What is monetary policy and how does it affect investments?

What is monetary policy and how does it affect investments? Learn what monetary policy is and explore its advantages and disadvantages for the stock market.

Capital.com – Reading and listening to various financial news media, we often hear about monetary policy. But do we fully understand what it really means in the investment world? Let’s see.

What is monetary policy and how does it affect investments?

What is monetary policy and how does it affect investments?Talking about monetary policy, we usually refer to strategies and techniques, implemented by central banks, to control money circulation in the economy. These approaches have the primary aim of ensuring long-term economic growth.

Overseeing the money supply by purchasing troubled assets and setting interest rates, most central banks tend to control inflation and deflation. Some of them also work to reduce the unemployment rate and ensure stable prices.

All in all, monetary policy has the following most common goals:

As monetary policy may significantly affect investment portfolios, every investor should at least have a basic understanding of how it works.

What is monetary policy for investments?

There are several types of monetary policy, including:

During the fast growth of economy when inflation rate is getting significantly higher, the central bank can take measures to chill the economy, for example, by increasing short-term interest rates. This is called tight or restrictive monetary policy.

Vice versa, when the economy is slow, the central bank may lower short-term interest rates in order to enhance the economic growth. This technique is known as the accommodative policy.

As we may see, monetary policy has both, direct and indirect impact on the investments. Direct works through the level of interest rates, while the indirect – through beliefs about the inflation direction.

Monetary policy instruments

There are a number of various techniques used by central banks to achieve their goals and control the supply of money. The most popular are open market operations, presupposing the sale and purchase of financial instruments. This tool is meant to affect the federal funds rate in the federal funds market, where banks borrow or keep the required reserve capital.

Open market operations may change the interest rates by buying and selling government securities. Buying creates an influx of cash for banks that may further lend the extra money to other banks and lower the interest rates. Selling government securities means taking cash out of the market.

But what happens when the interest rates are already low? During especially challenging times for the economy, central banks may turn to unconventional techniques to combat the crisis and pump money into the country’s economy:

Quantitative easing 

Quantitative easing is the purchase of financial instruments directly from commercial banks and other financial institutions using newly created money.

Altered maturity dates

Shifting of central bank assets from short-term to long-term, or from long-term to short-term maturity dates. It will help to increase or decrease the amount of available cash.

Advantages and disadvantages of monetary policy

Monetary policy can have a significant and immediate impact on every asset class in the stock market. Lower interest rates stimulate the economy and make loans to purchase securities on margin cheaper.

Regardless of the immediate effects, the advantages of monetary policy are intensely debated by economists. For instance, artificially lowered interest rates do no good for retired citizens, who depend on the percentage from their pensions and savings.

However, depending on the type of investor you are, an aggressive or a conservative one, you can always enhance your returns by positioning your portfolio and benefit from monetary policy accordingly.

About author

This article What is monetary policy and how does it affect investments? was provided by Capital.com.

Capital.com is a fin-tech startup providing an AI-powered trading platform, designed to take trading to the next level. Available on both desktop and smartphone, the trading platform lets users trade CFDs on the world’s top markets including Forex, cryptocurrencies, commodities, indices and more.

The company received a $25 million investment from VP Capital and Larnabel Ventures. Capital.com is licensed by the CySEC.

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