Monetary Policy

What is Monetary Policy?

Monetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.

• Monetary policy is the central bank's action to establish economic stability in a nation and fulfil other goals like unemployment, inflation, price instability, recession, etc.
• It is considered to be a corrective measure since such a policy reform is made to control the prevailing economic situation or adversity.
• There are two forms of monetary policy, i.e., the contractionary and expansionary policy.
• The tools or measures initiated by the central bank under this policy include changes in the discount rate, open market operations and reserve requirements.

How Does Monetary Policy Work?

In economics, both monetary and fiscal policies fall under the definition of critical mechanisms with which an economy flourishes and survives adversities. The fiscal policy influences government spending and revenue. Conversely, the monetary policy focuses on the money supply to enhance employment, GDP, price stability, national demand, etc.

The underlying idea is that if there is inflation or excessive price rise, reducing the amount of money available to the consumers will decrease their purchasing power. With less money, people will buy less, reducing demand and consequently the overall price. To attain this, various measures are employed, such as changing the interest rates, reserve requirements of the banks, open market transactions, etc. 

For example, Paul A Volcker, the 1979 US’s central bank’s chairman, ended a painfully prolonged inflation with aggressive interest hikes. It put the economy under recessions, with millions losing jobs and consumption falling to record lows. But Volcker pulled the economy out of the inflation, which laid a strong foundation for a stable economic future.

It also paved the way for separating such policies from political inference. Most central banks, such as the US’s Federal Reserve (Fed), India’s RBI, European Central Bank (ECB), etc., are responsible for monetary policies. A country’s central bank prepares and implements the policy as per the economic requirements. The Fed, for example, aims to maintain price stability and boost employment. The central bank usually takes the help of a committee in formulating and implementing monetary policy.

Types of Monetary policy

The types are discussed below :

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Contractionary Policy:

The central bank adopts contractionary monetary policies to control the economic conditions like inflation by shrinking the money supply in the financial system. For this purpose, the central bank sells off short-term government securities, hikes borrowing rates or increases banks' reserve requirements.

Expansionary Policy:

In situations of economic slowdown, the central bank implements various expansionary policies like buying short-term government securities, lowering borrowing rates and decreasing the banks' reserve requirements. The purpose is to uplift the money supply in the economy for enhancing consumer spending and decreasing unemployment. However, it may result in inflation.

Monetary Policy Tools

The central bank’s policy reforms majorly deal with economic recession and expansion. The prominent tools used for this purpose involves:

Open Market Operations: The central bank purchases short-term government assets such as the US Treasury bonds or Federal assets in the open market operations. If the central bank is targeting recession, it will purchase the securities from a bank offering them. This will increase the bank’s cash flow and reserve.

Doing this at the macro level will increase the money supply in the country. In contrast, when it plans to reduce the cash flow, it sells the securities, reducing the reserves and availability of cash.

Reserve Requirement: Changes in the central bank's prescribed limit of reserves that the commercial banks need to maintain from their customer deposits is an essential tool. In the situation of economic expansion, the reserve requirement is increased to decrease the money supply in the system. On the other hand, it is decreased as part of the expansionary policy.

Discount Rate: Central bank changes an interest for short-term lending to the commercial banks, which is referred to as a discount rate. The loan helps in meeting reserve requirements and short-term cash flow. If the bank increases the discount rate, it eventually permeates to other rates, including those on commercial loans.

As a result, increasing commercial loan rates will discourage people from borrowing, thereby bringing down the money supply under inflation.

Real-World Examples

Let’s look at some recent monetary policy examples from the real world. Amidst the coronavirus pandemic, the US Federal Reserve lowered the benchmark interest rate close to zero per cent. Although the benchmark indicates the rate of interbank short-term borrowing, it affects the overall borrowing rate, including those for consumer loans.

As such, this was an example of expansionary monetary policy which was adopted to avoid a money crunch. It also focussed on bringing down unemployment numbers and economic slowdown. Another recent report talked about China’s Coronavirus stimulus program ending in advance as the economy showed an impressive recovery. The stimulus had involved lowering interest rates.

FAQs

Recommended Articles

This has been a guide to Monetary Policy. Here we discuss its definition, Objective and types of monetary policies. You may also look at the following economics articles to learn more -

• Zero Depreciation Policy
• Fiscal Policy vs Monetary Policy
• Unemployment Rate Formula
• Macroeconomics Books