Monetary policy: how central banks move money, inflation and markets
By the MeridIAn Screener team · Published on 13 October 2026 · 6 min read
Monetary policy is the set of decisions a central bank uses to control the amount and the price of money. It sounds distant, but it explains why mortgage rates jumped in 2022 and 2023, why savings accounts paid almost nothing in 2020 and why the stock market reacts to a press conference in Washington. This guide explains how it works and what the different schools of economics say, without hard formulas.
What money is and who creates it
Almost all the money you use isn’t cash: it’s entries in bank accounts. There are two creators of money:
- The central bank creates the monetary base: notes and coins, plus the reserves banks hold with it.
- Commercial banks create most of the money when they lend: when a bank gives you a $300,000 mortgage, it doesn’t move another customer’s savings; it credits $300,000 of new money to the seller’s account. When the loan is repaid, that money disappears.
That’s why there are several “monetary aggregates”:
| Aggregate | What it includes | What it’s used for |
|---|---|---|
| M0 / monetary base | Notes, coins and bank reserves at the central bank | What the central bank controls directly |
| M1 | Currency held by the public + checking and savings deposits | Money ready to spend |
| M2 | M1 + small time deposits and retail money market funds | The most quoted measure of “the amount of money” |
What the Federal Reserve does
Every central bank has a mandate, the job the law gives it:
| Federal Reserve (US) | European Central Bank | |
|---|---|---|
| Mandate | Dual: maximum employment and stable prices | Price stability |
| Inflation target | 2% (measured with the PCE price index) | 2% over the medium term, symmetric |
| Who decides | Federal Open Market Committee (FOMC), 12 votes | Governing Council: 6 Executive Board members and the euro-area governors |
| Rate meetings | Eight a year | Every six weeks |
And these are its tools:
- Policy rates. The main one: they set the cost of overnight money and, from there, of every other term.
- Buying and selling bonds. Buying Treasuries injects money and lowers long-term rates; selling them or letting them mature withdraws it.
- Lending to banks. It provides liquidity in times of stress so credit doesn’t dry up.
- Words (forward guidance). Announcing what it plans to do moves markets before it acts. That’s why every press conference is analyzed sentence by sentence.
How a decision reaches the economy
A rate hike travels through several channels at once:
| Channel | What happens when rates rise |
|---|---|
| Credit | Loans and mortgages cost more: people borrow, spend and invest less |
| Saving | Saving pays more: people consume a bit less |
| Asset prices | Bonds, stocks and real estate fall: people feel less wealthy and spend less |
| Exchange rate | The dollar tends to strengthen: imports get cheaper and exports more expensive |
| Expectations | If the Fed is credible, businesses and workers expect less inflation and raise prices and wages less |
The economist Milton Friedman said monetary policy acts with “long and variable lags”: the full effect on prices takes one to two years.
The quantity theory: more money, more inflation?
The oldest idea in monetary economics fits in one equation:
M × V = P × Y
- M: the amount of money.
- V: velocity, how many times each dollar changes hands in a year.
- P: the price level.
- Y: real output (what the economy produces, without inflation).
If the amount of money grows much faster than output and velocity doesn’t change, prices have to rise. Hence Friedman’s line: “inflation is always and everywhere a monetary phenomenon.”
Two episodes that seem to contradict each other: between 2008 and 2019 central banks created huge amounts of monetary base and inflation stayed low: the money sat as bank reserves and velocity fell. Between 2020 and 2021, by contrast, US M2 grew by around 40% because the money went straight to households and businesses (relief payments financed largely by bond purchases), and in 2022 came the highest inflation in 40 years.
The lesson: the amount of money matters, but where it ends up and whether it gets spent matter more. The link isn’t mechanical, which is why central banks today target inflation, not the amount of money.
Quantitative easing (QE) and tightening (QT)
When rates are already at zero and can’t go lower, central banks buy bonds on a large scale with newly created money: that’s quantitative easing (QE). It lowers long-term rates, pushes investors toward riskier assets and supports lending.
The Fed’s balance sheet went from about $4 trillion to almost $9 trillion between 2020 and 2022. Then it started doing the opposite, quantitative tightening (QT): from June 2022 it let bonds mature without replacing them, slowly draining money. It stopped shrinking its balance sheet on December 1, 2025. The ECB followed a similar path.
For investors, QE tends to be a tailwind for the price of almost everything (stocks, bonds, real estate) and QT a headwind, although how much is hotly debated.
The schools of thought, in one table
There’s no single accepted theory. These are the main schools and what they propose, summarized and without taking sides:
| School | Core idea | What it recommends | Common criticism |
|---|---|---|---|
| Keynesian | Crises come from falls in demand; prices and wages adjust slowly | Government and central bank stimulus in recessions, cooling in booms | Can create inflation and debt if stimulus isn’t withdrawn in time |
| Monetarist (Friedman) | Inflation depends mainly on money growth | Fixed, predictable rules instead of discretionary decisions | The link between money and inflation became unstable from the 1980s |
| Austrian (Mises, Hayek) | Artificially cheap credit creates bubbles and bad investments that end in crises | Market-set rates and little intervention | Hard to test with data; implies accepting harsher recessions |
| New consensus (inflation targeting) | An independent, credible central bank anchors expectations | Move rates with inflation and activity (the Taylor rule as a reference) | Was late on the 2021-2022 inflation and doesn’t prevent financial bubbles |
| Modern Monetary Theory (MMT) | A government that issues its own currency can’t go bankrupt in it; the real limit is inflation | Use spending and taxes, more than rates, to manage the economy | Hotly debated: risk of inflation and of losing confidence in the currency |
Three episodes worth knowing
| Episode | What happened | What it teaches |
|---|---|---|
| Volcker, 1979-1982 | With US inflation at 14.8% (March 1980), the Fed raised rates to around 20%. There was a recession, but inflation fell to about 3% in 1983 | Stopping entrenched inflation is costly, but possible |
| Zero and negative rates, 2009-2022 | The Fed kept rates near zero for years; the ECB and Japan went below zero, and some German bonds paid less than nothing | With free money, asset prices rise and risk-free savings stop paying |
| The great hike, 2022-2023 | Inflation at a 40-year high and the fastest rate hikes in decades; 2022 was a bad year for stocks and bonds at the same time | Bonds and stocks can fall together when the problem is inflation |
What it means for your money
- Expectations matter, not the decision. A rate hike that was announced is already in prices; the unexpected is what moves the market.
- Watch real rates. Rates below inflation push people into assets; above it, they make risk-free savings attractive again.
- Liquidity is a wind that changes. Years of bond buying inflated many valuations; withdrawing it works the other way.
- Diversify by asset type and country. Central bank cycles aren’t always in sync.
- Money is created by the central bank (the monetary base) and, above all, by banks when they lend.
- The Fed pursues maximum employment and 2% inflation. Its main tool is the interest rate, and when that isn’t enough, buying bonds (QE).
- More money doesn’t always mean more inflation: it depends on whether it’s spent. Schools of economics disagree on how much the central bank should intervene.
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General information for educational purposes. Not financial or tax advice, nor a recommendation to buy or sell securities. Investing in shares involves the risk of loss. · Contact: info@meridianscreener.com