The actions of a monetary authority in determining the money supply of an economy, and its rate of growth.
This in turn affects interest rates. The goal of monetary policy is to influence the economy and the inflation rate.
Expansionary monetary policy involves increasing money supply or decreasing interest rates and generally aims at encouraging economic growth and reducing unemployment.
Consumers can either spend or save. Lower interest rates discourage saving (as the return on money saved is relatively low) and thus encourages consumption.
Low interest rates incentivise corporations to borrow in order to invest in profitable project.
Therefore the combination of increased money in circulation and lower interest rates expands the economy by increasing consumption expenditure and investment expenditure.
If the money supply grows too fast, however, the rate of inflation will increase, as the increase in consumption and investment results in an increase in the overall demand for goods and services in an economy. If the supply of goods and services is fixed, this creates a situation of scarcity, which puts upward pressure on the price level.
Contractionary or tightening monetary policy involves reducing money supply growth or increasing interest rates and is aimed at slowing down an economy.
Higher interest rates encourage saving and thus a lower amount of income is spent on goods and services. Companies face a higher cost of financing investments and are therefore discouraged from investing.
The combination of less money in circulation and higher interest rates constrains the economy by reducing consumption expenditure and investment expenditure. This type of policy is usually used when the inflation rate is higher than the central bank’s target. Because of the threat of inflation from excessive money supply growth, such actions can sometimes be necessary.
If monetary policy is tightened too much, and authorities go too far in cooling down the economy, recession or deflation could result.