Monetary Policy

It is the central bank's policy to manage the supply of money with a view to achieve predetermined macroeconomic goals. Monetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment. Monetary policy aims at influencing the economic activity in the economy mainly through two major variables, i.e., (a) money or credit supply, and (b) the rate of interest.

Types of Monetary Policy:

1. Contractionary Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They reduce the money supply by restricting the volume of money banks can lend. The banks charge a higher interest rate, making loans more expensive. Fewer businesses and individuals borrow, slowing growth.

2. Expansionary Monetary Policy

Central banks use expansionary monetary policy to lower unemployment and avoid recession. They increase liquidity by giving banks more money to lend. Banks lower interest rates, making loans cheaper. Businesses borrow more to buy equipment, hire employees, and expand their operations. Individuals borrow more to buy more homes, cars, and appliances. That increases demand and spurs economic growth.

Objectives of Monetary Policy:

Inflation

Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.

 

Unemployment

Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.

 

Currency exchange rates

Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.

^{Tools of Monetary Policy}

Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.

 

Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.

Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).

 

Open market operations

The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.

^{Role of Monetary Policy in Developing countries:}

1. Developmental Role:

In a developing economy, the monetary policy can play a significant role in accelerating economic development by influencing the supply and uses of credit, controlling inflation, and maintaining balance of payment.

Once development gains momentum, effective monetary policy can help in meeting the requirements of expanding trade and population by providing elastic supply of credit.

2. Creation and Expansion of Financial Institutions:

The primary aim of the monetary policy in a developing economy must be to improve its currency and credit system. More banks and financial institutions should be set up, particularly in those areas which lack these facilities.

The extension of commercial banks and setting up of other financial institutions like saving banks, cooperative saving societies, mutual societies, etc. will help in increasing credit facilities, mobilising voluntary savings of the people, and channelising them into productive uses.

It is also the responsibility of the monetary authority to ensure that the funds of the institutions are diverted into priority sectors or industries as per requirements of be development plan of the country.

3. Effective Central Banking:

To meet the developmental needs the central bank of an underdeveloped country must function effectively to control and regulate the volume of credit through various monetary instruments, like bank rate, open market operations, cash-reserve ratio etc. Greater and more effective credit controls will influence the allocation of resources by diverting savings from speculative and unproductive activities to productive uses.

4. Integration of Organised and Unorganised Money Market:

Most underdeveloped countries are characterized by dual monetary system in which a small but highly organised money market on the one hand and large but unorganised money market on the other hand operate simultaneously.

The unorganised money market remains outside the control of the central bank. By adopting effective measures, the monetary authority should integrate the unorganised and organised sectors of the money market.

5. Developing Banking Habits:

The monetary authority of a less developed country should take appropriate measures to increase the proportion of bank money in the total money supply of the country. This requires increase in the bank deposits by developing the banking habits of the people and popularising the use of credit instruments (e.g, cheques, drafts, etc.).

6. Monetisation of Economy:

An underdeveloped country is also marked by the existence of large non-monetised sector. In this sector, all transactions are made through barter system and changes in money supply and the rate of interest do not influence the economic activity at all. The monetary authority should take measures to monetise this non-monetised sector and bring it under its control.

7. Integrated Interest Rate Structure:

In an underdeveloped economy, there is absence of an integrated interest rate structure. There is wide disparity of interest rates prevailing in the different sectors of the economy and these rates do not respond to the changes in the bank rate, thus making the monetary policy ineffective.

The monetary authority should take effective steps to integrate the interest rate structure of the economy. Moreover, a suitable interest rate structure should be developed which not only encourages savings and investment in the country but also discourages speculative and unproductive loans.

8. Debt Management:

Debt management is another function of monetary policy in a developing country. Debt management aims at- (a) deciding proper timing and issuing of government bonds, (b) stabilising their prices, and (c) minimising the cost of servicing public debt.

The monetary authority should conduct the debt management in such a manner that conditions are created “in which public borrowing can increase from year to year and on a big scale without giving any jolt to the system. And this must be on cheap rates to keep the burden of the debt low.”

However, the success of debt management requires the existence of a well- developed money and capital market along with a variety of short- term and long-term securities.

9. Maintaining Equilibrium in Balance of Payments:

The monetary policy in a developing economy should also solve the problem of adverse balance of payments. Such a problem generally arises in the initial stages of economic development when the import of machinery, raw material, etc., increase considerably, but the export may not increase to the same extent.

The monetary authority should adopt direct foreign exchange controls and other measures to correct the adverse balance of payments.

10. Controlling Inflationary Pressures:

Developing economies are highly sensitive to inflationary pressures. Large expenditures on developmental schemes increase aggregate demand. But, output of consumer’s goods does not increase in the same proportion. This leads to inflationary rise in prices.

Thus, the monetary policy in a developing economy should serve to control inflationary tendencies by increasing savings by the people, checking expansion of credit by the banking system, and discouraging deficit financing by the government.

11. Long-Term Loans for Industrial Development:

Monetary policy can promote industrial development in the underdeveloped countries by promoting facilities of medium-term and long-term loans to tire manufacturing units. The monetary authority should induce these banks to grant long-term loans to the industrial units by providing rediscounting facilities. Other development financial institutions also provide long-term productive loans.

12. Reforming Rural Credit System:

Rural credit system is defective and rural credit facilities are deficient in the under-developed countries. Small cultivators are poor, have no finance of their own, and are largely dependent on loans from village money lenders and traders who generally exploit the helplessness, ignorance and necessity of these poor borrowers.

The monetary authority can play an important role in providing both short-term and long term credit to the small arrangements, such as the establishment of cooperative credit societies, agricultural banks etc.

^{Adopted from:}

https://www.economicsdiscussion.net/monetary-policy/monetary-policy-meaning-objectives-scope-role-and-targets-economics/31314

https://corporatefinanceinstitute.com/resources/knowledge/economics/monetary-policy/

https://www.thebalance.com/what-is-monetary-policy-objectives-types-and-tools-3305867