Types of Monetary Policy

Monetary policy is a central bank’s actions to control the money supply and interest rates to achieve macroeconomic goals such as controlling inflation, maintaining employment, and achieving economic stability. The two main types of monetary policy are:

1. Contractionary policy

2. Expansionary policy

1. Contractionary policy

It aims at reducing the supply of money in the hands of the public and also at decreasing the certain of credit. To achieve this, it offers government securities and treasury bills for sale through the commercial banks. When the public and other institutions purchase these securities through cheques drawn on the commercial banks, there is a withdrawal of money from their accounts with the banks. Hence, there occurs a decrease in the cash reserves of banks thereby reducing their capacity to credit. There is thus a decrease in the money supply.

Effects of Contractionary Monetary Policy

Contractionary monetary policy aims to reduce the money supply and increase interest rates to control inflation and stabilize the economy. The effects of contractionary monetary policy can be both positive and negative, depending on the context and how aggressively the policy is implemented. Here are the key effects:

 

Positive Effects

1. Reduced Inflation:

• Primary Goal: One of the main objectives of contractionary monetary policy is to reduce inflation. By making borrowing more expensive and reducing the money supply, demand for goods and services decreases, which can help bring down prices.
• Stabilized Prices: Controlled inflation leads to more predictable pricing, which benefits consumers and businesses by allowing for more accurate financial planning and budgeting.

2. Controlled Economic Overheating:

• Preventing Bubbles: By curbing excessive growth, contractionary policy helps prevent asset bubbles in markets such as real estate and stocks, which can lead to economic instability if they burst.
• Sustainable Growth: Ensuring that economic growth does not exceed sustainable levels can promote long-term economic stability and health.

3. Stronger Currency:

• Attracting Foreign Investment: Higher interest rates can attract foreign investors seeking better returns, leading to an appreciation of the domestic currency.
• Improved Trade Balance: A stronger currency can reduce the cost of imports and improve the trade balance by making exports more expensive and imports cheaper.

 

Negative Effects

1. Slower Economic Growth:

• Reduced Consumer Spending: Higher interest rates increase the cost of borrowing for consumers, leading to reduced spending on big-ticket items like homes and cars.
• Lower Business Investment: Businesses may cut back on investment in new projects, equipment, and expansion due to higher borrowing costs.

2. Increased Unemployment:

• Job Cuts: As economic activity slows, businesses may respond by reducing their workforce to cut costs, leading to higher unemployment rates.
• Reduced Hiring: Companies may be less likely to hire new employees during periods of slower growth.

3. Reduced Consumer and Business Confidence:

• Uncertainty: Higher interest rates and reduced economic activity can lead to uncertainty and reduced confidence among consumers and businesses.
• Lower Spending and Investment: Reduced confidence can further decrease spending and investment, compounding the effects of the contractionary policy.

4. Higher Borrowing Costs:

• Debt Servicing: For individuals and businesses with existing variable-rate debt, higher interest rates increase the cost of servicing this debt, reducing disposable income and profits.
• Credit Access: Tighter monetary policy can make it more difficult for consumers and businesses to access credit.

5. Potential for Recession:

• Economic Downturn: If contractionary policies are too aggressive, they can push the economy into a recession, characterized by negative growth, high unemployment, and reduced economic activity.
• Policy Risks: Balancing the need to control inflation with the risk of causing a recession is a critical challenge for central banks.

2. Expansionary monetary policy

It aims at raising the supply of money in the hands of the public and also at increasing the creation of credit. To achieve this, it purchases government securities and treasury bills through the commercial banks. When the public and other institutions sell these securities, there is an increase in the flow of money to their accounts with the banks. Hence, there occurs an increase in the bank’s deposits and also in their cash reserve. This improves their capacity to create credit. There is , thus, an increase in the money  supply.

Effects of expansionary monetary policy

Expansionary monetary policy is implemented to stimulate economic growth, increase employment, and prevent or mitigate recessions by increasing the money supply and lowering interest rates. Here are the primary effects of expansionary monetary policy:

 

Positive Effects

1. Increased Economic Growth:

• Boosting Spending: Lower interest rates reduce the cost of borrowing, encouraging consumers to spend more on goods and services, which stimulates economic activity.
• Business Investment: Cheaper credit facilitates businesses’ investment in new projects, equipment, and expansion, leading to increased production and economic growth.

2. Reduced Unemployment:

• Job Creation: Higher demand for goods and services leads businesses to hire more workers to meet increased production needs, reducing unemployment rates.
• Support for New Ventures: Easier access to credit can help new businesses start and grow, further contributing to job creation.

3. Higher Consumer and Business Confidence:

• Economic Optimism: Lower interest rates and increased economic activity can boost confidence among consumers and businesses, leading to more spending and investment.
• Financial Stability: Expansionary policy can help stabilize financial markets during periods of economic uncertainty, improving overall confidence in the economy.

4. Improved Credit Conditions:

• Easier Borrowing: Lower interest rates make loans and mortgages more affordable for consumers and businesses, increasing access to credit.
• Debt Servicing: Reduced interest rates lower the cost of servicing existing variable-rate debt, freeing up more disposable income for consumers and profits for businesses.

5. Weaker Currency:

• Export Competitiveness: Lower interest rates can lead to a depreciation of the domestic currency, making exports cheaper and more competitive in international markets, which can boost export-related industries.
• Trade Balance: A weaker currency can reduce the trade deficit by increasing exports and reducing imports.

Negative Effects

1. Higher Inflation:

• Demand-Pull Inflation: Increased consumer and business spending can lead to higher demand for goods and services, which, if supply does not keep pace, can cause prices to rise.
• Asset Price Inflation: Prolonged low-interest rates can lead to excessive investment in assets like real estate and stocks, potentially creating bubbles that could burst and destabilize the economy.

2. Reduced Savings:

• Lower Returns: Lower interest rates mean lower returns on savings accounts and fixed-income investments, which can discourage savings and affect income for savers, particularly retirees.
• Risk-Taking: Investors may seek higher returns by investing in riskier assets, which can increase financial market volatility.

3. Potential for Overheating:

• Unsustainable Growth: If the economy grows too rapidly due to expansionary policy, it can lead to overheating, characterized by high inflation, excessive debt, and imbalances in the economy.
• Resource Constraints: Rapid growth can strain resources, leading to bottlenecks and inefficiencies.

4. Debt Accumulation:

• Consumer and Corporate Debt: Easier access to credit can lead to increased borrowing by consumers and businesses, potentially resulting in high levels of debt that could be difficult to manage if economic conditions change.
• Government Debt: Expansionary policy can also lead to increased government borrowing and debt, especially if fiscal policy is also expansionary.