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What is Monetary Policy?

Governments use monetary policy to influence economic goals such as inflation, unemployment, interest rates and exchange rates.

Monetary policy is the regulation of interest rates and the availability of money in order to provide sustainable growth and prevent hard crashes in the market.

They can do this by setting a target interest rate or a target exchange rate, and then buying and selling government bonds or currency to achieve their target rates.

Easing the monetary policy, which is expansionary, means that interest rates or exchange rates are lowered and the total supply of money in the economy is increased. A contractionary policy, which involves tightening the policy, has the opposite outcome.

Monetary policy determines interest rates - in Singapore's case, by way of tweaking the exchange rate. In Australia terms, The Reserve Bank of Australia (RBA) is responsible for formulating and implementing monetary policy. While in U.S., the U.S. Federal Reserve determines its monetary policy.

Monetary policy works by first considering how the economy is performing. In more difficult times when the economy is down, a lowering of interest rates may be needed in order to stimulate borrowing. As borrowing increases, so will economic activity associated with that borrowing, which will create jobs and provide money for others. If the economy is going well, the Federal Reserve or other governing body may become concerned there is too much growth, which could set the economy up for a hard crash. To try to avoid that, there may be an increase in interest rates to try to gently cool off the economy.

However, any institution that controls monetary policy needs to be aware that interest rates are tied to inflation to a great degree. As interest rates are lowered, money becomes cheaper to borrow and more is passed around. This devalues the currency by leading to an oversupply, which causes inflation to increase. If interest rates are raised, then inflation may decrease because there is less money flowing through the system and it, therefore, becomes more valuable.

Easing monetary policy can help encourage consumer borrowing and spending in a downturn, while tightening monetary policy can help tackle inflation.

What is Tight Monetary Policy?