Glossary

Monetary Policy

Monetary policy is how a central bank steers the economy by adjusting how much money is in circulation and how expensive it is to borrow. When the central bank cuts its policy interest rate, loans, car finance, and mortgages all get cheaper — households and firms borrow more, spend more, and the economy picks up. Raising the rate does the opposite: borrowing costs rise, spending cools, and inflation pressure eases.

More precisely, monetary policy refers to deliberate actions by a central bank — such as the U.S. Federal Reserve — to influence the money supply and short-term interest rates. Expansionary (loose) policy lowers rates and grows the money supply to stimulate aggregate demand. Contractionary (tight) policy raises rates to fight inflation. The main tools are open market operations (buying or selling government securities), the policy interest rate (the rate banks pay to borrow overnight), and reserve requirements (the fraction of deposits banks must hold). Because the central bank operates independently of the government's spending and tax decisions, monetary policy is distinct from fiscal policy.

MV = PY

Quantity theory of money

The money supply

M

times its velocity

V

— how often each dollar is spent in a year — equals the price level

P

times real output

Y

. With

V

and

Y

roughly stable in the short run, expanding

M

feeds into a higher price level, which is why sustained money growth tends to produce inflation.

Expansionary monetary policy: A central bank action that lowers interest rates or increases the money supply $M$ to stimulate borrowing and spending, shifting aggregate demand to the right.
Contractionary monetary policy: A central bank action that raises interest rates or reduces $M$ to slow spending and reduce inflation, shifting aggregate demand to the left.
Fiscal policy: Government use of spending and taxation to influence the economy — the counterpart to monetary policy. Unlike monetary policy, fiscal policy is set by elected governments, not independent central banks. See fiscal policy.
Aggregate demand: The total demand for goods and services in an economy at a given price level. Monetary easing shifts the aggregate demand curve rightward by making credit cheaper.