How monetary policy works: practical examples of its impact

Monetary policy is the set of decisions made by central banks to regulate the amount of money available in an economy and control interest rates. Its main purpose is to maintain economic stability, prevent runaway inflation, and promote growth. Although it seems like an abstract concept, its effects are felt directly in the pocket of every individual.

The two sides of monetary policy

There are two main approaches that monetary authorities can implement according to economic needs. The contractionary monetary policy seeks to curb economic growth when inflation is out of control. In these cases, the central bank may raise interest rates, making borrowing more expensive for businesses and citizens. This reduces the amount of money circulating in the economy and prices rise less.

On the contrary, the expansive monetary policy aims to reactivate a stagnant economy. The central bank lowers interest rates, facilitates access to credit, and purchases financial assets. This puts more money in the hands of investors and consumers, stimulating spending and investment.

Concrete examples of monetary policy

When a central bank sells government bonds and treasury securities to commercial financial institutions, it is draining liquidity from the economy. Banks end up with less money to lend, raise their interest rates, and fewer people access credit. This is a clear example of contractionary monetary policy.

On the opposite side, if the central bank reduces reserve requirements ( the amount of money that banks must hold in cash ), they automatically have more funds available to lend. Banks compete with each other by lowering interest rates, which encourages new loans and more investment. This mechanism is typical of an expansive monetary policy.

The dilemma between growth and inflation

Here lies the real challenge of monetary policy: every measure has consequences. A contractionary policy slows down inflation, but it also slows economic growth and can increase unemployment. People and businesses borrow less money, reduce investments, and consume less.

An expansive monetary policy stimulates employment and growth, but it can lead to rampant inflation. Additionally, it can weaken the country's currency, which makes exports cheaper (benefit) but makes imports more expensive (problem).

How central banks control money

Central banks use various instruments to implement their monetary policy. They adjust benchmark interest rates, buy and sell securities in the open market, and modify the reserve requirements that financial institutions must maintain. Each of these moves generates waves that ripple throughout the economy.

Monetary policy is decisive because it defines the pace of economic expansion or contraction. Understanding its mechanisms and examples helps to understand why credit conditions change, investment yields rise or fall, and how the central bank attempts to maintain a balance between stability and growth.