Monetary policy is how the supply of money is controlled within a country. Monetary policy involves the increase or decrease in the money supply by the central bank (in most cases). The money supply is linked directly to the interest rate and thus monetary policy is used to affect the interest rate. Monetary policy can be either expansionary or contractionary (sometimes called loose and tight) with contractionary monetary policy increasing the interest rate and expansionary monetary policy decreasing the interest rate. Lowering interest rates will typically boost the economy by encouraging investment, but this often comes at the price of higher inflation.
The government can change the money supply in three ways. Firstly, it can change the reserve requirements of banks. Reserve requirements are the amount of actual cash that a bank has to hold proportionate to the deposits in the bank. Lower reserve requirements means that the bank can lend out more money. When this happens the supply of money increases which will decrease the interest rate when at equilibrium. Secondly, the central bank can also change it's overnight interest rate that it offers to banks. If the central banks lower it, then the commercial banks will lower interest rates as well due to competition. Lower interest rates will cause an increase in the money supply as people are discourage to save and encouraged to invest. Lastly, the government can engage in open market operations by either buying or selling government bonds which would either decrease or increase the money supply respectively.
Monetary policy is an important concept to know in order to understand economics because it demonstrates how significant decisions are made based on expectations. The relationship between an economy’s interest rates and money supply is what monetary policy is based on. Monetary policy is an important economic concept because it influences parts of the economy that affect our own lives, such as unemployment, inflation, and economic growth.