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What Is the Connection between Monetary Policy and Financial Crisis?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 02 September 2016
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The relationship between monetary policy and financial crisis is related to the manner in which monetary policies are applied during a period of financial crisis. Application of a monetary policy depends on the country, the ideology of the monetary policy makers, the unique circumstances surrounding the crisis, and the aim that those in charge of making financial policies are trying to achieve. In other words, there is no single response to a financial crisis through the application of monetary policy since different countries may apply different monetary policies in similar a financial crisis.

The first consideration when looking at the connection between monetary policy and financial crisis is an identification of the exact type of financial crisis the country under consideration is facing. Assuming the financial crisis is in the form of an economic bust or a recession, the country may apply monetary policies aimed at reviving the economy from the slump it is facing. When a country is facing a recession the general response of the monetary policy makers, usually the central bank of the country, will be to reduce the interest rates with the hope that such a measure will ease the pressure on consumers causing downturn in the economy.

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For instance, the reduction in interest rates will make it easier for people to obtain credit and other forms of finance for various purposes. Easier access to money might encourage people to spend more, leading to more demand for finished products and other consumables. Where this is the case, companies will be encouraged to produce more, and the increase in financial activities will serve as a much needed jolt to the economy. This shows a link between monetary policy and financial crisis. When this type of monetary policy is applied, it is described in economics as an effort to expand the economy.

In the same way that monetary policy may be used to cause an expansion in the economy, it may also be applied to the opposite effect. That is to say that monetary policy may be used to cause the economy to contract. This is another connection between monetary policy and financial crisis, because this method may also be utilized as a solution to a financial crisis. When the intent of the monetary policy makers is to cause a contraction in the economy it may increase the interest rates with a view to bringing about a desired result in the resolution of the financial crisis.

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