Monetary policy refers to the actions and communications of a central bank that manages the money supply. This money supply includes various forms of cash, credit, money market mutual fund, and checks. Among these, credit is most important. It includes mortgages, loans, and bonds. Monetary policies increase liquidity to generate economic growth, and it reduces liquidity to avoid inflation. The three main goals of a monetary policy are controlling inflation, maintaining long-term interest rates, and managing employment levels.
What Is Monetary Policy?
Monetary Policy is a process of outlining, announcing, and implementing a plan of action. The plan of action is formulated by the currency board, central bank, or other capable monetary authorities of control. These authorities are generally responsible for controlling the amount of money in a country’s economy. They also control the channels from where new money comes.
The monetary policy includes the management of interest rates and money supply. It intends to meet macroeconomic goals like controlling consumption, growth, inflation, and liquidity.
Types of Monetary Policy
Monetary policies are categorized as:
Expansionary: If a specific country is experiencing a high unemployment rate during a recession or a slowdown. The monetary authorities can go for the expansionary policy. It intends to increase economic growth and expand economic activities. Since monetary authorities are a part of the expansionary policy, they generally lower the interest rate via various measures. It helps them serve to promote spending of money and make a saving of money pretty unfavorable. An increase in the supply of money in the market boosts consumer spending and investment. A lower rate of interest means that individuals and businesses can secure a loan on suitable terms to spend more on expensive consumer goods and expand productive activities.
Contractionary: Increase in the supply of money can result in higher inflation, an increase in the costs of doing business, and costs of living. With a contractionary policy, the interest rates increase while the money supply slows down to bring inflation down. It, in turn, can slow down economic growth and boost unemployment. But it is frequently vital to implement this to keep the economy in check and cool it down.
How Does Monetary Policy Affect the Value of Currencies?
Effect of Expansionary Policy On the Value of Currencies
By implementing an expansionary policy, a central bank cuts down the interest rates. With a reduction in the interest rates, the country’s capital and financial assets become less attractive due to their low rate of return. Foreign investors cut down their positions in real estate, stocks, domestic bonds, and other assets. Domestic investors will also abstain from investing money in their country. They will look for a better rate of returns overseas. It contributes to the increase in a foreign country’s account balance. A steep decline in domestic investment activities will result in low domestic currency demand and higher demand for a foreign currency. Thus the domestic currency’s exchange rate will decrease.
When it comes to expansionary monetary policy, there is a possibility of higher inflation. It is mainly because of the large amount of money available in the country’s economy. So, this decreases the spending power, and the currency becomes less valuable. Thus, when a central bank implements an expansionary policy, it harms the worth of the country’s currency.
Effect of Contractionary Policy on the Value of Currencies
By implementing a contractionary policy, there is an increase in interest rates. With this increase, capital and financial assets become more attractive due to their higher rate of returns. Foreign investors expand their position in real estate, bonds, stocks, and more. The capital account of the country improves. Domestic investors also become keener to invest money in their country. The rise in domestic investment activities results in higher demands for the country’s domestic currency. Hence, the currency’s exchange rate increases.
So, if a central bank implements a contractionary policy, it causes a positive impact on the value of a currency.
Effect of Monetary Policy on the Forex Market
The exchange rate in the Forex market draws a large amount of attention in a monetary policy. Changes in an exchange rate are vital for countries that stabilize the currency exchange rate to targeting or another country’s currency. A monetary policy can affect the exchange rate in the Forex market through three main channels:
- Effect of monetary policy as per the kind of currency system
A monetary policy has different effects on the exchange rates depending on the country’s kind of currency system. If a central bank applies the expansionary policy, then an increase in a country’s money supply will decrease the interest rates. If all other conditions remain constant, a capital outflow occurs. It raises the exchange rate in the Forex market and reduces the currency supply. If the system works on a fixed regime, then the central bank will intervene in the Forex market and does not let the exchange rate increase. Hence, a few of its reserves will come into the market. With the floating regime, the exchange rates increase, and the central bank will not interfere. Since the exchange rate increases, imports decrease, and exports increase.
- Effect of Monetary Policy Based on Price Levels
If a central bank applies an expansionary policy, an increase in the supply of money will also increase the price levels. Boost in the domestic prices will make all the domestic goods costlier as compared to the foreign goods. Hence the competitiveness of export falls in the worldwide market. Decreasing the competitiveness power increases the imports and decreases exports. So, the demand for foreign currency increase by importers, and the supply of currencies reduces. It, in turn, raises the exchange rates in the Forex market from two channels.
- Effect of Monetary Policy Concerning Portfolio
When a central bank applies an expansionary policy, an increase in money supply reduces the interest rates. Reduction in the interest rate does not attract people to deposit capital in the banks. So, people generally withdraw their money and invest in other markets like Forex with forex broker platforms. If the rate of interest is low and other conditions are stable, returns of currencies increase, and their demand also rises. This increasing demand gets a boost for the currency in the Forex market.
Changes in the monetary policy can have a substantial impact on a currency and its exchange rates. But by being cautious of the nuances associated with monetary policies, traders can position their portfolio correctly and advantage from the changes in policy and boost returns.