Monetary Policy

What is Monetary Policy?

Monetary policy is an economic policy that manages the size and growth rate of the money supply in an
economy. It is a powerful tool to regulate macroeconomic variables such as inflation and
unemployment.

These policies are implemented through different tools, including the adjustment of the interest rates,
purchase or sale of government securities, and changing the amount of cash circulating in the economy.
The central bank or a similar regulatory organization is responsible for formulating these policies.

Among several functions of central bank, monetary policy is regarded as one of the important function.
Monetary policy is a policy that helps to maintain the price and interest rate at the desired level -
through the management of supply of money in the economy. The level of money is managed by
increasing or decreasing the supply of money by the monetary authority (i.e. central bank).

Definition and views:

According to Harry G. John:

“Monetary policy is the policy employing the central bank’s control on the supply of money as an
instrument for achieving the objectives of general economic policy.”

According to G.K. Shaw:

“Monetary policy is any conscious action undertaken by central monetary authority.”

According to Edward Shapiro:

“Monetary policy is the central bank’s control over the money supply as an instrument for achieving the
objectives of general economic policy.”

So, in order to achieve the macro-economic goals, the central bank formulates the monetary policy
aligned with the fiscal policy of the government. In other words, the monetary policy is designed by
considering the existing situation and outlook of the economy along with priorities, policies and
programs of the government’s budget.

Objectives of monetary policy:

The basic objectives of monetary policy are as follows:

 To make Price level stable

 To achieve full employment
 To make interest rate stable
 To make the Exchange rate stable
 To achieve rapid economic growth
 To Correct the adverse BOP
 To Induce savings
 To Invest the savings
 To Create and expand Financial Institution
 To reduce economic inequality
The primary objectives of monetary policies are the management of inflation or unemployment, and
maintenance of currency exchange rates:

a) Inflation:
Monetary policies can target inflation levels. A low level of inflation is considered to be healthy
for the economy. If inflation is high, a contractionary policy can address this issue.

b) Unemployment:
Monetary policies can influence the level of unemployment in the economy. For example, an
expansionary monetary policy generally decreases unemployment because the higher money
supply stimulates business activities that lead to the expansion of the job market.

c) Currency exchange rates:

Using its fiscal authority, a central bank can regulate the exchange rates between domestic and
foreign currencies. For example, the central bank may increase the money supply by issuing
more currency. In such a case, the domestic currency becomes cheaper relative to its foreign
counterparts.

Expansionary Monetary Policy:

This is a monetary policy that aims to increase the money supply in the economy by decreasing interest
rates, purchasing government securities by central banks, and lowering the reserve requirements for
banks. An expansionary policy lowers unemployment and stimulates business activities and consumer
spending. The overall goal of the expansionary monetary policy is to fuel economic growth. However, it
can also possibly lead to higher inflation.

Contractionary Monetary Policy:

The goal of a contractionary monetary policy is to decrease the money supply in the economy. It can be
achieved by raising interest rates, selling government bonds, and increasing the reserve requirements
for banks. The contractionary policy is utilized when the government wants to control inflation levels.

What is a Contractionary Monetary Policy?

A contractionary monetary policy is a type of monetary policy that is intended to reduce the rate of
monetary expansion to fight inflation. A rise in inflation is considered the primary indicator of an
overheated economy, which can be the result of extended periods of economic growth. The policy
reduces the money supply in the economy to prevent excessive speculation and unsustainable capital
investment. A contractionary monetary policy is generally undertaken by a central bank or a similar
regulatory authority. The central bank usually sets a target for the inflation rate and uses the
contractionary monetary policy to meet the target.

Tools for a Contractionary Monetary Policy:

Every monetary policy uses the same set of tools. The main tools of monetary policy are short-term
interest rates, reserve requirements, and open market operations. A contractionary monetary policy
utilizes the following variations of these tools:
 1. Increase the short-term interest rate (discount rate)

Interest rates are the primary monetary policy tool of a central bank. Commercial banks can
usually take short-term loans from the central bank to meet short-term liquidity shortages. In
return for the loans, the central bank charges the short-term interest rate.

In order to reduce the money supply, the central bank can opt to increase the cost of short-term
debt by increasing the short-term interest rate. The increase in interest rates will also affect
consumers and businesses in the economy as commercial banks will raise the interest rates they
charge their clients.

2. Raise the reserve requirements:

Commercial banks are obliged to hold the minimum amount of reserves with the central bank
and a bank’s vault. A rise in the required reserve amount would decrease the money supply in
the economy.

3. Expand open market operations (sell securities):

The central bank is involved in open market operations by selling and purchasing government-
issued securities. The central bank can reduce the money circulated in the economy by selling
large portions of the government securities (e.g., government bonds) to investors.

Effects of a Contractionary Monetary Policy

A contractionary monetary policy may result in some broad effects on an economy. The following effects
are the most common:

1. Reduced inflation:

The inflation level is the main target of a contractionary monetary policy. By reducing the money
supply in the economy, policymakers are looking to reduce inflation and stabilize the prices in
the economy.

2. Slow down economic growth:

Reducing the money supply usually slows down economic growth. As the money supply in the
economy decreases, individuals and businesses generally halt major investments and capital
expenditures, and companies slow down their production.

3. Increased unemployment:

An unwanted side effect of a contractionary monetary policy is a rise in unemployment. The

economic slowdown and lower production cause companies to hire fewer employees.
Therefore, unemployment in the economy increases.
Expansionary/ Cheap/ Ease monetary policy:

Expansionary monetary policy is the monetary policy that is designed to increase the aggregate demand
in an economy. It is also called ‘Cheap/ Ease monetary policy’. As we know, the aggregate demand falls
during the period of recession. So, this policy is implemented to overcome recession and encourages to
expand credit in an economy. This is done through:

 Reducing the bank rate

 Reducing CRR
 Purchasing securities (bills and bonds) in open market and so on.

Under this kind of monetary policy, the monetary authority makes a deliberate effort to increase the
money supply in the economy.