The Economy's Thermostat
Monetary policy is the central bank's management of interest rates and the money supply to keep inflation low and output stable. In the euro area, the European Central Bank (ECB) targets an inflation rate near 2%.
The main lever: the policy interest rate, the rate at which commercial banks borrow from the central bank. It ripples outward: bank funding costs → loan and mortgage rates → spending and investment.
| Stance | When to Use | Action | Economic Chain |
|---|---|---|---|
| Expansionary | Economy weak, inflation low | Cut policy rate | Cheap credit → spending rises |
| Restrictive | Inflation high | Raise policy rate | Dear credit → demand cools |
Mechanics & Limits
How banks multiply money. Banks keep a fraction of deposits as reserves and lend the rest. With reserve ratio , the money multiplier is . A 10% ratio turns 1,000€ into up to 10,000€ in total deposits.
Transmission lags. Policy changes reach prices only after 6–24 months, so central banks steer by forecast. Expectations of future policy move markets before the actual rate change hits.
Common pitfall: Treating the multiplier as a strict prediction. It is an upper bound; if banks hold excess reserves or borrowers stay away, actual money creation falls short.