Types of Monetary Policy

Definition: The Monetary Policy is a programme of action undertaken by the

central banks and other regulatory bodies to control and regulate the money supply
to the public and a flow of credit, so as to ensure the stability in price and trust in
the currency by targeting the inflation rate and the interest rate.

Simply, the process by which the monetary authority, generally the Central Bank
controls the money supply in the economy is called as the monetary policy. There
are two 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 spendings 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.