Understanding Monetary Policies in Relation to Investments

Cost Value Matrix - Arrow and TargetMonetary Policies represent the actions taken by a central bank to control the supply of money and credit available in an economy. Since the supply of money and credit available to an economy will dictate the way in which the markets within will behave, it is important for a personal investor to understand how it is that the economy will react to different monetary policies, and how it is that they combine with the other aspects of the market as a whole. Once we have that understanding, we can start to look ahead at how it is that government involvement in the markets will have an impact on our personal portfolios.

Monetary policy can be considered to be expansionary, neutral, or Contractionary. An expansionary monetary policy refers to a strategy of increasing the money supply available to markets through either increased access to credit, or direct inflation. A Contractionary policy is the exact opposite of an expansionary policy, in that it aims to slow down the growth of the economy. Lastly, a neutral policy aims to maintain a constant rate of growth in the money supply in the interests of maintaining predictability.

There are two ways for a central bank to increase the supply of money within an economy. The first is to physically print new money. In doing so, the funds are distributed strategically to institutions that are most capable of redistributing the wealth throughout the economy as a whole. While expansionary in practice, this strategy is usually saved for situations pertaining to the servicing of debt. Governments will generally save direct inflation strategies for when they need to repay bonds that they are having trouble servicing, so as to prevent a default. Instead, they tend to prefer manipulating the credit constraints that are placed on banks, so as to promote money growth of the economy through the private markets.

Money multiplication works on the assumption that only a fraction of all deposits placed within a bank will ever be required on-hand for withdrawal at any given time. As such, banks are able to operate by lending out a certain percentage of their holdings to borrowers, while still maintaining an amount of cash on hand that will ensure that customers seeking their deposits will be able to access them.

Assuming borrowing institutions are then re-investing these funds, we will actually see the amount of money in the economy effectively increase by a factor known as the money multiplier, which will in turn either stimulate, or discourage demand. For example, by reducing the restrictions placed on lending institutions for the amount of money that they need to hold on reserve, they will be able to lend out more funds, and therefore reduce the costs of debt associated with the funds being provided. This will in turn make capital more affordable, and therefore increase the demand for goods purchased.

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