Forex Trading Fundamental Analysis Masterclass

Types of Monetary Policy

Earlier in this series, we mentioned the fact that governments and central banks set policies in an effort to encourage certain economic conditions, such as stimulating growth or keeping inflation under control.

Although there tends to be a lot of similarities in terms of the overall goals of various central banks, the specific goals of central banks can change in accordance with the particular economic conditions faced by the countries in question. At the end of the day, monetary policy is all about creating the conditions for growth, while keeping prices relatively stable. In order to achieve these aims, central banks their tools to control things such as:

Interest rates
Inflation,
The supply of money
Reserve requirements over banks
Discount window lending to commercial banks

There are three main types of monetary policy: expansionary; restrictive/contractionary; and neutral.

Expansionary Policy

An expansionary monetary policy is one where the central bank either decreases the interest rate or expands/increases the money supply. The end result of both these actions is to reduce the cost of borrowing, with the aim of encouraging spending and investment. When this policy is based purely around lowering interest rates, it is known as an accommodative policy.

forex monetary policy — The Reserve Bank of New Zealand (RBNZ) lived through an expansionary monetary policy moving rates from 2.50 to 3.50 between 2009 and 2014.

Restrictive/Contractionary Policy

A contractionary or restrictive monetary policy is one where the supply of money is reduced, and this can often be accompanied by raising interest rates. A policy of purely raising the interest rates is known as a ‘tight’ monetary policy.

The aim of this is to slow down the rate of economic growth by making borrowing money more expensive and difficult, which will reduce spending and investment by consumers and businesses.

Neutral Policy

A neutral monetary policy is intended neither to fight inflation or create growth and would be implemented when the economy is in good shape and does not require central bank intervention in order to keep it that way.

Other articles in this series: