Monetary Policy, Objectives, and Instruments

 

Monetary Policy

A monetary policy consists of all those measures adopted by a nation's central bank or monetary authority to control the supply of money and credit. The primary goal of monetary policy is to control inflation, stabilize currency, achieve low unemployment, and promote economic growth. 

Definition: "The policy adopted by the central bank of a country to control the supply of money and credit is known as monetary policy ".

In the United States, the Federal Reserve Bank implements monetary policy through a dual mandate to achieve maximum employment while keeping inflation in check.

Types of Monetary Policy

Monetary policies are categorized into two types. These are Expansionary Monetary Policy and Contractionary Monetary Policy. 

Contractionary 

The country's central bank raises interest rates, making borrowing more expensive and saving more attractive, which reduces consumption and investment. It might also sell government securities, reduce the money supply, or increase reserve requirements, limiting the banks' ability to lend.

In the 1980s, the U.S. Federal Reserve under Paul Volcker significantly raised interest rates to combat high inflation.

Expansionary

The country's central bank lowers interest rates, making borrowing cheaper and saving less attractive, which encourages spending and investment. The central bank might also increase the money supply through open market operations (buying government securities) or reduce reserve requirements for banks to increase lending. This policy was adopted during the recession.

Objectives of Monetary Policy 

The main objectives of monetary policy are as under:

Maintain a Stable Exchange Rate:

There is the main objective of monetary policy is to maintain a stable exchange rate. Change in the exchange rate may create uncertainty in foreign trade, speculation will be developed, and the resources, prices, and output level will be disturbed. This can be important for economies that depend on international trade.

Economic Growth:

Through monetary policy, a suitable environment can be created whereby attractive saving schemes can be introduced. The money and capital market can be made dynamic. The credit facilities by financial institutions can be increased. Through the monetary policy, central banks can build public confidence in the economy, which supports investment, consumption, and overall economic activity.

Correct BoP:

In the case of a deficit BoP, the monetary policy can be used to remove a deficit in BoP whereby the money supply is decreased. As a result, the prices will fall and exports will increase. Moreover, due to strict monetary policy, the people's income will also decrease, leading to reduced imports and increased exports.

To achieve Full Employment Level:

Full employment represents such a situation where all the job seekers get jobs by their capabilities at the prevailing wage rate. When the economy is operating near full employment, it indicates efficient use of labor resources. Thus, according to Keynes, by raising effective demand through monetary policy, income and employment can be increased.

Stabilizing the Prices:

One of the most important objectives is to maintain low and stable inflation. High inflation erodes purchasing power, reduces savings, and can create uncertainty in the economy, while deflation can lead to reduced consumption and investment. The general rise in prices represents inflation, while the fall in the general level of prices is called deflation. Both of these situations are undesirable, therefore, monetary policy is used to stabilize prices.

Manage Interest Rate:

By adjusting interest rates, monetary policy affects the cost of borrowing for consumers and businesses. Lower interest rates make borrowing cheaper, stimulating investment and consumption, while higher rates can cool down an overheating economy.

Instruments of Monetary Policy

The instruments of monetary policy are classified into two methods.

1. Quantitative Method 

2. Qualitative Method 

Quantitative Method 

Open market Operation (OMO):

This is the buying and selling of government securities (bonds, treasury bills) by the central bank in the open market. It is an essential monetary policy instrument as it influences the interest rate, the monetary base, and the money supply in the economy.

Expansionary OMO: In case of deflation, the central bank buys securities, it increases the money supply by injecting cash into the economy, lowering interest rates, and encouraging borrowing and spending.

Contractionary OMO: In inflation, the central bank sells securities, it reduces the money supply by taking cash out of circulation, raising interest rates, and discouraging borrowing and spending.

Change in Bank Rate:

The interest rate at which the central bank advances loans to commercial banks or rediscounts the bills of exchange is known as the Bank Rate Policy or rediscount policy. During inflation, the central bank will increase the bank rate, whereas in deflation, the central bank will decrease the bank rate.

Change in Reserve Ratio:

Each commercial bank has to deposit a specific percentage of its time and demand deposits with the central bank. During inflation, the central bank enhances this ratio, and the resources of commercial banks will decrease, and they will not be able to advance more loans. In deflation, banks can lend more of their deposits, increasing the money supply and stimulating economic activity.

Change in Liquidity Ratio:

Legally, each commercial bank must keep a certain percentage of its total deposits, and the central bank fixes such a ratio. The central bank can change it whenever it likes.

Credit Rationing:

The central bank can restrict the loans that a commercial bank can obtain from a central bank; in this way, the prices can be controlled.

Qualitative Method

There are qualitative methods or selective credit controls at the disposal of the central bank.

Change in Margin Requirement:

The margin requirement is the percentage difference between the collateral against the loans and the loan amount given to the borrower by a commercial bank. By changing such conditions, the central bank can influence the activities of commercial banks.

Consumers Credit Control:

It is commonly observed that consumer credits accelerate inflation, in which the central bank instructs specific measures targeting certain sectors of the economy to control credit flow. For example, the central bank may impose limits on lending for speculative purposes, such as real estate, to prevent bubbles in specific markets.

Rationing of Credit:

Commercial banks have to depend upon the central bank while borrowing. If the central bank finds that commercial banks are involved in advancing excessive loans, then the central bank can impose limits on the total amount of credit that banks can extend to specific sectors or industries.

A central bank might impose caps on the amount of credit extended for real estate or consumer loans to prevent bubbles or excessive borrowing in these areas.

Moral suasion:

The central bank is the head of the money market activities, and it advises the commercial banks. This involves using persuasion, appeals, or directives from the central bank to influence commercial banks' behavior without using formal policy tools. Central banks might encourage banks to adopt certain lending practices or maintain liquidity under certain conditions.