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Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often as an attempt to reduce inflation or the interest rate, to ensure price stability and general trust of the value and stability of the nation's currency.
Monetary policy is a modification of the supply of money, i.e. "printing" more money, or decreasing the money supply by changing interest rates or removing excess reserves. This is in contrast to fiscal policy, which relies on taxation, government spending, and government borrowing as methods for a government to manage business cycle phenomena such as recessions.
Further purposes of a monetary policy are usually to contribute to the stability of gross domestic product, to achieve and maintain low unemployment, and to maintain predictable exchange rates with other currencies.
Monetary economics can provide insight into crafting optimal monetary policy. In developed countries, monetary policy is generally formed separately from fiscal policy.
Monetary policy is referred to as being either expansionary or contractionary.
Expansionary policy occurs when a monetary authority uses its procedures to stimulate the economy. An expansionary policy maintains short-term interest rates at a lower than usual rate or increases the total supply of money in the economy more rapidly than usual. It is traditionally used to try to reduce unemployment during a recession by decreasing interest rates in the hope that less expensive credit will entice businesses into borrowing more money and thereby expanding. This would increase aggregate demand (the overall demand for all goods and services in an economy), which would increase short-term growth as measured by increase of gross domestic product (GDP). Expansionary monetary policy, by increasing the amount of currency in circulation, usually diminishes the value of the currency relative to other currencies (the exchange rate), in which case foreign purchasers will be able to purchase more with their currency in the country with the devalued currency.
Contractionary policy maintains short-term interest rates greater than usual, slows the rate of growth of the money supply, or even decreases it to slow short-term economic growth and lessen inflation. Contractionary policy can result in increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession if implemented too vigorously.
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