Monetary Policy

Monetary policy can be described as the alteration of the (nominal) money supply Opens in new window by the reserve bank.

Monetary policy, in general, refers to the action taken by the monetary authorities (the reserve or central banks) to control and regulate the demand for and supply of money Opens in new window with a given purpose.

Monetary policy is one of the two most powerful tools of economic control and management of the  Opens in new windoweconomy. It consists in managing the quantity and price of money to achieve one or several objectives depending on the central bank’s mandate: price stability, full employment, and, depending on the exchange rate regime, exchange rate stability.

Monetary policy is a demand-side policy just like fiscal policy Opens in new window, but there are two important differences.

  • First, monetary policy is generally delegated to an independent agency—the central bank—with an explicit and narrow mandate, generally price stability.
  • Second, monetary policy affects aggregate demand only indirectly, whereas fiscal authorities purchase goods and services directly.

In the Musgrave and Musgrave taxonomy, monetary policy can be classified, like fiscal policy Opens in new window, as a stabilization policy: by affecting interest rates, it alters households’ and firms’ intertemporal decisions. For instance, a cut in interest rates will reduce the cost of investing, and the subsequent increase in investment will raise aggregate demand.

Monetary policy is designed and implemented by central banks, institutions which may have private shareholders but operate under a public mandate written in law or constitution.

Central banks operate at the level of a country (such as the US Federal Reserve [Fed] Opens in new window; also the Bank of Japan Opens in new window, the People's Bank of China Opens in new window or the Bank of England Opens in new window) or, in the case of a monetary union, of a group of countries (such as the European Central Bank [ECB] for the euro area).

They have the privilege of creating what is called base money, or sometimes high-powered money. This consists in providing liquidity to individuals in the form of banknotes, and to the financial system in the form of bank reserves deposited on accounts at the central bank. This is why the central bank is sometimes called the “bank of the banks.”

Monetary policy consists primarily in setting the price and quantity of central bank liquidity. By arbitrage Opens in new window, this price determines short-term interest rates paid on the interbank market (where banks lend to each other) and on short-term financial instruments.

Depending on market expectations and risks, monetary policy also influences longer term interest rates and a wider range of financial variables in the economy, which in turn influence economic behavior.

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Scope of Monetary Policy

The scope of monetary policy spans the entire area of economic transactions involving money and the macroeconomic variables that monetary authorities can influence and alter by using the monetary policy instruments Opens in new window.

The scope of monetary policy depends, by and large, on two factors:

  1. the level of monetization of the economy, and
  2. the level of development of the financial market.

In a fully monetized economy, the scope of monetary policy encompasses the entire economic activities. In such an economy, all economic transactions are carried out with money as a medium of exchange.

In that case, monetary policy works by changing the supply of and demand for money and the general price level. It is therefore capable of affecting all economic activities—production, consumption, savings and investment.

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The monetary policy can influence all major macro variables—GDP, savings and investment, employment, the general price level, foreign trade and balance of payments.

Generally, the following are the objectives of monetary policy which the central bank aims to achieve:

1.     Economic Growth

One of the twin aims of the economic policy is to accelerate the process of economic growth with a view to raise the national income.

2.     Expansion of Money

It sought to achieve the twin objectives of meeting in full the needs of production and trade and at the same time moderating the growth of money supply to contain the inflationary pressures in the economy.

3.     Encourage Exports

Its boots exports in order to solve the problem of balance of payment deficit.

4.     Social Justice

It supports programs of social justice (i.e., more equitable distribution of income) by influencing the cost, volume and direction of credit to priority sectors of the economy.

5.     Reduce Deficit

It tries to reduce the monetized deficit in order to bring down government’s gross deficit.

6.     Stability in the External Value of its currency

The central bank strives to achieve stability in the external value of the country’s currency. If exchange rate fluctuates excessively then the Reserve Bank takes appropriate action like purchase or sale of foreign currency so as to regulate demand and supply of foreign currency and thereby maintain stability in the external value of the currency.

7.     More credit for priority sector

Monetary policy aims at providing more fund to priority sector by lowering interest rates for these sectors. Priority sector includes agriculture, small-scale industry, weaker sections of society, etc.

Although its purpose is macroeconomic stabilization (and hence intertemporal redistribution), monetary policy also has allocative and distributive consequences. For example, at a given point in time, a lower interest rate reduces the income of savers and benefits debtors.

Central bankers consider such distributive consequences limited and balanced over the business cycle, and they see them as means to an end. Politicians and citizens sometimes disagree, which may lead them to challenge the central bank’s mandate. Controversies have become more frequent since the global financial crisis, as the scope and magnitude of central bank intervention have increased.

Households and companies take consumption, investment, and savings decisions depending on present and future interest rates on products offered by financial intermediaries (banks, pension funds, etc.).

The central bank influences this process indirectly by affecting financing conditions, but it does not lend directly to households and nonfinancial companies, nor does it collect their savings.

A key implication is that monetary policy cannot be effective if the financial system is impaired, as was the case during the 2008 financial crisis. Hence, monetary policy cannot be isolated from financial stability, and financial crises make the task of central bankers much more difficult.

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