Definition of monetary policy: The policies and programmes put in place typically by a central bank to control the money supply of an economy.

What is monetary policy?

Monetary policy relates to the decisions taken by a central bank when making changes to the money supply of a country. Economics books tend to focus on monetary policy perhaps more than any other driving factor because such policy is placed within the control of a few economists.

The key lever available to monetary policy setters which sits at the heart of monetary policy is the official interest rate.

Changes to the official rate will change the disposable income available to households, and will change behaviour with regards to saving versus spending. The rate is therefore a powerful tool. Monetary policy can be used to ‘cool down’ or ‘speed up’ the economy.

Monetary policy also relates to other methods of impacting the supply of currency to an economy. Central banks can reduce or increase the supply of money quite simply by printing more money and using this to buy back government bonds. This injects the cash into the economy. This is known as quantitative easing and was engaged in on a massive scale following the 2007 – 2011 financial crisis.

How does a change in the official interest rate impact the economy?

This is a key national reference rate which many loan agreements, business agreements and other contracts are based upon. For example, mortgages in the UK which refer to the ‘Standard Variable Rate’ or SVR are usually calculated as the official rate plus a fixed percentage.

Therefore, a small change in the official rate of interest will have a direct impact on these contracts.

The official rate is also usually the rate at which commercial retail and investment banks can borrow funds from the central bank. A change in this rate therefore has an impact upon the cost of finance across banking in general. The supply of funds from the central bank is seen as a key ‘input cost’ in the supply chain of finance. If this cheap source becomes more costly, then banks will naturally wish to pass this cost onto borrowers indirectly in the form of general rates increases across their savings and loan products.

Whether they feel it directly or indirectly, changes to the official interest rate will be felt by many households. Let’s consider the impact on two groups of people – wealthy retirees with savings, and young borrowers with a mortgage.

If interest rates rise:

• Retirees may see their savings account interest rates improve. Their income will increase, allowing them to spend more in the economy.
• Borrowers may experience an increase in their monthly mortgage payment, which will leave them with less disposable income to spend on consumable goods.

If interest rates fall, the opposite will occur. Savers may be ‘penalised’ and borrowers may enjoy a saving on their monthly payments.

This is all hypothetical, as many savings and borrowing products include ‘fixed rates’, which are contractually agreed between the bank and consumer, and will not change over the agreed period. However, as these fixed periods end, the consumer will need to switch to a variable rate or a new product – both of which will have been re-priced based on the latest official rate.

As a result, we cannot say that fixed rates ‘protect’ households from interest rate changes, they merely delay the impact.

How is monetary policy set?

Central banks are more effective when they are free to make independent decisions about the money supply in an independent way, free from political interference.

This way, the judgements can be made purely on the best information available, analysed through the lens of macroeconomics to help the bankers predict the impact of their action (or inaction).

This is one of the reasons why central banks generally set monetary policy rather than the treasury department of a democratically elected body such as a parliament or congress.

It’s also the reason why monetary policy is usually clearly defined and communicated to the public in a transparent way.

For example, the minutes taken at meetings of the Monetary Policy Committee of the Bank of England in the UK are regularly published and are available to read here.

This way, the public, including investors and banks, can understand the arguements considered by the committee when reaching their decision.

This is done both to increase confidence in the ability of central banks to take appropriate actions if needed, but also to communicate what factors or circumstances might cause a central bank’s committee to change course.

Of course, not all central banks are run in this way. The Reserve Bank of Australia, for example, is not as transparent as many of its peers in the way it communicates with the public, leading to calls for its reform.

How is the phrase monetary policy used in a sentence?

“The Monetary Policy Committee of the Bank of England set monetary policy, including the official interest rate.”

Why monetary policy matters

As you may have realised, monetary policy is a very powerful tool which can have a widespread impact on the economy.

From a macroeconomics perspective, monetary policy is an intervention – a manual piece of interference to the free market.

This means that changes made to the interest rate may move the market for finance away from its market equilibrium – the rate at which supply and demand for credit is equal.

This is why the monetary policy commitee deliberate in detail and take so much time over this single percentage.

If the rate is raised too high, aggregate demand in the economy could fall and tip the country into a great recession.

If the rate is kept artificially low, the economy may ‘overheat’. This is where too much cash is pumped into an economy that had no need for it. Price inflation picks up, asset bubbles appear, and the risk of eventual crash increases.

In the most extreme of cases, poor monetary policy can lead to hyperinflation, where trust in the supply of money becomes so poor that a currency becomes practically worthless.

How does the definition of monetary policy relate to investing?

As I explain in the macroeconomics definition, factors like interest rates and inflation can directly impact the performance of entire asset classes such as shares, property, bonds and commodities.

I recommend you check out the best investing books and investing courses to become an expert on monetary policy, and how it interacts with investing.