Monetary policy

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Monetary Policy is the process by which a central bank, reserve bank, or monetary authority adjusts mechanisms such as interest rates, required reserve ratios, liquidity levels, foreign exchange rates, and other money supply related measures e.g. asset purchase programs. Typically the goal of monetary policy is price stability, which is often linked to a specific inflation target. Other goals of monetary policy include maximizing economic growth, optimal employment, and financial stability.

The key tool of monetary policy is official interest rates. These interest rates are often strongly linked through to the rest of the interest rates in a financial system, thus changes in the monetary policy interest rate can said to be transmitted through wider market interest rates to effect changes in the broader economy.

Generally banks will increase interest rates to bring down inflation and reduce the risks of asset price bubbles and an overheating economy. Conversely banks will reduce interest rates to stimulate economy activity, and lending, and to encourage risk taking and investment. When a bank lifts interest rates it is called tight monetary policy, will reducing is called loosening.

Thus, clearly the actions around monetary policy have a deep impact on the behavior of participants in an economy and financial system, and have a strong impact on the path of financial markets. This is why investors and traders often pay close attention to monetary policy actions, because they can move the markets by a large degree.