| Updated: October 23, 2025Monetary policy and its influence on global markets
You will learn about the following concepts
- A bit more about banks’ monetary policy
- Accommodative monetary policy
- Restrictive monetary policy
- How central banks decide which policy to implement
- and more…
Monetary policy
When it comes to the fundamental analysis of a particular nation’s currency, one of the most influential factors affecting how currency pairs trade is the monetary policy stance adopted by central banks.
A nation’s central bank, acting as the monetary authority that ultimately strives to achieve price stability, uses monetary policy to control the money supply – the total amount of money available in the economy. Generally, each central bank tries to strike a balance between the rate of inflation and economic growth in the country it serves. Put another way, a central bank aims to preserve price stability and the pace of economic growth.
Monetary policy refers to the entire process by which the central bank controls the money supply, the availability of money and the cost of money (also known as borrowing costs or interest rates) in order to achieve its objectives, which are usually geared towards economic growth and overall economic stability.
Monetary policy therefore concerns the relationship between interest rates and the total supply of money. If the central bank expands the money supply, more money becomes available for investment or spending, which tends to have a favourable effect on economic growth, as business investment and household spending are major growth drivers. However, if the money supply grows too quickly and reaches excessive levels, it can generate high inflation, which is generally harmful to the economy because it erodes the purchasing power of the national currency (each unit buys fewer goods and services). Conversely, if the money supply is tightened excessively, inflation will fall but growth may also slow.
In order to strike a balance between a reasonable rate of inflation and healthy economic growth, central banks implement two main types of monetary policy: accommodative and restrictive.
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Accommodative monetary policy
When the monetary authority pursues an accommodative (expansive) policy, it increases the money supply. As noted, this leads to higher business investment, stronger consumer spending and, therefore, faster economic growth through lower interest rates (cheaper borrowing).
There are, however, other effects. By implementing an accommodative policy, the central bank cuts real interest rates (we shall discuss this further in the next article). With real rates reduced, financial and capital assets in the country become less appealing because of their lower real rates of return (returns and the benchmark rate are closely related). Foreign investors tend to trim their positions in domestic bonds, real estate, shares and other assets. As a result, the nation’s capital account balance will tend to deteriorate (foreign investors hold fewer domestic assets). At the same time, domestic investors may seek more attractive returns overseas, thus contributing to the capital account balance of the foreign country. The decline in domestic investment activity (fuelled by both foreigners and residents) leads to lower demand for the domestic currency and higher demand for the foreign currency. Consequently, the exchange rate of the domestic currency tends to fall.
Another possible consequence of an accommodative policy is higher inflation. As mentioned, the larger amount of money in circulation reduces the purchasing power of the domestic currency (it becomes less valuable).
So, to sum up, when the central bank implements an accommodative policy, it is likely to have a negative impact on the value of the national currency.
Restrictive monetary policy
When the monetary authority adopts a restrictive (contractionary) policy, it decreases the money supply.
If the money supply is high and the central bank wants to reduce it, it will raise interest rates. Such a measure limits the ability of businesses and households to borrow because higher rates mean higher borrowing costs. With borrowing restrained, company investment and household spending fall, reducing demand for goods and services. As these economic agents become less active, growth may slow. On the other hand, higher interest rates and reduced demand ease inflationary pressures.
There are, however, additional effects. By implementing a restrictive policy, the central bank increases real interest rates. With these rates higher, financial and capital assets in the country become more attractive because of their higher real returns. Foreign investors tend to expand their positions in domestic bonds, real estate, shares and so on. As a result, the nation’s capital account balance improves (foreign investors hold more domestic assets). At the same time, domestic investors become more willing to invest at home. The rise in domestic investment activity (fuelled by both foreigners and residents) leads to higher demand for the domestic currency. Consequently, the exchange rate of the domestic currency tends to rise.
Summing up, when the central bank adopts a restrictive policy, it is likely to have a positive impact on the value of the national currency.
How do central banks decide which policy to implement?
Usually, each central bank has at its disposal break-even numbers for the inflation rate, economic growth (GDP) and various other macro-economic indicators, such as the unemployment rate, which are calculated in accordance with the bank’s own methodology. In addition, central banks compare these figures with so-called preferred values. If any of these figures reach a break-even value, or begin to move together in one direction, indicating a developing trend in the economy, the central bank considers it a signal that monetary policy needs to be adjusted.
Central banks of developed nations usually specify an acceptable level or range that the inflation rate should not breach. For example, both the Federal Reserve and the European Central Bank have set an annual inflation target of 2%. This level is considered a healthy rate, compatible with price stability and moderate economic growth. If an event causes the inflation rate to fluctuate away from this target, the central bank will usually explain the deviation in a statement.
If the inflation rate remains well below target, it signals subdued inflationary pressure and the central bank is likely to maintain an accommodative policy, and vice versa.
Central banks tend to adjust monetary policy gradually, in small steps, not only to preserve stability but also to assess how each move affects the broader economy. The usual increment for changes to the benchmark interest rate is 0.25%-0.50%, and cycles of increases or decreases can last from one to three years. Cuts often come more quickly and in larger steps – from 0.25% to 1%. However, moves of 0.50%-1% are typically reserved for severe economic problems, such as the turmoil in 2008.
Next, we shall discuss interest rates and inflation in greater detail.