Monetary policy

Monetary policy is the process of which the monetary authority of a country,

like the central bank or currency board, controls thesupply of money, often
targeting an inflation rate or interest rate to ensure price stability and general
trust in the currency.
Further goals of a monetary policy are usually to contribute to economic
growth and stability, to lower unemployment, and to maintain
predictable exchange rates with other currencies.
Monetary economics provides insight into how to craft an optimal monetary
policy. Since the 1970s, monetary policy has generally been formed separately
from fiscal policy, which refers to taxation, government spending,
and associated borrowing.
Monetary policy is referred to as either being expansionary or contractionary.
Expansionary policy is when a monetary authority uses its tools to stimulate the
economy. An expansionary policy increases the total supply of money in the
economy more rapidly than usual. It is traditionally used to try to
combat unemployment in a recession by lowering interest rates in the hope that
easy credit will entice businesses into expanding. Also, this increases
the aggregate demand (the overall demand for all goods and services in an
economy), which boosts growth as measured by gross domestic product (GDP).
Expansionary monetary policy usually diminishes the value of the currency,
thereby decreasing the exchange rate.
The opposite of expansionary monetary policy is contractionary monetary
policy, which slows the rate of growth in the money supply or even shrinks it.
This slows economic growth to prevent inflation. Contractionary monetary
policy can lead to increased unemployment and depressed borrowing and
spending by consumers and businesses, which can eventually result in an
economic recession; it should hence be well managed and conducted with care.
 Types of monetary policy…….

1. Expansionary Monetary Policy: The expansionary monetary policy is adopted

when the economy is in a recession, and the unemployment is the problem. The
expansion policy is undertaken with an aim to increase the aggregate demand by
cutting the interest rates and increasing the supply of money in the economy.
The money supply can be increased by buying the government bonds, lowering
the interest rates and the reserve ratio. By doing so, the consumer spending
increases, the private sector borrowings increases, Unemployment reduces and
the overall economy grows. Expansionary policy is also called as “easy
monetary policy”.

Although the expansionary monetary policy is useful during the slow period in a
business cycle, it comes with several risks. Such as the economist must know
when the money supply should be expanded so as to avoid its side effects
like inflation. There is often a time lag between the time the policy is made and
the time it is implemented across the economy, so up-to-the-minute analysis of
the policy is quite difficult or impossible. Also, the central bank and legislators
must know when to stop the supply of money in the economy and apply
a Contractionary Policy.

2. Contractionary Monetary Policy: The Contractionary Monetary policy is

applied when the inflation is a problem and economy needs to be slow down by
curtailing the supply of money. The inflation is characterized by increased
money supply and increased consumer spending. Thus, the Contractionary
policy is adopted with an aim to decrease the money supply and the spending in
the economy. This is primarily done by increasing the interest rates so that the
borrowing becomes expensive.

Thus, these are the monetary policies applied by the monetary authority to
control the inflationary or recessionary pressures in the economy.

PROBLEM OF MONETARY POLICY

1. Deflation

Deflation makes monetary policy much less effective. In fact deflation can
cause a liquidity trap which implies a cut in rates will have no effect on
boosting demand.

1. Firstly, deflation can increase the real interest rate. Suppose we have
deflation of -2%. Interest rates cannot fall below 0%. Therefore, the real interest
rate is effectively 2%. This will discourage borrowing and investment. (At the
moment, we have negative real interest rates because inflation is higher than
base rates; in theory this should encourage people to spend and invest. A fall in
prices has the effect of making monetary policy tighter.)

2. Deflation discourages consumer spending because consumers expect prices to

be cheaper in the future, therefore, they delay purchasing leading to lower
aggregate demand. The evidence of Japan suggests this is a real problem.

3. Deflation also increases the real value of debt. Firms and consumers spend a
higher % of their income on paying off debts leading to lower growth.

See also Problems of deflation.

Solutions to Deflation
Deflation can be very damaging for attempts to avoid a recession. Monetary
policy can play a role in avoiding deflation and recession.

Zero interest rates . Firstly Central Banks can reduce base interest rates to zero.
Lower interest rates reduce cost of borrowing. However, with deflation, zero
interest rates will not be enough to avoid a fall in economic growth

Quantitative Easing . The Central Bank can electronically create money and use
this to buy bonds (both government and other financial bonds). This helps to

1. Increase the money supply. Bank reserves should rise; in theory this should
encourage them to lend more

2. Lower interest rates on long term bonds. By purchasing bonds, the Central
Bank will reduce interest rates on bonds. These lower interest rates can help to
encourage lending and spending. E.g. in 2011, the US Fed unveiled ‘operation
twist’ this involved buying mortgage securities to reduce interest rates on
mortgage bonds. The hope was this would encourage mortgage lending

3. More on quantitative easing

Inflation Target . The Central Banks can make it very clear they are targetting
positive inflation. They could even increase the inflation target from 2% to 3%.
Increasing inflation expectations help to avoid the pressure of deflation.

Inflation

Inflation is a period of rising prices. Most Central Banks target low inflation. If
inflation rises above this inflation target, there are several economic policies,
such as monetary policy to reduce the inflation rate.

Monetary policy – Higher interest rates . This increases the cost of borrowing
and discourages spending. This leads to lower economic growth and lower
inflation.

monetary policy is the most important tool for maintaining low inflation. In the
UK, monetary policy is set by the MPC of the Bank of England. They are given
an inflation target by the government. This inflation target is 2%+/-1, and the
MPC use interest rates to try and achieve this target.
The first step is for the MPC to try and predict future inflation. They look at
various economic statistics and try to decide whether the economy is
overheating. If inflation is forecast to increase above the target, the MPC are
likely to increase interest rates.

Increased interest rates will help reduce the growth of aggregate demand in the
economy. The slower growth will then lead to lower inflation. Higher interest
rates reduce consumer spending because:

Increased interest rates increase the cost of borrowing, discouraging consumers

from borrowing and spending.

Increased interest rates make it more attractive to save money

Increased interest rates reduce the disposable income of those with mortgages.

Higher interest rates increased the value of the exchange rate leading to lower
exports and more imports.