ROLE OF

GOVERNMENT IN
ECONOMY.
Monetary Policy
Monetary policy
• Monetary policy is the process by which the government,
central bank, or monetary authority of a country controls
• the supply of money,
• Availability of money, and
• Cost of money or rate of interest,
• in order to attain growth and stability of the economy.
• Monetary policy is generally referred to as either being an
expansionary policy, or a contractionary policy.
Expansionary policy
• An expansionary policy increases the total supply of
money in the economy and is traditionally used to combat
unemployment in a recession by lowering interest rates.
Lowered interest rates encourage the household and the
firms to increase their consumption and investment
respectively. This will shift the AD to the right and result in
higher real output and more employment.
•
Contractionary policy
• Contractionary policy decreases the total money supply and
involves raising interest rates in order to combat inflation.

• It is argued that an increase in the money supply causes an

increase in the rate of inflation. Maintaining a low and stable
inflation is one of the main macroeconomic objectives of the
Government. Government does so by controlling the supply of
money to the economy. This policy is known as monetary
policy.
• Monetary policy is concerned with controlling the supply of
money and the interest rates in the economy. The
government cannot control both the supply of money and
interest rates at the same time.
• Monetary policy in any country is usually controlled by the
Central Bank of that country. The Central bank alters the
interest rates in the economy after assessing the
inflationary pressures in the market.
Monetary Policy tools

• Central Bank has three tools of monetary policy:

• Open market operations.
• Open market purchases: The central bank buys
government securities to increase the monetary base.
• Open market sales: The central bank sells government
securities to decrease the monetary base.
• Open market operations have a number of advantages:
• They are under the direct and complete control of the
central bank
• They can be large or small.
• They can be easily reversed.
• They can be implemented quickly
Discount loans

• Discount loans
• When a bank receives a discount loan from the central
bank, it is said to have received a loan at the “discount
window.” The Central  Bank can a?ect the volume of
discount loans by setting the discount rate:
• A higher discount rate makes discount borrowing less
attractive to banks and will therefore reduce the volume of
discount loans.
• A lower discount rate makes discount borrowing more
attractive to banks and will therefore increase the volume of
discount loans.
• Discount lending is most important during Financial panics:
Discount lending is most important during
Financial panics:

• When depositors lose confidence in the Financial system,

they will rush to withdraw their money.
• This large deposit outflow puts the banking system in
great need of reserves.
• The central bank stands ready to supply these reserves
by making discount loans. In such situations, the central
bank acts as a lender of last resort.
Changes in reserve requirements

• Changes in reserve requirements

• The portion (expressed as a percent) of depositors'
balances banks must have on hand as cash. This is a
requirement determined by the country's central bank. It
affects the money multiplier; changes in the required
reserve ratio can lead to changes in the money supply.
This is also referred to as the "cash reserve ratio"
(CRR).
Central Banks
• Central Banks are charged with regulating the size of a
nation’s money supply, the availability and cost of credit,
and the foreign-exchange value of its currency. Regulation
of the availability and cost of credit may be designed to
influence the distribution of credit among competing uses.
The principal objectives of a modern central bank in
carrying out these functions are to maintain monetary and
credit conditions conducive to a high level of employment
and production, a reasonably stable level of domestic
prices, and an adequate level of international reserves.
Function of a Central Bank
A central bank usually carries out the following
responsibilities:
Implementation of monetary policy.
Controls the nation's entire money supply.
The Government's banker and the bankers' bank ("Lender of
Last Resort").
Manages the country's foreign exchange and gold reserves
and the Government's stock register;
Regulation and supervision of the banking industry
Setting the official interest rates- used to manage both
inflation and the country's exchange rate - and ensuring that
this rate takes effect via a variety of policy mechanisms
• The primary objective of the ECBs monetary policy is to
maintain price stability. The ECB aims at inflation rates of
below, but close to, 2% over the medium term.The
operational framework of the Eurosystem consists of the
following set of instruments: 
Open market operations

• Open market operations play an important role in steering

interest rates, managing the liquidity situation in the market
and signalling the monetary policy stance.

• Link for more information-

• https://www.youtube.com/watch?
v=M9Uy0opVF3s&list=OLAK5uy_nzEPBPA0x5BxgeWmvf
kSQMqSoLL9MH1G4&index=1
Standing facilities

• Standing facilities aim to provide and absorb overnight

liquidity, signal the general monetary policy stance and bound
overnight market interest rates. Two standing facilities, which
are administered in a decentralised manner by the NCBs, are
available to eligible counterparties on their own initiative.

• Link for more information-

• https://www.ecb.europa.eu/mopo/implement/sf/html/
index.en.html
 Minimum reserve requirements

• The intent of the minimum reserve system is to pursue the

aims of stabilising money market interest rates, creating
(or enlarging) a structural liquidity shortage and possibly
contributing to the control of monetary expansion.

• Link for more information-

• https://www.ecb.europa.eu/mopo/implement/mr/html/
index.en.html
Evaluation of Monetary Policy

• Monetary policy is considered to be more successful

during inflationary times because an increase in interest
rates reduces the borrowings and thus stabilises the
prices. Whereas, during deflation, Monetary policy may
not be as effective. During deflation or recession, there is
uncertainty in the market which discourages
entrepreneurs and producers to take risk.