Monetary policy differs from fiscal policy as it is the action by which the monetary authorities, particularly the reserve bank influences the money supply to accomplish its goal of price stability.
It is also referred to as either being an expansionary policy, or a contractionary policy, and it strives to achieve the various objectives of economic policy, which include economic growth, full employment and external equilibrium.
To attain their respective policy objectives, central banks tackle the money supply and interest rates, thus act on the financing conditions in the economy. Typically, this is achieved through setting realistic milestones, which are ideally achievable in the short, medium or long term basis.
According to modern economic theory, the purpose of the central banks is to maximize the economic welfare of households, hence the importance of price stabilization efforts. And as such, price stability is a prerequisite for sustained economic activity.
A policy is known as contractionary whenever the reduction of money supply or a hike in the interest rate is involved. On the other hand, the opposite which relates to an expansionary policy inflates the volume of money supply, while cutting down the interest rate. Additionally, policies meant to promote economic growth are described as accommodative, and policies which neither promote growth or curb inflation are said to be neutral.
The quantity theory of money dictates that there is no trade-off between long-term price stability and economic activity because money is neutral in the long term.
Monetary policy can be designed to maintain the exchange rate of the national currency with another currency or basket of currencies. The fixed exchange rate can be maintained by the central bank by selling or buying foreign currencies on a daily basis to achieve the target rate.
The central bank interest rate policy is critical to the financial conditions of companies and consumers alike. While bond yields are the result of supply and demand influenced indirectly by the reserve bank’s policy instruments. But there other cases of open capital markets and international capital market situations in which the central bank can influence more sufficiently.
The intermediate objectives, such as aggregates or currency exchange rates established, are interim targets that have no value in themselves, except their correlation with the ultimate goals with which they have a casual relationship, but they are more controllable.
Small countries with a large foreign trade sector, may be more interested in subordinating monetary policy, the subordination in a currency board, can bring in so much money into circulation.