Monetary Policy

Updated on 2023-08-29T11:59:20.752383Z

What is Monetary policy and its Key Tools?

The macroeconomic policy set out by the central bank of a country to influence economic activity, is termed as monetary policy. Considered as the demand-side economic policy, the monetary policy involves the management of interest rate and money supply to attain macroeconomic goals.

To influence the supply and demand of money in an economy, the central bank primarily uses three different tools to implement monetary policy, as stated below:

• Open Market Operations: When the central bank indulges in purchase and sale of government securities to influence the level of interest rates and the quantity of bank reserves, it is considered as open market operations.
  • It is worth noting that when the central bank purchases long-term securities from its member banks to stimulate spending in an economy, it is referred to as quantitative easing.
• Changing the Interest Rates: The other key tool used by the central bank to induce economic activity is the change in cash rate or interest rate. By altering the cash rate, the central bank is able to influence savings and investment behaviour, the supply of credit, household expenditure, exchange rate and the price of assets.
• Changing Reserve Requirements: The third tool used by the central bank to change the money supply is the alteration in reserve requirement, which can be defined as funds that banks must maintain as a percentage of the deposits made by their clients to ensure that they can meet their liabilities.

What are the Key Goals of Monetary Policy?

There are three key objectives of monetary policy of almost every central bank – controlling inflation, reaching full employment and ensuring economic stability.

• Controlling Inflation: Central banks usually intend to maintain inflation at low and stable levels, which helps in preserving the value of money, or purchasing power, over time. This goal can be most effectively pursued with the use of monetary policy, which supports in battling with deflation or prolonged inflation.
• Reaching Full Employment: This objective connects to the central bank promoting an environment endorsing full employment. In the labour market, full employment is reached when there are enough jobs for individuals who are available and want to work. While, it is important to note that some people might remain unemployed owing to movement between jobs and skill mismatches, even at full employment levels, referred to as frictional unemployment.
• Output Expansion and Economic Stability: Monetary policies are also aimed at promoting an environment that supports GDP growth, economic prosperity and welfare of the country citizens. This goal is majorly achieved by sustaining a stable macroeconomic environment and ensuring financial stability.

What are the Different Kinds of Monetary Policy?

Monetary policy is broadly classified into two categories - expansionary and contractionary monetary policy.

Expansionary Monetary Policy: The monetary policy, which is focused on increasing or expanding the money supply in an economy, is referred to as expansionary monetary policy. To increase the money supply in an economy, the central bank utilizes its key tools in the following ways:

• Reducing the short-term interest rates: When central banks lower the interest rates on short-term loans provided to commercial banks, the cost of borrowing reduces. In response, commercial banks further decrease the interest rates on loans they charge their customers, thereby stimulating money supply.
• Lowering the Reserve Requirements: Sometimes, central banks reduce reserve requirements of commercial banks, which leaves the banks with extra funds to be lent out to their customers, thereby increasing the money supply.
• Buying Securities on Open Market: When central banks purchase government securities on an open market, it injects reserves into the banking system, creating downward pressure on the interest rate, which further encourages borrowing and money supply.

Contractionary Monetary Policy: In contrary to the expansionary monetary policy, the contractionary monetary policy is aimed at reducing the amount of money circulating in an economy. Therefore, central banks take opposite actions in expansionary monetary policy to reduce the money supply, which include:

• Increasing the short-term interest rates
• Bolstering the Reserve Requirements
• Selling Securities on Open Market

How Can You Differentiate Between Conventional and Unconventional Monetary Policy?

Economists often classify monetary policy based on conventional and non-conventional monetary policy, differing on the basis of tools used by central banks to control the money supply.

Conventional Monetary Policy: It involves central banks altering the short-term interest rates or their key policy interest rate to attain economic objectives. The interest rate changes influence individuals’ decision to save or consume and business decisions to produce, thereby affecting economic activity.

This kind of policy is majorly aimed at achieving goals for employment, inflation and aggregate demand. While increasing interest rates diminishes growth in employment and aggregate demand and puts a downward strain on inflation, reducing interest rates promotes growth in employment and aggregate demand while putting upward pressure on inflation.

Unconventional Monetary Policy: As against conventional monetary policy, the unconventional policy involves usage of different tools other than interest rates by central banks, which comprise:

• negative interest rates
• asset purchases (quantitative easing)
• extended liquidity operations
• forward guidance

Do Not Miss! Investing in Low-Interest Rate Environment And Unconventional Monetary Policy

How does Monetary Policy Help in Financial Crisis?

Looking at previous episodes of recession, Policy responses have been seen to play an integral role in containing the economic and financial shocks. Central Banks have been seen to use a combination of interest rate cuts (Conventional Monetary Policy Tools), Open Market Operations (Quantitative Easing) and Reserve Requirements.

Global Financial Crisis during 2008-10 displayed the sharpest dip in the world economy since the 1930s Great Depression. Experts suggest that effective policy implementation was successful in averting another global depression.

Global Banks were seen to rely aggressively on monetary policy tools in order to stabilize prices, output, employment and alleviate financial market shocks. What raised concerns for the monetary authorities during the Global Financial Crisis were slow recoveries witnessed in many advanced economies, with a disappointing scenario on meeting the inflation targets, output growth and job scenario. For instance, the US unemployment rate was seen to be returning to pre-crisis levels in 2016.

There was an emergence of broad-based debate if the monetary tools are generally less effective during the crisis, witnessing a dent on transmission channels amidst high financial distress, low business sentiments, reduced consumer confidence and considerable balance sheet adjustments of financial institutions.

Also, there were questions on the appropriate depth and intensity of policy accommodation, as a protracted period of loose monetary policy may see some economic distortions during a period of crisis.

While these questions have opposing answers, appropriate mix of monetary policy and fiscal policy, no doubt ease out the economic recovery post crisis. However, the duration and shape of recovery may differ depending on varied circumstances.

Moreover, the effectiveness of negative interest rates, in aiding the growth prospects during an adverse crisis as during Global Virus Crisis (2020), is also under the debate scanner of policymakers. And, the combination of monetary policy and fiscal effectiveness is also not showing the desired results on employment and growth prospects.

Must Read! Can Negative Interest Rates help Economies?