Monetary policy: Definition, types and tools

What is monetary policy?

Monetary policy refers to the actions taken by a central bank or monetary authority to manage the money supply and interest rates in an economy in order to promote economic growth and stability. To affect the price and availability of credit, this may involve changing the money supply, setting interest rates, or using other instruments.

The ultimate goal of monetary policy is to achieve and maintain a healthy economy. This usually involves balancing multiple goals such as:

To ensure economic stability, reduce the effects of economic shocks, and promote sustainable economic growth, central banks carefully control the money supply and interest rates. However, depending on the unique circumstances and requirements of each economy, the exact objectives and tactics of monetary policy may change.

Types of monetary policy

There are two main types of monetary policy:

  • Expansionary monetary policy. The goal of an expansionary monetary policy is to increase the money supply and promote economic growth. This can be done by lowering interest rates, expanding the money supply, and easing reserve requirements.
  • Contractionary monetary policy: aims to reduce the money supply and control inflation. This can be done by raising interest rates, shrinking the money supply, and raising reserve requirements.

Various types of monetary policy instruments

The instruments used to implement monetary policy can be roughly divided into three types:

  • Open Market Operations: This involves the central bank buying or selling government securities on the open market to increase or decrease the money supply.
  • Interest rates: The central bank can change the base interest rate, which is the rate at which banks can borrow from the central bank. This affects other interest rates in the economy, affecting borrowing and spending.
  • Reserve requirements: The central bank can change the reserve requirements for banks, which affects the amount of funds that banks must hold in reserve and can lend.

Other less commonly used tools include discount lending, moral persuasion, and direct control over bank lending.

Fiat Currency Monetary Policy vs. Cryptocurrency Monetary Policy

To achieve macroeconomic goals such as price stability, full employment, and economic growth, central banks such as the US Federal Reserve set and enforce monetary policy for fiat currencies. To influence the supply and demand of money in the economy, central banks use various monetary policy measures, including changing interest rates, conducting open market operations, and imposing reserve requirements.

Cryptocurrency better fits the BIS vision of an ideal monetary system

On the other hand, cryptocurrencies such as Bitcoin (BTC) use decentralized monetary policy, which refers to an approach to controlling the supply of money in cryptocurrencies that is based on decentralized algorithmic rules rather than centralized decision making by a central authority. or the central bank.

In a decentralized monetary system, mathematical algorithms stored in the cryptocurrency software control the creation and circulation of money. This ensures that the money supply remains stable and is not subject to arbitrary changes by the central government. For example, Bitcoin is capped at 21 million and the rate at which it is created gradually slows down over time.

Decentralization of monetary policy has a number of advantages over centralization. By establishing a more stable and predictable monetary policy, it eliminates the need for faith in centralized authority and reduces the risk of inflation. It also makes it harder for governments to manipulate the money supply for political or commercial purposes.

What is the economic impact of cryptocurrencies?

However, decentralized monetary policy also has its problems. They may not be able to respond quickly to changes in market conditions because they are less flexible than centralized monetary policy. In addition, deflationary pressure due to the lack of various cryptocurrencies can prevent people from investing and spending money.

What will CBDC monetary policy look like?

Since central banks will be able to change the amount of central bank digital currencies (CBDCs) to achieve their macroeconomic goals, similar to conventional fiat currencies, CBDCs issued by central banks can provide more control over the money supply and demand than cryptocurrencies. This indicates that central banks can influence the amount of money in circulation and the demand for it in the economy by changing interest rates, conducting open market operations and imposing reserve requirements.

Wholesale CBDC vs Retail CBDC: Key Differences

However, the exact monetary policy of CBDCs will depend on their individual design and the goals of the central banks issuing them. The monetary policies of some CBDCs may be more open, while those of others may be more closely linked to existing fiat currencies or cryptocurrencies. The evolving nature of digital currencies and the requirement for central banks to adopt this new technology is likely to eventually influence CBDC monetary policy.

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