Monetary Policy: Tools for Economic Stability

Monetary Policy: Definition and Function

Monetary policy is an economic policy that uses money as a control variable to ensure and maintain economic stability. To achieve this, monetary authorities utilize mechanisms such as varying the interest rate and participating in the money market.

When applied to increase the amount of money in circulation, it is called expansionary monetary policy, and when applied to decrease it, it is called restrictive monetary policy.

Core Objectives of Monetary Policy

• Maintaining a stable value of money.
• Achieving Full Employment (the highest possible level of employment).
• Avoiding continuing disparities in the balance of payments.

Key Mechanisms of Monetary Control

The central bank can influence the amount of money and the rate of interest through the following primary tools:

1. Changes in the Interest Rate

This mechanism indicates the cost of borrowing money (how much banks must pay for the money they borrow).

2. Change in the Cash Ratio (Reserve Requirement)

The cash ratio indicates the percentage of bank deposits that must be maintained in liquid reserves, or stored without being available for lending. This is done to avoid risks and ensure liquidity.

3. Open Market Operations (OMO)

Open Market Operations refers to the operations where the central bank buys or sells government bonds on the open market. The public debt consists of securities issued by the State, which can include letters, notes, and bonds.

Expansionary and Restrictive Policies

Expansionary Monetary Policy

This policy is implemented when the goal is to put more money in circulation. When there is little money in the market, an expansionary monetary policy may be applied to increase the money supply. This involves using the following mechanisms:

1. Reduce the interest rate to make bank loans more attractive.
2. Reduce the reserve requirement (bank reserve), allowing banks to lend more money with the same reserves.
3. Buy government debt to inject money into the market.

Restrictive Monetary Policy

This policy is implemented when the goal is to remove money from the market. When there is an excess of money in circulation, authorities aim to reduce the money supply, and for this, a restrictive monetary policy can be applied. This consists of the opposite actions of the expansionary policy:

1. Increase the interest rate, making borrowing more expensive.
2. Increase the reserve requirement (bank reserve), to keep more money in the bank and less in circulation.
3. Selling debt to withdraw money from circulation.