What is Monetary Policy? Definition, Instruments, Types, and Importance

Definition of Monetary Policy

Monetary policy concerns the country’s monetary system. It refers to the policy measures undertaken by the Central Bank to influence the money supply as an investment in achieving the objectives of general economic policy.

Monetary policy helps realize objectives such as the optimum level of output and employment, price stability, and economic growth by regulating the level of aggregate demand and aggregate supply and thereby the level of money income.

It includes all monetary decisions and measures and non-monetary decisions that have monetary effects.

Monetary policy aims at influencing economic activity mainly through two major variables i.e. money or credit supply and the rate of interest.

According to Paul Einzig, an ideal monetary policy may be defined as “the effort to reduce to a minimum the disadvantages and increase the advantages, resulting from the existence and operation of a monetary system”.

The Central Bank of a country is the traditional agent, which formulates and operates monetary policy in a country.

Nepal Rastra Bank of Nepal as it is obvious carries out monetary policy in Nepal. The Reserve Bank of India regulates and formulates the monetary system of India. Federal Reserve Bank of America overseas the monetary system in the USA.

Monetary policy is only a means to an end, not an end in itself. Its objectives and scope change according to changes in business activities and the level of economic development.

A sound monetary policy is the prerequisite of a successful and comprehensive development planning program.

Objectives of Monetary Policy

The main objectives are:

• Neutrality of Money: Ensures that money functions as a medium of exchange without causing distortions in economic decisions or leading to inflationary or deflationary pressures.
• Exchange Rate Stability: Aims to maintain a stable value of the national currency about foreign currencies, which fosters international trade and economic confidence.
• To Correct Disequilibrium: Focuses on addressing imbalances in the economy, such as trade deficits, fiscal imbalances, or inequalities in resource distribution, to restore equilibrium.
• Price Stability: Seeks to control inflation and deflation, ensuring that prices remain stable over time, which is crucial for economic predictability and consumer confidence.
• Full Employment: Strives to create conditions that lead to the maximum utilization of a country’s labor force without causing inflationary pressures.
• Economic Growth with Stability: Promotes sustainable economic development by balancing rapid growth with measures to avoid excessive volatility or economic crises.

Instruments of Monetary Policy

Qualitative controls and selective credit controls are two tools or instruments of monetary policy:

Quantitative Controls

Quantitative controls affect the level of aggregate demand through the supply of money, cost of money, and availability of credit. They are meant to regulate the overall level of credit in the economy through commercial banks.

The quantitative methods include bank rate policy, open market operations, and changes in reserve ratio, which are discussed below:

Bank Rate Policy:

The bank rate is the minimum lending rate of the central bank at which it rediscounts first-class bills of exchange and government securities held by commercial banks. At times of inflationary pressures within the economy, the central bank raises the bank rate.

Borrowing from the central bank becomes costly. Commercial banks borrow less from the central banks. Commercial banks also raise their lending rates. So the borrowers borrow less from the central bank.

And, So the borrowers borrow less from Commercial banks. There is a contraction of credit and prices are checked from rising further.

On the contrary, during the depression (deflationary pressure), the central bank lowers the bank rate. So commercial banks will also lower their lending rates. Businessmen are encouraged to borrow more. Investment is encouraged. Output, employment, income, and demand start rising.

Open Market Operations:

It refers to the sale and purchase of securities by the central bank. When prices are rising, the central bank sells securities. The reserve commercial banks are reduced and their lending power is contracted. Investment is discouraged and the rise in prices is checked.

On the other hand, when recessionary forces (deflationary pressure), start in the economy, the central bank buys securities. The reserves of commercial banks are raised. They can lend more credit. As a result, investments, output, employment, income, and aggregate demand start rising.

Changing Cash Reserve Ratios:

The variable reserve ratio is a direct quick and effective method of controlling the power of commercial banks to create credit. Commercial banks are required by law to keep a certain percentage of their deposits with the central bank in the form of cash reserves.

This is known as the statutory minimum reserve, and the excess over this statutory minimum reserve is the excess reserve. It is based on these excess reserves that commercial banks can create credit.

Selective Credit Controls

Selective or qualitative methods of credit control aim at regulating and controlling the allocation of credit among various users rather than influencing the general availability of credit.

We discuss below the main selective credit control instruments of monetary policy:

Regulation of Consumer Credit:

An important instrument of selective credit control is the regulation of consumer credit. It aims at regulating consumer installment credit or hire-purchase finance. Hire purchase finance is the method of using bank credit by the consumers to buy expensive durable goods like motor cars, houses, computers, etc.

A certain percentage of the price of the durable goods is paid by consumers as a downpayment and the remaining portion of the price is financed by the bank credit.

Regulation of Margin Requirements:

As we know, commercial banks generally give loans to their customers against some securities. However, they do not give loans to the full amount of the value of the security, but to an amount that is less than its value.

The difference between the value of the security and the amount of loan granted is known as margin requirements. The banks keep this margin to protect themselves against any fall in the value of the security. The central bank influences the availability of bank credit by fixing this margin requirement.

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Credit Rationing:

It aims at limiting the maximum or ceiling of the total amount of bank loans and advances, as well as, in certain cases, fixing the maximum limit of loans for specific purposes. Rationing of credit may take two forms:

• The central bank may fix the maximum amount of loans and advances for every commercial bank.
• The central bank may fix the maximum ratio of the capital of a commercial bank to its total assets.

Direct Action:

Direct action refers to various directives issued by the central bank from time to time to the commercial banks to regulate their lending and investment activities. The central banks in all countries pursue direct action against commercial banks.

This policy may not be used against all banks, but against erring banks that do not follow the policies of the central bank. These direct actions may take the form of refusal of discounting facilities, refusal of loans, charging of penal rate of interest, etc.

Moral Suasion:

Moral suasion (suasion is the short form of persuasion) is the method of persuasion, request, informal suggestion, and advice to the commercial banks by the central bank.

The central bank convenes the meeting of the heads of the commercial banks and explains to them the need for the adoption of a particular monetary policy and appeals to them to follow this policy, e.g. central bank relies upon its moral influence on the commercial banks as the head and leader of the financial institutions.

Publicity:

Publicity is another method of selective credit control of monetary policy. The central bank expresses its views about various monetary and banking policies.

It may put forward its views by using facts and figures through the media of publicity. The central bank uses this method both to influence the credit policies of the commercial banks as well as to influence public opinion in the country.

Read More: Classical Theory of Employment

Types of Monetary Policy

Monetary policy may be of two types – restrictive and expansionary:

Restrictive Monetary Policy

A monetary policy designed to curtail aggregate demand is called a restrictive (or dear or contractionary) monetary policy. It is used to overcome an inflationary gap.

The economy experiences inflationary pressures due to rising consumer demand for goods and services and there is also a boom in business investment.

The central bank starts a restrictive monetary policy to lower aggregate consumption and investment by increasing the cost and availability of bank credit.

The main instruments are:

• Selling government securities in the open market
• Raising reserve requirements of member banks
• Raising the bank rate, and adopting appropriate selective measures such as controlling consumer and business credit and credit rationing, etc.

By such measures, the central bank increases the cost and availability of credit in the money market and thereby controls inflationary pressures.

Effects of restrictive monetary policy are:

• Money supply decreases
• Interest rate rises
• Investment decreases
• Aggregate demand decreases
• Price level falls

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Expansionary Monetary Policy

A monetary policy designed to increase aggregate demand is called expansionary monetary policy. It is used to overcome a recession a depression or a recessionary gap.

When there is a fall in consumer demand for goods and services and business demand for investment goods, the central bank starts an expansionary monetary policy that eases the market conditions and leads to an upward shift in aggregate demand.

The main instruments are:

• Purchasing government securities in the open market by the central bank, lowering the reserves requirements of member banks, lowering the bank rate, and
• Adopting appropriate selective measures such as encouraging consumer and business credit and credit rationing, etc.

Such measures decrease the cost and availability of credit in the money market and improve the economy.

• Money supply increases
• Interest rate falls
• Investment increases
• Aggregate demand increases
• Aggregate output increases by a multiple of the increase in investment.

Read More: Macroeconomic Issues

Importance of Understanding Monetary Policy

Let’s explore the 5 key advantages of understanding monetary policy:

Economic Stability

Understanding monetary policy helps individuals and businesses grasp how the central bank stabilizes the economy by controlling inflation, deflation, and unemployment rates, ensuring a steady and predictable economic environment.

Informed Financial Decision-Making

Awareness of monetary policy changes, such as interest rate fluctuations or credit regulations, enables businesses and individuals to make informed decisions regarding investments, savings, and loans.

Promotion of Sustainable Growth

By comprehending how monetary policy supports long-term economic growth, individuals and policymakers can align their strategies to encourage innovation, employment generation, and productivity while avoiding boom-bust cycles.

Impact on International Trade and Currency

Monetary policy significantly affects exchange rates, which influence export and import competitiveness.

Understanding its mechanisms allows businesses engaged in international trade to anticipate currency fluctuations and plan accordingly.

Policy Advocacy and Public Awareness

A clear understanding of monetary policy empowers citizens to engage in policy discussions, advocate for sound economic strategies, and hold policymakers accountable for decisions that impact national and individual economic well-being.

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FAQs on Monetary Policy