Monetary policy
What is monetary policy?
Monetary policy is a set of actions central banks or governments can take to help control how much money is in the economy and how much it costs to borrow money. The main aim of monetary policy is to keep the prices of things low and stable.
There are two main monetary policy tools – interest rates and quantitative easing.
The interest rate is set by central banks – officially called the bank rate. In the UK, it’s set and reviewed every six weeks by the Monetary Policy Committee (MPC), part of the Bank of England (BoE).
The bank rate is the rate of interest central banks, such as the BoE, pay commercial banks to keep their money with them. This has a big influence on the interest rate consumers receive on their cash savings and the cost to borrowing on loans, such as mortgages.
Quantitative easing (QE) is where central banks purchase bonds to lower interest rates on savings and loans.
In theory, buying bonds increases the price of bonds which should mean that bond yields, or the rate of interest, goes down. This process increases money supply which encourages spending on goods and services to help stimulate the economy.
Who controls monetary policy?
Monetary policy is controlled by the country’s central bank or government. In the UK, monetary policy is controlled by the Bank of England (BoE) – the UK central bank.
The US central bank, the Fed Reserve (FED), has authority over the US’s monetary policy.
What is an expansionary monetary policy?
Expansionary monetary policy is where central banks are looking to increase the money supply in the economy to stimulate growth and keep inflation at the target which is normally set by the government. In the UK, the inflation target is 2%.
In this scenario, central banks will be looking to increase the value of bond buying programs and keep interest rates on savings low.
What is a contractionary monetary policy?
Contractionary monetary policy is the opposite to an expansionary monetary policy. Central banks will look to contract the supply of money in the economy by selling bonds. This is called Quantitative Tightening (QT).
What is the difference between monetary and fiscal policy?
Monetary policy and fiscal policy are both tools to influence the economy and are similar in terms of their aim of achieving positive economic growth and keeping inflation low.
However, there are some key differences to note:
| Monetary policy | Fiscal policy |
|---|---|
| Interest rates and money supply | Government spending and taxes |
| Set by a central bank | Set by the government |
| Impacts exchange rates and bond yields | Impacts government deficit/surplus and borrowing |
| Independent from political intervention | Strong link to political policies |
| Inflation target | No inflation target |
Related topics
Read more related glossary terms
Base interest rate
A base rate is the interest rate central banks, like the Bank of England (BoE) in the UK, will charge commercial banks and building societies for loans. The base rate is also known as the bank rate or the base interest rate.
Inflation
Inflation measures how much the price for goods and services has gone up over time.