What is Monetary Policy? Definition, Objective, Tools and Types

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Latest Update:
For the eighth time in a row, MPC led by RBI Governor Mr. Shaktikanta Das, kept the Monetary Policy unchanged in October 2021.
Interest rate – 4 %
Repurchase/Repo rate – 4 %
central bank’s borrowing rate/Reverse Repo Rate – 3.35 %

Article Content:

What is Monetary Policy?

Monetary Policy is issued by the communications and actions of a central bank which handles the chain of money supply, in the forms of cash, credit, money market and checks. Credit is the most vital form of monetary policy, which includes bonds, loans and mortgages.

It helps in the economic growth of the nation by increasing liquidity and prevents inflation by reducing liquidity. Central banks use bank reserve requirements, interest rates, and government bonds that should be held by the banks. All such tools influence the amount of money banks can lend. The money supply is affected by the volume of loans.

Key Highlights for Monetary Policy

  • Monetary policy is used to manage unemployment, economic growth, and inflation in the country by the Federal Reserve.
  • It is vital to influence prices, production, employment, and demand.
  • The monetary policy is implemented by the Feds through reserve requirements, open market operations, federal funds rate, discount rates, and inflation targeting.
  • There are three objectives of monetary policy – managing employment, inflation control, and keeping up with long-term interest rates.
  • Expansionary policy boosts economic growth and contractionary monetary policy slows down the growth rate of the economy.

What are the Objectives of Monetary Policy?

There are three objectives of monetary policy – Inflation management is the most common objective. Controlling Unemployment is another objective that can be done by controlling inflation. Promoting long term and Moderate Interest Rates is the third objective.

There are specific targets of the US Federal Reserve like other central banks. The core inflation should be 2% to meet those objectives. If it exceeds the limit, the rate of unemployment will be considered to be around 3.5% to 4.5%. Healthy economic growth is the overall goal of the Fed. In the gross domestic market of the nation, it is the annual rise of 2% to 3%.

What are the Types of Monetary Policy?

types of monetary policy

Usually, a Contractionary Monetary Policy is used by central banks to control inflation. They limit the amount of money that can be lent by the banks to control the money supply. As a result, the banks make loans even more expensive by charging higher interest rates. Only a few people and businesses with the highest need manages to borrow.

Expansionary Monetary Policy is used by central banks to avoid recession and control unemployment. They provide more money for lending to increase liquidity. Banks make loans more affordable and charge lower interest rates. Businesses borrow more to hire staff, expand, and buy equipment. On the other side, individuals borrow more to buy new cars, appliances, and homes. It spurs economic growth and boosts demand.

Following are The Types of Monetary Policy:

  • Inflation

Inflation levels are highly affected by monetary policies. For a healthy economy, a low level of inflation is considered to be good. In case the inflation is high, a contractionary policy can be used to address it.

  • Unemployment

Monetary policies are one of the reasons for influencing the level of unemployment in the economy. Expansionary monetary policy decreases unemployment because a higher money supply increases business expansions that lead to an increase in the number of jobs in the market.

  • Currency Exchange Rates

The central bank has the fiscal authority to regulate the exchange rates between domestic & foreign currencies. For example, if the central bank issues more currency than it may increase the money supply in the markets. In such a case, the domestic currency becomes cheaper.

  •  Interest Rate Adjustment

By changing the discount rates, the central bank can influence the interest rates. The discount rate is an interest rate charged by the central bank for short term loans. E.g. if the central bank increases the interest rate, the rate of borrowing loans will also increase.

  • Change Reserve Requirements

Central bank usually set up the amount of reserves that must be held by the commercial banks. The money supply in the economy can be directly influenced by changing this required amount. If the amount of holding reserves is increased by the central bank, then the commercial banks find less money available to lend as loans. This decreases the money supply in the markets.

  • Open Market Operations

The central bank can sell or purchase securities issued by the government will affect the money supply.

  • Contractionary Monetary Policy

This policy aims at decreasing the money supply in the economy. This can be done by increasing interest rates, selling government bonds or increasing the reserve requirements for banks. This policy comes into play when the government wants to control the inflation level.

  • Expansionary Monetary Policy

This policy aims to increase the money supply by purchasing government securities, decreasing the interest rates & lowering the reserve requirements for banks. It stimulates business growth & lowers unemployment. The overall aim of the expansionary policy is to stimulate economic growth. At times, it may result in higher inflation.

What is Monetary Policy vs Fiscal Policy?

Monetary policy should usually work with the Fiscal policy by the national government. Government lenders are re-elected for increasing spending or reducing taxes.

Hence, they go with expansionary fiscal policy. The Fed has to use limiting monetary policy to avoid inflation.

What are the Tools Used for Monetary Policy?

There are three basic tools used by all central banks for monetary policy.

  1. Open market operations
  2. Reserve equipment
  3. Discount rate

First of all, they use Open Market Operations. They deal with member banks on government bonds and securities. It changes the amount of reserve on the banks. Banks may lend less due to higher reserves.

Reserve Equipment is the second tool. Central banks decide how much money the members should keep in reserve. Banks can safely lend most of that amount because everyone doesn’t need all of the money every day. This way, they have ample cash to meet a lot of redemption demands. Previously, there was a 10% reserve needed. Since March 2020, this reserve requirement has been reduced to 0 by the Fed.
The reserve requirement is increased when it comes to restricted liability for a central bank. This way, banks have less amount of money to lend. It controls the requirement to expand liquidity. This way, member banks can lend more money. The reserve requirement usually remains the same by central banks as member banks have to go through a lot of paperwork.

The Discount Rate is the third tool. A central bank charges its member banks and they have their discount window to borrow funds. To keep banks from borrowing much, the discount rate is increased. It slows down the economy and controls liquidity. On the other side, a lowered discount rate encourages borrowing and it boosts growth and liquidity.

Monetary Policy in India

The Reserve Bank of India (RBI) is the monetary policy authority which is aimed to maintain the country’s price stability to meet the needs of various sectors and to improve economic growth.

The monetary policy is implemented by the RBI through a reserve system, bank rate policy, moral persuasion, credit control policy and other tools. No matter which instrument is used, it brings changes to the money supply and interest rate. For the economy, liquidity plays a vital role to encourage growth. The RBI relies on monetary policy to maintain liquidity. It introduces money to the system by buying bonds from the open market.

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