Monetary policy is decided by the central bank of a country. However, these actions are taken to control money supply in the economy. Besides, there is another goal of monetary policy i.e. to promote sustainable economic growth. WHAT IS MONETARY POLICY ?

Different sources provide information to frame monetary policy in the economy. Authorities look into data of many indicators to draw a policy. These indicators are GDP, inflation, economic growth etc. As a result, the purpose of monetary policy is inflation targeting and output stabilization. But certain economist also suggest, monetary policy is for price stabilization.

WHAT IS MONETARY POLICY
WHAT IS MONETARY POLICY ? (Source- FreeBcomNotes)

The functions of monetary policy is to maintain price stability in the economy. However, price stability is a connected factor. As a result, it requires targeting other indicators too for maintaining constant prices. In the long run, output is same but money supply changes. Because of money supply in the economy, prices change. WHAT IS MONETARY POLICY ?

However, in the short run, price and wages do not change. As a result if money supply change it affects the production of goods and services. These monetary policy is a useful policy tool to achieve inflation and growth.

Monetary Policy Definition – WHAT IS MONETARY POLICY ?

Monetary policy is from the demand side of economic policy. It is the process of implementing the plan of central bank to control money supply in the economy. Besides, monetary policy also aim to control other sources that change the money supply. The change in money supply is an interconnected process. It is sometimes healthy for the economy. But sometimes it may prove bad for the economy too.

Monetary policy serves to modify interest rate, regulate forex to achieve its objectives. However, this is not the only ways of achieving its objectives. The other ways are open market operations, reserve requirement. [Source- Britannica]

Business analyst, investors follow monetary policy decision to keep track of the latest developments. It is crucial for many business decisions. These decisions taken have a long-lasting impact on the economy. However some sectors face the impacts of these policies more as compared to the others.

The basis of monetary policy is to achieve

  • Stable rise in GDP
  • Keep unemployment level low
  • Maintain foreign exchange
  • Inflation targeting

The definite purpose of monetary policymaker is to manage output and price. The key responsibilities of policymakers is to decide the final price of goods and services. Monetary policy helps to maintain the aggregate demand for goods and services in the economy.

Objectives of Monetary Policy – WHAT IS MONETARY POLICY ?

The primary objectives of monetary policy is to manage inflation. Other than that monetary policy also manages unemployment and currency exchange rates.

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Objectives of Monetary Policy (Source- CorporateFinance)

Inflation

Inflation is the increase in the general price level in the economy. Monetary policy targets inflation to keep under check. Inflation targeting is the primary objective of this policy. Economists suggest to keep inflation rate between 4% to 6%. A low level of inflation is healthy for the economy. Because it helps in economic growth of the economy.

Unemployment

Monetary policy influences the unemployment level in the economy. In contractionary policy, money supply in the economy reduces. As a result, this soaks investment. When there is less investment production will be less. As a result, this increases the unemployment level.

Currency Exchange Rates

The central bank uses monetary policy to regulate the currency exchange rates. Central bank uses expansionary policy to increase money supply in the economy. This leads to fall in the value of currency in the economy.

Monetary Policy vs Fiscal Policy

The government of the country manages fiscal policy. It is a policy where government employs tax revenues and government expenditure to influence the demand and supply of goods and services in the economy. As a result of this policy, government maintains the equilibrium between receipts and spending. [Source- StLouisFed]

Fiscal surplus means that revenue exceeds expenditure. But fiscal deficit is when expenditure exceeds revenue. The objective of fiscal policy is to bring stability, control unemployment and maintain growth in an economy.

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Fiscal Vs Monetary Policy (Source- KeyDifference)

Types of Fiscal Policies

There are two types of fiscal policy, as listed below.

Expansionary

It is a policy when government reduces the tax burden on the citizens. At the same time, the government also increases the spending on social lines. This will increase the money supply in the economy.

Contractionary

Through this policy the government increases the tax burden on the citizens. However, the government expenditure also decreases. This decreases the money supply in the economy.

Monetary policy is the strategy used by central bank to regulate money supply in the economy. When money supply in the economy increases and interest rates decreases then it is called expansionary monetary policy. But when money supply decreases and interest rate increases then it is called contractionary monetary policy.

Comparison

The key difference between monetary policy and fiscal policy can be stated as that fiscal policy uses tax and expenditure to affect the economy. But in monetary policy the central bank regulates the money supply in the economy. Normally the fiscal policy change every year. Monetary policy change but it also depends upon the economic status of the country. Fiscal policy focuses on economic growth. At the same time, monetary policy focuses on economic stability.

Types of Monetary Policy

Monetary policy is divided into broadly two types i.e. expansionary monetary policy and contractionary policy.

Expansionary Policy

Expansionary monetary policy is when money supply increases and interest rate decreases in an economy. The increased money supply helps to increase investment. As a result the consumer spending also increases in the economy. This helps to influence economic growth and expand economic activity in the economy.

Central banks also decrease the interest rates in the economy. This motivates the people to spend more and save less. As a result the demand for goods and services rises. At the same time, due to low interest rates it is possible to take loans. As a result, businessmen take loans for expansion of their business. This also helps to stimulate economic activity in the economy.

Contractionary Policy

Contractionary monetary policy refers to when the central bank reduces money supply and interest rates are also high. When money supply in the economy decrease then cash in hand also reduce. As a result consumer spending also decreases in the economy.

When interest rates are high in the economy people tend to save more. This reduces the liquidity in the economy. The cost of loans also rise due to high interest rates. Therefore during this time business cannot expand. During this period, the economic activities in the economy are less.  

Tools of Monetary Policy – WHAT IS MONETARY POLICY ?

Central banks use different tools to implement monetary policy in the economy. These tools influence the money supply in the economy.

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Monetary Policy Tools (Source- TamoClass)

Open Market Operations

Open market operations is the buying and selling of the government bonds to regulate the money supply in the economy. When the central banks buy bonds then the money supply in the economy increases. But when it sells government bonds the money supply decreases. The objective of open market operation is to influence the interest rate in the short run. It helps in increasing the money supply in the economy.

When central banks buys government securities, money is pushed into the economy. This will increase the supply of money in the economy. As a result, the demand for goods and services also increase. This also helps businessmen to take loans for business. Because the interest rate in the short run declines. [Source- Investopedia]

When central banks sells government securities, it soaks the liquidity from the market. Less money is available for loans and at the same time the interest rates in the long run is also high. Therefore, businessmen cannot take loans from commercial banks. Savings are profitable as interest rates are high.

Discount Rate

It is the basic tool of central bank in monetary policy decision making. Discount rate is the interest rate that is charged when commercial banks take loan from the central bank of a country. When discount rate is high then commercial banks cannot take much loans from the central bank.

When central banks increase the discount rate, the cost of loans increase. The higher the cost of loans reduces the liquidity of the commercial banks. Because they cannot borrow much from the central bank. When liquidity of commercial banks reduce the loan giving facility also reduces. This reduces the level of investment in the economy.

In another case, when central banks decrease the discount rate, the cost of loans decrease. This influences the liquidity in the economy. Commercial banks have funds available with them to give loans. Businessmen take loans for investments from commercial banks. As a result the investment level in the economy will also rise.

Reserve Requirement

It is one of the important tools of macroeconomic policy. Reserve requirement is the amount of the deposits that has to be kept with the central bank. This also influences the money supply in the economy.

If reserve requirement is increased by the central bank then liquid assets will be less with the commercial banks. When liquidity is less then credit availability will decrease. This reduces the loan opportunities for the commercial banks. As a result the level of investment in the economy also reduces. This will decrease the money supply in the economy.

Now if reserve requirement is decreased. Then availability of credit with the commercial banks will increase. More the liquidity more will be the loan facility. Thus it increases the investment opportunities in the economy.

WHAT IS MONETARY POLICY ? (Source: YOUTUBE)

Conclusion – WHAT IS MONETARY POLICY ?

Monetary policies are very important tool to regulate money supply in the economy. Money supply influences inflation and unemployment level in the economy. Economic growth and output is an important aspect of macroeconomic policy. There are two types of monetary policy in the economy that is followed by the central bank. They are expansionary and contractionary monetary policy.

Both the tools of monetary policy are used by the central bank to check different objectives. Monetary policy most remain same unlike the fiscal policies. Monetary policy mainly focuses on economic stability. We can conclude by saying that monetary policy is an important tool used by central bank to regulate the economic stability from time to time.

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