Understanding Monetary Policy: Types and Economic Effects

Types of Monetary Policy

Monetary policy can be categorized based on the instruments used and their general effects on the economy.

According to the Nature of the Instruments:

• Open Market Operations:

  This is the main tool for controlling the amount of money in circulation (M) and interest rates (i). The most important operations are the main refinancing operations, which are regular auctions of money available to commercial banks operating in the Eurozone. The minimum bid rate is set by the ECB itself, which becomes the official interest rate.

• Standing Facilities:

  As the name suggests, these are facilities available to commercial banks from the central bank in their own country. They are manipulated through overnight operations for granting credit (cash injection) or absorbing deposits (withdrawals), as appropriate. These facilities affect interest rates and the amount of money in circulation. Since they do not require approval by the ECB, this is the only instrument where the central banks of EU countries enjoy autonomy.

• Minimum Reserve Mechanism:

  This mechanism increases or reduces the liquidity of the banking system by requiring banks in the Eurozone to maintain a certain reserve requirement, either in the relevant central bank or in cash. If the monetary authority increases this ratio, banks must hold more reserves, thereby reducing their ability to lend, which leads to a drop in the money supply.

According to the General Effects on the Economy:

• Expansionary Monetary Policy:

  The aim is to promote economic growth and job creation. This can be achieved in different ways. For example, if the ECB wants to revive the economy:

  • Pay more money in the weekly auctions: When this happens, banks are better able to lend more money to individuals and businesses. If banks make more loans, the money supply increases, and money becomes more plentiful. This lowers interest rates in the economy.
  • Download the official interest rate: Banks can get money cheaper and thus may also provide a lower interest rate.
  • Reduce the legal rate of cash: Though not usually taken, the banks should have fewer reserves and thus increase their ability to pay with a consequent increase in the money supply. By becoming more abundant, the money will be cheaper.
• Restrictive or Contractionary Monetary Policy:

  If prices are rising more than expected, the ECB should pay less money in the weekly auctions, increase the official interest rate, or raise the legal ratio of cash. Through any of these pathways, individuals and companies cannot raise money as easily and therefore reduce their spending capacity. Consumption and investment decrease, thus reducing aggregate demand. As a result, prices would be controlled but generate negative effects on output and employment.