What is monetary policy? solved

1- What do you mean by monetary policy?

Ans: Monetary policy refers to the action taken by the monetary authorities, generally the central bank, to control and regulate the supply of money, flow of credit with a view to achieve predetermined macroeconomic goals. Thus, the policy used by the central bank to affect the money supply and rate of interest (cost of borrowing credit) with an objective of achieving optimum level of output, employment, price stability, economic growth, exchange rate, balance of payment is known as monetary policy.

There are various tools of monetary policy such as, bank rate, cash reserve ratio, open market operations, selective credit controls etc. By applying these tools the central bank expands or contracts flow of money and credit to reduce economic adversaries.

Monetary policy is categorized as expansionary and contractionary monetary policy.

1-Expansionary monetary policy

Expansionary monetary policy refers to the monetary policy which expands money supply in the economy to stimulate aggregate demand. This type of monetary policy is adopted when stagflation, depression or recessionary trends are seen in the economy due to supply shocks and fall in aggregate demand.

2- Contractionary monetary policy

Contractionary monetary policy refers to the monetary policy which contracts money supply in the economy to dampen aggregate demand. To check the inflationary pressure in the economy this type of monetary policy is implemented.

2. Explain the objectives of monetary policy.

Ans: The economic condition of an economy is not always the same. So, the objectives of monetary policy are also not the same, they defer from time to time as per the economic condition of the economy. Hence, the objectives of monetary policy are of various types. The objectives of monetary policy are given as follows.

1-Price stability

One of the main objectives of monetary policy is to maintain price stability. The economy often suffering from inflation and deflation is called price instability. Both situations are harmful to the economy. So in order to maintain price stability, money supply is pushed up at times of recessionary trends and money supply is cut down when there is inflation.

2-High rate of employment

Monetary policy can be used for achieving full employment. If the monetary policy is expansionary then credit supply can be encouraged. It could help in creating more jobs in different sectors of the economy and hence there is a high employment rate.

3-Rapid Economic Growth

It is the most important objective of monetary policy. Monetary policy can influence economic growth by controlling real interest rates and its impact on the investment. If the central bank adopts a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. The increased investment can speed up economic growth.

4-Exchange Rate Stability

Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy which influences the balance of payment. Therefore, it is essential to maintain exchange rate stability.

5-To correct balance of payment

To achieve balance of payment is also one of the objectives of monetary policy. When the economy faces a deficit balance of payment, money supply is cut to reduce the price level so that exports can be encouraged and imports discouraged. Thus, the deficit balance of payment is corrected.

3- What are the tools or instruments of monetary policy?

Ans: The tools or instruments of monetary policy are quantitative tools/instruments and selective tools/instruments. These tools are describes as follows.

1- Quantitative instruments

Quantitative instruments or measures of monetary policy are bank rate policy, open market operations and cash reserve ratio which are explained as below.

1.1-Bank rate policy

Bank rate is the rate at which the central bank provides loans to commercial banks. When the central bank increases its bank rate, commercial banks also push up interest rates. As a result, investors do not take more loans while depositors deposit more in banks because of high interest rates. It causes a fall in money supply and the rate of inflation falls. On the other hand, with a cut in bank rate, borrowing for commercial banks will be easier and cheaper. This will boost credit creation and recessionary trends get checked.

1.2-Open market operation

Under this method, the central bank sells government securities to the public. They withdraw their bank deposits and purchase government bonds and securities. This process reduces lending capacity of commercial banks and also flows, the cash with people, to the central bank. As a result, money supply falls and inflation drops down. Contrary to this, when the central bank buys securities from the open market, commercial banks and the public sell the securities and get back the money they had invested in them. Obviously the stock of money in the economy increases and with this recession is checked and employment and output increases.

1.3-Cash reserve ratio

Cash reserve ratio CRR is also called statutory liquidity ratio SLR. By the law, the commercial banks must keep a certain percentage of deposit-collection in the central bank as cash reserve. If the ratio of this cash reserve (CRR) is increased by the central bank, more cash out of deposit is to be kept as cash reserve by commercial banks and the lending capacity of commercial banks fall. As a result, money supply falls and inflation comes under control. With the fall in cash reserve ratio, money supply increases and there is increase in AD which checks recessionary trends or controls a fall in output and employment.

2- Selective instruments

By quantitative measures, the monetary authorities influence the flow of credit but it may not be equally desirable in all situations. If the quantitative measures are not desirable, the policy makers may adopt selective measures. The selective instruments are credit rationing, margin requirements, moral suasion and direct action.

2.1-Credit rationing

Credit rationing refers to that policy measure in which the central bank fixes credit quotas for different business activities. In this situation, the central bank cannot grant loans to the business firm beyond the limit. Thus, the unnecessary flow of credit breaks and inflationary pressure get paused. If there is recessionary trend, credit quota is increased and with this the flow of credit overshoots in the economy.

2.2-Margin requirements

Margin requirement is also one of the methods of monetary policy. The commercial banks provide loans against some securities. While lending loans it provides fewer amounts than the current market value of the security. The difference between market value of security and loan provided against it is the margin requirement. It is fixed by the central bank. If the central bank fixes high margin requirements, the flow of credit decreases and on the contrary, with the low margin requirement flow of credit increases. This is how the central bank regulates the economy.

2.3-Moral suasion

Sometimes, the central bank persuades or pressurizes commercial banks to flow its directions on account of credit flow. The commercial banks generally follow the directions of the central bank. So, at the time of inflationary pressure, the central bank gives direction to cut in credit flow and at recession, it directs the commercial banks to flow more credit. This is how the economy is handled by using moral suasion policy.

2.4-Direct action

In case, the commercial banks do not follow the directions of the central bank regarding credit flow, it takes direct action against the commercial banks. It may refuse to provide loans, discounting facilities, also may penalize some extra amount. Thus, with direct action, the central bank regulates the economy.