What is Monetary Policy?
Monetary authority of every country decides various policies to control the money supply in the economy to maintain adequate demand which is known as monetary policy and it includes policy on repo and reverse repo rate of banks, changes in CRR ratio of banks, etc. and hence helps a country to maintain a balance in the economy.
The keyword of monetary policy is “liquidity”. The central bank of a country needs to use this liquidity in the economy to ensure economic growth. And the policy which dictates the availability of liquidity is called the monetary policy of the country.
We note from the above snapshot that Bank of Japan will continue to follow its ultra-loose monetary policy easing and is targeting 2% inflation which is still far away.
Since this policy isn’t necessarily done for a particular period, its importance lies in the market conditions. The central bank needs to see where the economic condition of the country is at a particular time. If the economy has enough flow of money, the central bank needs to do nothing. If the opposite happens, the central bank needs to take certain measures for enhancing the movement and flow of money in the economy.
Monetary policy is one of the sub-sets of fiscal policy because the liquidity of the economy directly affects the policymakers of the country as well.
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Objectives of Monetary Policy
The central bank of every country forms this policy with an objective. Of course, they want to increase the flow of money in the economy; but that can’t be the only objective. Other than ensuring enough liquidity in the country, there are basically two objectives behind this policy.
Let’s have a look at them one by one –
#1 – Controlling Inflation:
Since the main objective of this policy is to ensure enough liquidity in the economy, it so happens that the consumers get more purchasing power due to which the country eventually suffers from inflation. As inflation affects the GDP (Gross Domestic Product) of the country, it’s should be curbed at the right time. Through this policy, the central bank of the country tries to pare down the inflation rate to a minimum.
#2 – Reduce Unemployment:
The next most important objective of this policy is to ensure that the country has less unemployed individuals. But authorities only concentrate on reducing unemployment after they take care of inflation. So here you can see how this policy and fiscal policy are connected and how it is a subset of fiscal policy.
Two Types of Monetary Policies
There are two types of monetary policy:
#1 – Contractionary Monetary Policy:
The contractionary monetary policy is one of the most used monetary policies because it helps reduce the inflation rate. Contractionary monetary policy is taken by the authorities when the inflation rate is sky-high and the central bank needs to do something immediately. The main tools of this policy are interest rates and security options. When the central bank adopts a contractionary monetary policy, it tries to raise the interest rates of the bank so the people keep their money in banks to avail of higher interest rates. This will result in less money in the hands of people and as a result, the inflation rate will reduce. Secondly, the central bank also sells off securities in the open market so that the public would be more interested to buy more securities which will result in the same i.e. lowering the inflation rate.
#2 – Expansionary Monetary Policy:
This is just the opposite of the previous type. Expansionary monetary policy is only adopted when the inflation is curbed and the main objective of the central bank becomes to reduce the unemployment rate and to avoid recession (if at all). As per expansionary policy, the central bank reduces the interest rate so that the public keep their money in their hands. This step results in more purchasing power and as a result, the public consumes more from businesses in the country. This helps avoid unemployment and recession. The central bank also stops selling securities in the open market and they only allow securities to be sold through the member banks. This also ensures that the economy grows rapidly, enhances the employment rate, and reduces the chances of a recession.
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 –