans the monetary authority can directly increase the size of the money supply. By advertising that the discount window will increase future lending, the monetary authority can also indirectly increase the money supply by raising risk-taking by financial institutions. After the September 11, 2001 attacks in the United States, the Federal Reserve announced that it would extend discount window loans to any and all financial institutions who requested funds. This had the effect of preventing any panics due to fear of insufficient liquidity. Interest rates The expansion of the monetary supply can be achieved indirectly by decreasing the nominal interest rates.
In nation other than US, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By decreasing the interest rate(s) under its control, a monetary authority can expand the money supply, because lower interest rates discourage savings and encourage lending. Both of these effects increase the size of the money supply.

Contractionary Monetary Policy

Contractionary monetary policy

Contractionary monetary policy is monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry. New classical and Keynesian economics significantly differ on the effects and effectiveness of monetary policy on influencing the real economy; there is no clear consensus on how monetary policy affects real economic variables (aggregate output or income, employment). Both economic schools accept that monetary policy affects monetary variables (price levels, interest rates). Monetary policy relies on a number of tools: monetary base, reserve requirements, discount window lending and interest rates.

Policy tools
Monetary base Contractionary policy can be implemented by reducing the size of the monetary base. This directly reduces the total amount of money circulating in the economy.

A central bank can use open market operations to reduce the monetary base. The central bank would typically sell bonds in exchange for hard currency. When the central bank collects this hard currency payment, it removes that amount of currency from the economy, thus contracting the monetary base. Reserve requirements The monetary authority exerts regulatory control over banks. Contractionary policy can be implemented by requiring banks to hold a higher proportion of their total assets in reserve. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By requiring a higher proportion of total assets to be held as liquid cash, a central bank or finance ministry reduces the availability of loanable funds. This acts as a reduction in the money supply. Discount window lending Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans the central bank can directly reduce the size of the money supply. By advertising that the discount window will be reduced for future lending, the central bank can also indirectly reduce the money supply by reducing risk-taking by financial institutions. Interest rates The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. In nation other than US, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage lending. Both of these effects reduce the size of the money supply.