Understanding Monetary Policy Tools and Economic Impact

Monetary Policy Fundamentals

Monetary Policy is the set of actions undertaken by monetary authorities to monitor changes in the amount of money and the interest rate. This should seek a joint and coordinated action. The macroeconomic objectives are to operate equally with other intervening variables determining monetary targets or a very complex interrelationship between the financial system and the real economy.

Monetary Targets and Objectives

Monetary targets, in turn, are instrumental to achieve the ultimate objectives, which are:

• To balance the level of money supply or amount of money available.
• To control interest rates for operations.
• To manage exchange rates or equivalence relation to other currencies.

The action of monetary policy seeks to influence economic activity and prices. Given the instrumental nature of the money supply, it is possible to work on it in any of its manifestations. Although most countries pursue the same ultimate goals, the different order of priority, according to the most relevant from a monetary point of view, is to control inflation.

Types of Monetary Policy

Expansive Monetary Policy

Monetary policy can be expansive, which increases the amount of money and lowers the interest rate. This is accomplished by allowing banks to grant more loans. Having more money in the hands of applicants decreases its price. This allows a boost to investment and consumption and, consequently, production and employment.

Restrictive Monetary Policy

RESTRICTIVE policy is based on reducing the money available to borrowers. This limits private banks from granting loans. The shortage of money leads to an increase in its price, which will contract production due to more expensive investment and consumption.

Price Stability Measurement

The objective of stability of prices is measured by indicators such as:

• Indicators that determine the amount of money available in the economy.
• The Consumer Price Index (CPI), which compares the evolution of prices.

Monetary Authority Influence

The Monetary Authority (OM) is represented by a straight line being determined strictly by the monetary authority. An expansionary monetary policy is reflected in an increase in OM. If all other variables remain constant, this leads to a greater demand for money and an equilibrium interest rate lower than the original, resulting in greater investment and reviving the economy.