Monetary Policy
BeginnerMonetary policy is the set of actions a central bank takes to influence interest rates, the supply of money and credit conditions, in order to achieve goals such as stable prices and steady economic growth.
The main tool of monetary policy is the central bank's policy interest rate, the rate at which it lends to or pays interest to commercial banks. Changes in this rate ripple through the economy, affecting the interest rates on mortgages, business loans, savings accounts and bonds.
When inflation is too high, a central bank tightens monetary policy by raising interest rates. Borrowing becomes more expensive and saving more attractive, so households and businesses spend less, which eases pressure on prices. When the economy is weak and inflation is low, the central bank loosens policy by cutting rates, encouraging borrowing and spending.
For example, raising the policy rate from 3% to 4% might add to monthly payments for borrowers on variable-rate mortgages and lead businesses to postpone investment, gradually slowing inflation.
Central banks also use other tools, such as buying government bonds to lower long-term interest rates, a policy known as quantitative easing. The effects of monetary policy take time, often a year or more, to work through the economy fully, which makes timing decisions difficult.
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