Monetary Policy Meaning, Types and Instruments

The recognition that monetary policy is concerned primarily with the quantity of
money, not with the terms and availability of credit, and that inflation is always and
everywhere a result of a rapid rate of increase in the quantity of money and its effect
on economics. The best way to foster an effective and diversified financial structure
is to let financial institutions develop in response to market forces. Repressing prices
of goods and of labour, while no less frequently attempted than repression of
exchange rate and interest rates, generally does less economic harm. The reason is
that they tend to be easier to evade. However, they do great social harm. Given price
controls, black markets serve a socially useful purpose by preventing the distortions
that would otherwise develop. The effect of price controls is, therefore, to make
socially and individually beneficial action that is morally repugnant because it
involves breaking the law. The conflict tends to undermine the moral capital of a
nation. Good monetary policy cannot produce development. Economic development
fundamentally depends on much more basic forces: the amount of capital, the
methods of economic organization, the skills of people, the available knowledge, the
willingness to work and to save, and the receptivity of the members of the community
to change.

The objectives of monetary policies in a nation are usually related to money and
credit control, price stabilisation and economic growth. Many consider price stability
as the most important objective of monetary policies in a nation since they are
supposed to suffer more from inflation. Monetary policies are considered to be more
effective than the fiscal policies in dealing with inflation. A modest rise in prices (say
between 5 per cent and 10 per cent) is not regarded as harmful to the economy.
Indeed, in a growing economy, the rate of growth of money supply should keep pace
with the rate of growth of output to avoid deflationary pressure, and a rate of price
rise between 5 and 10 per cent could boost the level of profit, investment and rate of
economic growth. In this way, some argue that monetary policy could enable the
economy to achieve a higher rate of economic growth. The contribution of monetary
policy in achieving a higher rate of economic growth could enable the authorities to
attain another objective, full employment. In many nations, the existence of
unemployment and underemployment, particularly in the agricultural sector, has
emerged as a major problem. A better utilisation of resources is regarded as
imperative to promote a more decent standard of living and a greater equality of
income distribution in a nation.

What Is Monetary Policy?

Monetary policy is a set of tools used by a nation's central bank to control the overall
money supply and promote economic growth and employ strategies such as
revising interest rates and changing bank reserve requirements.

Monetary policy is the macroeconomic policy laid down by the central bank. It
involves management of money supply and interest rate and is the demand side
economic policy used by the government of a country to achieve macroeconomic
objectives like inflation, consumption, growth and liquidity.
In the United States, the Federal Reserve Bank implements monetary policy through
a dual mandate to achieve maximum employment while keeping inflation in check.

Understanding Monetary Policy

Monetary policy is the control of the quantity of money available in an economy and
the channels by which new money is supplied. The equation at the heart of
quantitative easing and crude monetarism is known as the “quantity theory of
money” where MV = PT.

M is the quantity of money.

V is the speed money flows round the economy.
P is the level of prices;
T is the number of transactions.

By definition, the equation is true, but controversy has raged over the use of this
formula. If you believe V and T are stable, then control of the money supply
guarantees control of inflation. Quantitative easing raises M, so if V is fixed, it will
push up P or T or both.

In today’s recessionary and deflationary world, that would be a welcome result. But if
banks, companies or households sit on the extra cash sending V plummeting, M may
go up while P and T still tumble. History tells us V has never been sufficiently
predictable to be reliable for use in policy.

Economic statistics such as gross domestic product (GDP), the rate of inflation, and
industry and sector-specific growth rates influence monetary policy strategy. A
central bank may revise the interest rates it charges to loan money to the nation's banks. As
rates rise or fall, financial institutions adjust rates for their customers such as businesses or
home buyers. Additionally, it may buy or sell government bonds, target foreign
exchange rates, and revise the amount of cash that the banks are required to maintain as
reserves.

Types of Monetary Policy

Monetary policies are seen as either expansionary or contractionary depending on

the level of growth or stagnation within the economy. Depending on the economic
circumstance, monetary policy may be categorized in one of two ways: expansionary
monetary policy or contractionary monetary policy.

Expansionary Monetary Policy

Also known as loose monetary policy, expansionary policy increases the supply of
money and credit to generate economic growth. A central bank may deploy an
expansionist monetary policy to reduce unemployment and boost growth during hard
economic times.

It usually does so by lowering its benchmark federal funds rate, or the interest rate
banks use when they lend each other money to satisfy any reserve requirements.
While in the U.S. the Federal Reserve cannot require a certain federal funds rate, it
can set guidelines and influence the rate banks charge each other by altering the
supply of money. In turn, this may lower other interest rates, like those banks use
when they lend money to consumers, which helps spur consumer spending through
increased credit and lending throughout the nation’s economy.

For example, when the U.S. banking system collapsed leading to the Great
Recession of 2007-2008, the Federal Reserve cut interest rates to near-zero to
jumpstart the U.S. economy, thus “expanding” economic growth. It recently did the
same thing to pull the country out of the 2020 Covid-19 recession.

Contractionary Monetary Policy

Also known as tight monetary policy, contractionary policy decreases a nation’s
money supply to curb rampant inflation and keep the economy in balance. A central
bank will likely hike interest rates and try to slow the growth of money and prices.

At the outset of the 1980s, for instance, when the U.S. inflation rate soared to almost
15%, the Fed aggressively raised interest rates to nearly 20%. While that move led
to a nationwide recession, it also brought inflation back to about 3%, helping set the
stage for a robust U.S. economy for the remainder of the decade.

Goals of Monetary Policy

A perennial goal of the monetary policy research agenda is to understand the

behavioural process by which the central bank's actions influence the nonfinancial
economy. In theory, there are many potential influences at work. But especially for
purposes of actual policy implementation, knowing how much of the overall effect of
policy is due to each is important. One particular focus of theoretical and empirical
research in this area, for example on the distinction between the ‘money view,’
according to which contractionary monetary policy works by restricting the amount of
deposits that banks can create (thereby driving interest rates higher, and thus
depressing demand for goods and services), and the ‘credit view,’ under which what
matters is instead banks' reduced capacity to extend loans to firms and households
seeking to finance expenditures.

Inflation

Contractionary monetary policy is used to target a high level of inflation and reduce
the level of money circulating in the economy.

Unemployment

An expansionary monetary policy decreases unemployment as a higher money

supply and attractive interest rates stimulate business activities and expansion of
the job market.

Exchange Rates
The exchange rates between domestic and foreign currencies can be affected by
monetary policy. With an increase in the money supply, the domestic currency
becomes cheaper than its foreign exchange.

The Instrument of Monetary policy

Fiduciary or paper money is issued by the Central Bank on the basis of computation
of estimated demand for cash. Monetary policy guides the Central Bank’s supply of
money in order to achieve the objectives of price stability (or low inflation rate), full
employment, and growth in aggregate income. This is necessary because money is
a medium of exchange and changes in its demand relative to supply, necessitate
spending adjustments. To conduct monetary policy, some monetary variables which
the Central Bank controls are adjusted-a monetary aggregate, an interest rate or the
exchange rate-in order to affect the goals which is does not control. The instruments
of monetary policy used by the Central Bank depend on the level of development of
the economy, especially its financial sector. The commonly used instruments are
discussed below.

Reserve Requirement:

The Central Bank may require Deposit Money Banks to hold a fraction (or a
combination) of their deposit liabilities (reserves) as vault cash and or deposits with
it. Fractional reserve limits the amount of loans banks can make to the domestic
economy and thus limit the supply of money. The assumption is that Deposit Money
Banks generally maintain a stable relationship between their reserve holdings and
the amount of credit they extend to the public.

Open Market Operations:

The Central Bank buys or sells ((on behalf of the Fiscal Authorities (the Treasury))
securities to the banking and non-banking public (that is in the open market). One
such security is Treasury Bills. When the Central Bank sells securities, it reduces the
supply of reserves and when it buys (back) securities-by redeeming them-it
increases the supply of reserves to the Deposit Money Banks, thus affecting the
supply of money.

Lending by the Central Bank:

The Central Bank sometimes provide credit to Deposit Money Banks, thus affecting
the level of reserves and hence the monetary base.

Interest Rate:

The Central Bank lends to financially sound Deposit Money Banks at a most
favourable rate of interest, called the minimum rediscount rate (MRR). The MRR sets
the floor for the interest rate regime in the money market (the nominal anchor rate)
and thereby affects the supply of credit, the supply of savings (which affects the
supply of reserves and monetary aggregate) and the supply of investment (which
affects full employment and GDP).
Direct Credit Control:

The Central Bank can direct Deposit Money Banks on the maximum percentage or
amount of loans (credit ceilings) to different economic sectors or activities, interest
rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way
the available savings is allocated and investment directed in particular directions.

Moral Suasion:

The Central Bank issues licenses or operating permit to Deposit Money Banks and
also regulates the operation of the banking system. It can, from this advantage,
persuade banks to follow certain paths such as credit restraint or expansion,
increased savings mobilization and promotion of exports through financial support,
which otherwise they may not do, on the basis of their risk/return assessment.

Prudential Guidelines:

The Central Bank may in writing require the Deposit Money Banks to exercise
particular care in their operations in order that specified outcomes are realized. Key
elements of prudential guidelines remove some discretion from bank management
and replace it with rules in decision making.

Exchange Rate:

The balance of payments can be in deficit or in surplus and each of these affect the
monetary base, and hence the money supply in one direction or the other. By selling
or buying foreign exchange, the Central Bank ensures that the exchange rate is at
levels that do not affect domestic money supply in undesired direction, through the
balance of payments and the real 3 exchange rate. The real exchange rate when
misaligned affects the current account balance because of its impact on external
competitiveness. Moral suasion and prudential guidelines are direct supervision or
qualitative instruments. The others are quantitative instruments because they have
numerical benchmarks.

The Discount rate.

This is the interest rate charged by the Fed on short-term loans to financial
institutions. Generally, these loans are meant to cover reserve requirements or
liquidity issues banks can’t meet through loans from other banks, which offer a lower
federal funds borrowing rate. Typically, when the U.S. economy is humming on all
cylinders, discount rates are relatively high because the Fed doesn’t need to make
borrowing money cheap to incentivize activity. However, when the economy is in a
slump, the Fed often lowers interest rates to spur lending and credit to individuals
and businesses.

Quantitative easing (QE).

With QE, a central bank like the Federal Reserve uses its massive cash reserves to
buy up large-scale financial assets like government and corporate bonds as well as
stocks. This may sound similar to open markets, but quantitative easing often takes
place on a much larger scale in more direct circumstances, involves buying more
than just shorter-term government bonds and generally occurs when interest rates
are already at or near 0%, meaning the Fed has already fully extended one of its
primary weapons. Central banks must be careful with QE, however, because
continued large-scale asset purchases can lead to economic conditions monetary
policy makers don’t want, like higher inflation and asset bubbles.