Everything you always wanted to know about money and monetary policy (but were afraid to ask)

The key task of central banks is to conduct monetary policy. In this article, we shed light on how they go about doing so and the precise role played by money in this regard. In fact, monetary policy is nowadays about setting interest rates – or the price of money – rather than about controlling the supply of money. We also discuss the ECB’s recent review of the operational framework for implementing monetary policy.

A focus on interest rates

Monetary policy is probably better understood as interest rate policy. Central banks tightly control short-term interest rates whereas money creation is mainly the preserve of commercial banks as loans create deposits. Neither the supply of money by central banks (so-called “base money”) nor the amount of money in circulation in the economy (known as “broad money”) is a direct target of monetary policy in modern times. Central banks thus merely influence – without entirely controlling or aiming to control – bank lending and money creation through the effects of their interest rate policy on financing conditions.

Money still matters

Money nevertheless remains important to monetary policy. In line with the quantity theory of money, the amount of money circulating in the economy is an important determinant of prices (at least in the long term). Therefore, while the link between monetary aggregates and inflation has weakened in the medium term, these aggregates continue to serve as longer-term information variables. A glut of money in the economy, for example, could give rise to financial stability concerns, owing to excess credit growth and indebtedness in the non-financial private sector or excessive risk-taking by commercial banks.

A new framework for implementing monetary policy

Revision of the Eurosystem’s operational framework for implementing monetary policy proved necessary. The operational framework had already undergone de facto changes as a result of the unconventional measures undertaken in response to various crises over the past fifteen years. The new framework, which formally entered into force in 2024, further modifies the way monetary policy is conducted in the euro area. It does not, however, usher in a return to the system that prevailed two decades ago. Moreover, another review of the framework is already scheduled for 2026 and will be based on experience gained and lessons learned in the meantime.