The Monetary Policy refers to the activity through which the central bank influences the amount of money circulating in the economy. Monetary Policy shows that the economic policy in which the size and growth rate of the money supply is managed. This policy is mainly used for the regulation of inflation and unemployment.
This policy is used to target the inflation levels in the economy. Sometimes, the low inflation level is good for the economy, while during high inflation times, the policy can be described as a contractionary monetary policy through which the supply of money circulating in the economy is reduced. Similarly, its other objective is to maintain the level of employment in the economy.
In times of unemployment, monetary policy is used to increase the money supply so that business activities can be increased which will ultimately generate employment opportunities. Another objective is the regulation of exchange rates. While issuing more currency in the economy, the money supply will increase and the domestic currency will become cheaper than the foreign currency.
There are various tools used for the implementation of monetary policy. The first one is the interest rate adjustment. The central bank can change the discount rate through which the banks get short-term loans from the central bank.
By changing the discount rate, the interest rate can be influenced. By increasing the discount rate, the cost of borrowing for the bank increases. Thus, the central bank increases the interest rate, and ultimately the borrowing cost will increase and the money supply in the economy will decline.
Another important tool for monetary policy implementation is the change Reserve Requirement.
There is a limit from the central bank for the commercial banks to set the minimum amount of reserves. The central bank can influence the supply of money in the economy by changing the number of minimum reserves maintained by the commercial banks.
If the central bank increases the limit of these reserves, then the banks will not find more money to be given to the customers as loan which will decrease the supply of money in the economy.
Another important tool of the monetary policy is the Open Market Operations. The central bank buys or sells the securities issued by the government to influence the money supply in the economy.
If the central bank buys the government securities and bonds, then the banks will get more money and this will increase the lending opportunities for the customers, and the money supply in the economy will increase. There are two types of open market operations.
One refers to the permanent open market operations in which the central bank is constantly using this tool to buy and sell securities to adjust the money supply in the economy. However, the temporary open market operations are generally for a short-term basis which addresses reserve needs that are transitory and for a short period of time.
The Monetary policy can further be classified into Expansionary and Contractionary Monetary policy. The former one is used to increase the supply of money in the economy while the latter shows the influence on the money supply by declining it.
The expansionary monetary policy is aimed to decrease the interest rates, purchase of government securities, and decrease the reserve requirements for the banks. Generally, the expansionary monetary policy lowers unemployment and increases the spending of the consumers which will ultimately enhance the business activities in the economy.
However, we can also infer that in expansionary policy, the expansion of business activities may also cause inflation which is defined as the persistent rise of prices of the goods.
The Contractionary monetary policy shows that the money supply can be declined using this policy. By increasing the interest rates, the money supply can be controlled and ultimately the inflation level in the economy will fall. The government bonds when sold and increasing the reserve requirement for the commercial bank will also decrease the money supply in the economy.
In past times, the primary goal for the central bank was to protect the gold reserves. When an economy is facing deficits in its balance of payments, then the gold would be shifted to other nations.
In order to cope up with this situation, the central bank increases the discount rate and undertakes open market operations so that the money supply circulating in the economy starts declining.
This step would decrease the prices, income, and employment which will decline the demand for imports and the trade deficit will be balanced. The same process was used to correct the balance of payment surplus.
During the inflationary situation in the 1960s and ’70s, in which inflation has been increased three times as compared to the time in the past decade. The monetarists such as Milton Friedman showed that there is a strong link between inflation and money supply in the economy.
They argued that the tight control money supply is a far much better way to control inflation. Monetary policy is one of the effective tools through which the national economy’s fluctuations can be controlled effectively.
The regulation of the economy is generally done by the Monetary and Fiscal policy. Both are used for the economy potential which includes the money supply and finance. Monetary policy is controlled by the central bank while fiscal policy is controlled by the government.
The coordination among the two policies is very important so that the objectives can be achieved such as controlling inflation, increasing employment opportunities, and generating of business activities.
Syed Talha Ali - currently working as Research Assistant at Pakistan Institute of Development Economics, Islamabad. He has an interest in Economics and Development issues of Pakistan.