Monetary Policy Explained: How Central Banks Influence the Economy

Though central banks may have been created with various missions, like creating “maximum employment,” as the United State’s Federal Reserve was tasked with doing when it was created in 1913, the primary lever they have to affect change is through interest rates.

If an economy is sluggish, and inflation isn’t a problem, standard monetary policy would be for the central bank to lower interest rates, that is, decrease the cost of borrowing money for everyone from huge corporations on down to the guy next door who wants Toyota payments he can afford. The fancy term for lowering interest rates is expansionary monetary policy. Conversely, if an economy is operating too well, that is, money is too prevalent and available, inflation will occur, and a currency will become less valuable, creating conditions where in extreme cases, citizens may need to roll a wheelbarrow full of paper currency to the store to buy a bar of soap. Raising interest rates to slow growth is called contractionary monetary policy.

Monetary policy may also include dictating how much banks must keep in reserve to guard against bank runs. Economies that are unable to lower interest rates because of inflation, may try to stimulate an economy using quantitative easing, a process in which a government buys large chunks of its own assets, like bonds, and the cash that it has paid itself will make its way into the country's banks, who will be free to lend it out, stimulating the entire economy.