Monetary Policy

Updated on April 26, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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.

What is Monetary Policy

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Key Takeaways

  • 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 policiesFiscal PoliciesFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more fall under the definition of critical mechanisms with which an economy flourishes and survives adversities. The fiscal policy influences government spending and revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more. 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 requirementsReserve RequirementsReserve Requirement is the minimum liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.read more 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 BankEuropean Central BankThe European Central Bank is the apex bank of the member European countries, monitoring the banking and financial functions of all member countries in order to maintain the price stability of the European currency, the Euro.read more (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.

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Types of Monetary policy

The types are discussed below :

Monetary policy types

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Contractionary Policy:

The central bank adopts contractionary monetary policiesContractionary Monetary PoliciesContractionary monetary policy is the type of economic policy that is basically used to deal with inflation and it also involves minimizing the fund’s supply in order to bring an enhancement in the cost of borrowings which will ultimately lower the gross domestic product and moderate or decrease inflation too.read more 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 policiesExpansionary PoliciesExpansionary policy is an economic policy in which the government increases the money supply in the economy using budgetary tools. It is done by increasing the government spending, cutting the tax rate to increase disposable income etc.read more 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 recessionEconomic RecessionEconomic recession is defined as the phase in which economic activities of a country become stagnant, leading to a disturbance in the business cycle and affecting the overall demand-supply balance. read more 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 operationsOpen Market OperationsAn Open Market Operation or OMO is merely an activity performed by the central bank to either give or take liquidity to a financial institution. The aim of OMO is to strengthen the liquidity status of the commercial banks and also to take surplus liquidity from them.read more. If the central bank is targeting recession, it will purchase the securities from a bank offering them. This will increase the bank’s cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more 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 banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more 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 loansCommercial LoansCommercial loans are short-term loans used to raise a company's working capital and meet heavy expenses and operational costs. It is a kind of financing often used by small companies that cannot afford to raise money from equity markets and bonds. Banks and well-established financial institutions often provide commercial loans against the debtor's financial statements and credit score.read more.

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 loansConsumer LoansA consumer loan is a type of credit given to a consumer to finance specified set of expenditures. The borrower must pledge a specific asset as collateral for the loan, or it may be unsecured depending on the loan's monetary value.read more.

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.


What is monetary policy? How does it work?

Monetary policy is the macroeconomic action taken by a country’s central bank to check the nation’s money supply and economic stability. In 1979, Paul A Volcker, the US’s central bank’s chairman, ended a painfully prolonged inflation with aggressive interest hikes. In the latter half of the 1980s, the average inflation hovered around 3.5%, record lows from double digits of troublesome years.

What are the 3 main tools of monetary policy?

The three tools of monetary policy are:
1. Open Market Operations – central bank buying or selling securities to expand or contract the money supply.
2. Reserve Requirement – Increasing or decreasing reserve amount requirements of the bank that are set aside to meet emergency fund requirements for consumers.
3. Discount Rate – Increasing or decreasing the interest rates the central bank charges for interbank short-term lending.

Who controls monetary policy?

A country’s central bank such as the US Federal Reserve (Fed), formulates, administers, and controls this policy.

What are the goals of monetary policy?

The primary goals of monetary policy include long-term interest rates regulation, price stability, employment generation and economic growth.

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 –

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