Monetary Policy
Authors: Jose Benjamin J. De la Cruz, Roland Ezekiel M. Devesa, Naomi Chyla G. Choo
Monetary policies are measures used by a country’s central bank to control the overall supply of money in the economy in order to spur or slow down economic growth, depending on what the situation calls for. It differs from the previously discussed Fiscal policy which is a tool used by the government to influence the economy. Depending on the situation, monetary policy could either be contractionary or expansionary. This type of economic policy employs different strategies that involve adjusting interest rates, open market operations (OMO), and regulating reserve requirements. (‘Monetary policy,’ 2022)
Countries implement different monetary policy frameworks depending on their economic situation, and these frameworks could change over time. In our case, the Bangko Sentral ng Pilipinas (BSP) currently employs an inflation targeting framework that aims to maintain price stability that fosters balanced and sustainable economic growth (Bangko Sentral ng Pilipinas, n.d.). Apart from stabilizing inflation, Monetary Policy can also be implemented to decrease unemployment and influence exchange rates (‘Monetary Policy,’ 2022), as well as, manage economic fluctuations (International Monetary Fund, 2022).
It is important for us to learn about Monetary Policy because it can help us understand how central banks operate to mitigate the effects of economic crises such as high inflation. With this, we can recognize the possible economic impact of the measures implemented by the central bank. As investors, we may also be able to plan the best time to buy or sell investments by considering the consequences of a central bank’s Monetary Policy on the prices of assets and potential investments.
Types of Monetary Policy
There are 2 main types of monetary policy by objective. The first is called contractionary monetary policy. This is usually employed if the inflation rate is getting too high, and the central bank seeks to lower the money supply in response. Contractionary monetary policy will typically involve increasing the discount rate, which is the rate imposed by a central bank to other banks for short-term loans (Corporate Finance Institute, 2022). If the discount rate increases, a bank’s lending cost increases as well, which discourages consumers from borrowing money. This decreases the money supply in circulation and reduces spending. In turn, this pushes down demand for goods and services which can cause inflation to fall.
A contractionary monetary policy can also mean increasing the reserve requirement of banks. By increasing the reserve requirement, banks are required to hold in more cash and liquid assets as reserve, which reduces the amount of money they can lend to customers. This again reduces the money supply. Another notable effect of contractionary monetary policy is that it could increase the demand for domestic bonds as the central bank engages in Open Market Operations (Chen, 2020). This also works to reduce the money in circulation when the government sells and issues domestic bonds to potential lenders, who will then pay cash to the government in return.
The second type of monetary policy is expansionary monetary policy. While contractionary policy aims to mainly combat inflation, expansionary policy is used to combat recession and unemployment. This type of policy involves decreasing the discount rates and reserve requirements imposed on banks, allowing for more cash in circulation (‘Expansionary Policy,’ 2020). With this in mind, it also means that a policy such as this allows for greater consumer spending, and consequently, also stimulates business activity. More money supply means more money to be used in business expansion and job creation, which typically leads to higher economic activity.
Effects of monetary policies on investments
Regardless of the long term stabilizing effects of monetary policies on the economy as a whole, it affects different securities in various ways. For example, expansionary policies are often associated with rallies in the stock market. This is because low interest rates make the cost of borrowing capital lower for companies, thus allowing them to invest more in their businesses and grow their output faster (‘How monetary policy affects,’ 2021). Additionally, as discussed above, expansionary policy increases the money in circulation and makes it easier for the public to borrow in general. These promote consumer spending which may contribute to higher revenues for many companies, possibly influencing stocks to perform better in the short run.
Another asset that tends to appreciate during periods of expansionary policy is real estate. Again, the low interest rates make it easier for consumers to take on loans, including mortgages. Houses, land, and other forms of real estate may experience increased demand because of this, which could then increase their value.
Conversely, contractionary policies can cause stocks to underperform as investors have decreased risk appetites considering the impending slowdown of the economy. Consumers’ lower spending power could eventually translate to lower corporate earnings as well, which may cause less favorable expectations on companies’ potential for growth in the current economic conditions.
However, investments such as debt securities have an inverse relationship with interest rates. For example, bonds pay a fixed yield depending on the concurrent interest rate they are issued at. This means that, during periods of contractionary policy, newly issued bonds would pay a relatively higher yield because of the higher interest rates. Thus, there is generally greater demand for bonds during contractionary policy among investors as these give better returns, as compared to periods of expansionary policy when interest rates, and thus yield, are relatively lower (PNC Insights, 2022).
Conclusion
Monetary policies are measures used by a country’s central bank to control the overall supply of money in order to stabilize the economy. This policy employs different strategies that may involve adjusting interest rates, reserve requirements, and open market operations. These could either be contractionary or expansionary in nature, depending on current economic conditions and the central bank’s inflation targeting objective. It is important to keep track of monetary policies as these have impacts not just on the economy as a whole, but also on various assets such as stocks and bonds. It also affects consumers’ ability to take on loans for their houses, cars, and general expenses, which means that these policies are also relevant to the general public in addition to investors.
References
Bangko Sentral ng Pilipinas. (n.d.). Monetary policy in the Philippines: A look at the central
bank’s changing approach. Retrieved November 19, 2022, from
https://www.bsp.gov.ph/Media_And_Research/Learning%20Materials/Q32019.pdf
Chen, J. (2020, December 14). What is contractionary policy? Definition, purpose, and
examples. Investopedia. https://www.investopedia.com/terms/c/contractionary-
policy.asp
Corporate Finance Institute. (2022, May 8). Monetary policy. Retrieved November 24, 2022,
Expansionary Policy. (2020, November 1). Investopedia.
https://www.investopedia.com/terms/e/expansionary_policy.asp
How Monetary Policy Affects Your Investments. (n.d.). Investopedia.
International Monetary Fund. (2022, March 3). Monetary policy and central banking.
Retrieved November 19, 2022 from
Monetary policy, meaning, types, and Tools. (2022, July 25). Investopedia. Retrieved
November 19, 2022 from, https://www.investopedia.com/terms/m/monetarypolicy.asp
PNC Insights (2022, March 1). How the Federal Reserve monetary policy can impact your
investments. PNC Insights.com. Retrieved November 25, 2022 from
https://www.pnc.com/insights/personal-finance/invest/how-federal-reserve-monetary-
policy-impacts-investments.html
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