Understanding the impact of monetary policy
Maybe forex trading is not as simple as we think it is since it even involves the national government. A national government is involved because its banking authorities are the ones who create the monetary policies to help them maintain or reach economic goals. Since we are talking about monetary policies, let us also talk about its inseparable twin: the central bank. The monetary policy is an instrument of the central bank to maintain or reach its goals, and these are:
- Interest rates concerning the value of money
- Increasing inflation
- Money supply
- Meeting the reserve requirement over the banks.
- Commercial bank lending
For additional information, reserve requirement means the amount or percentage of the depositor's balances that the banks need to have in hand if someone wants to withdraw their deposited money. Commercial bank lending is through the discount window.
Monetary policy classification
There are several types of monetary policies. Let us name them one by one:
- Contractionary or restrictive. It is an occurrence when the money supply size lessens or when the interest rates increase. The main gist of this monetary policy is slow economic growth, but the interest rates are high. If it is not easy to borrow money, there will be less spending and investment from consumers and businesses.
- Expansionary. As its name suggests, this monetary policy increases the money supply and decreases the interest rate.
- Accommodative. The aim is economic growth through decreasing interest rates. Tight monetary policy lessens inflation and restricts economic growth through increased interest rates.
- Neutral. It is a monetary policy that does not intend to grow or fight inflation, hence neutral.
Inflation
Central banks usually aim for inflation of 2%. Their unspoken rule says that their monetary policies do their best to make it to their comfort zone. So, if inflation is a good thing, then why do they have limits? Imagine this: inflation is already out of control. What would that make of the government? People will doubt the government and their money. Having an inflation level aim, people understand more how the central bank handles the economic landscape.
Stability
In life, it is normal to crave stability. The same is true with trading. Traders, central banks, and economies will always aim for stability. When a trader knows an inflation target, he will also understand the central bank more and what it does.
Tell me more about monetary policies
Monetary policy does not make a drastic change overnight. If it makes changes, it will be little by little. Drastic and fast changes will not happen because they will create chaos for traders and even the whole economy. If the economy wants price stability, it will need to change .25% to 1% only on interest rates. This will also happen very slowly, and when we say slowly, we mean several months to years.
Imagine this:
As traders, we do all sorts
of analysis to become more confident about our following trading decisions. Central banks do the
same. As more prominent entities, they have more significant responsibilities.
They are in charge of making decisions about the economy.
