What is Monetary Policy?

Monetary policy means the process through which a central bank or other financial authorities manage the money supply in an economy. It is an attempt to reduce inflation and contributes to the stable gross domestic product (GDP) to lower unemployment. The monetary authority reduces the interest rate for price stability in a nation’s currency. The central bank of a nation governs monetary policies and controls the overall money supply available to banks and customers.

Role of Monetary Policy in business economics

Monetary policy plays a vital role in business economics. The central bank focuses on controlling the economy's overall growth while considering monetary policies. The goal of a central bank is to control the interest rate in terms of borrowings and investments for stability.

The management of the supply of capital is the biggest challenge within an economy. A company should manage its finances and investments concerning to the basic goals of the monetary policy. While handling the capital, they need to take guidance and care. Monetary policy is an effective tool for banking in terms of savings, investment, lending loans to customers, printing currency notes, etc. The banking and finance process should be easy and convenient for all general people, customers, etc.

Worth noted points

• The goal and objectives should be clear and understandable. Monetary policy's common goal should be to bring economic stability and generate employment.
• As an aspect of monetary policy, fiscal policy is an economic tool. Both monetary and fiscal policies are used in a certain way by government and Federal Reserve programs.
• Business owners, companies, and industries should be very careful while dealing with investments and savings.
• Banks should be prepared and have proper plans to deal with inflation.
• People should be very much aware of the monetary policies as a monetary policy has certain applications in the field of business economics, business banking, and so on.
• Prior steps should be taken to handle the inflation rate in an economy.

Types of monetary policy

1. Contractionary monetary policy:

In this type of monetary policy, the central bank tightens the money supply to slow down inflation. It results in higher interest rates and makes less money available for borrowing. For example, the Federal Reserve might raise the federal funds rate to slow down inflation.

2. Expansionary monetary policy:

In this type of monetary policy, the central bank expands the money supply to stimulate economic growth. It results in lower interest rates and makes more money available for borrowing. For example, the Federal Reserve might lower the federal funds rate to stimulate economic growth.

Challenges in monetary policy

• Existence of black money: Black money is the income generated either in illegal ways or by not recording legal incomes for taxation purposes. It increases inflation within the economy, and as a result, prices for products and services increase.
• Unfavorable banking habits: In terms of developing nations, many unfavorable banking habits are found. Most people use cash transactions rather than banking transactions. This means a major portion of cash circulates within the economy, but it does not return to the bank in the form of a deposit.
• Limited role in controlling prices: Central bank plays a very limited role in terms of prices. Therefore, the central bank finds it difficult to control the inflationary pressure within the economy.
• Difficult to control inflation rate: Sometimes, it is difficult to control inflation due to a significant gap between high demand and a relatively less supply of products. This gap contributes to an increase in prices that cannot be controlled by monetary policy.

Tools of monetary policy

Tools are the various methods that the monetary authority of a country uses to achieve its macroeconomic objectives. The main monetary policy tools are as follows:

• Interest rates: Central banks use interest rates to encourage or discourage borrowing and spending. Raising the interest rates makes it more expensive to borrow money, which can slow down economic activities. On the other hand, lowering the interest rates makes it cheaper to borrow money, which can boost economic activities.
• Open market operations: Under this policy, the central bank either sells or purchases the government securities in the open market to have control over the money supply in the economy.
• Quantitative easing: This policy is considered to be the unconventional one in which the central bank invests in the government securities in the open market to free some of the money supply.
• Exchange rates: The central bank also influences economic activity by changing the exchange rates between the domestic currency and foreign currencies. A lower exchange rate makes exporting activities more expensive and imports cheaper, thus reducing the level of economic activity.

Monetary policies serve as a basis to impact economic activities in an economy for the central bank. These policies work toward promoting an economy while maintaining prices.

Common Mistakes

Readers might get confused between monetary and fiscal policy if they are not aware of the differences between the two. Monetary policies involve the policies through which a central bank manages the supply of money. These policies enable a central bank to manage the ways through which new money can be injected. On the other hand, fiscal policy involves the policies to influence the economy with the help of government spending and tax policies.

Monetary policy is generally used to fight inflation, while fiscal policy is typically used to boost economic growth. In times of economic recession, both monetary and fiscal policy can be used to stimulate the economy.

Context and applications

Monetary policy is a fundamental topic of economics and is important for other courses of study like Bachelors of Economics, Bachelors of Arts (Economics), Diploma in Economics, and Post Graduate Program (Economics).

Related concepts

While studying monetary policy information, it is important to read the following topics to understand the concept better:

• Economy financial condition
• GDP rate (Gross Domestic Product)
• Managerial Economics

Practice problems

1. The primary purpose of the RBI's (Reserve Bank of India) monetary policy is to maintain

1. Wealth
2. Interest rate
3. Personal growth
4. Price stability

Answer: d

Explanation: RBI's monetary policy deals with maintaining the balance of price stability, economic growth, and exchange rate stability within an economy.

2. Open market operations typically involve:

1. Purchase of stocks
2. Purchase and sale of government securities
3. Sale of stocks
4. Trading in debts

Answer: b

Explanation: Open market operations mean trading in government securities.

3. _______ can raise and lower federal funds rates.

1. Federal Reserve
2. Private banks
3. Government
4. Corporations

Answer: a

Explanation: Federal reserve has the right to lower and raise the federal funds rate as per the situation.

4. The objective of monetary policy is:

1. To achieve price stability
2. To control the demand for money
3. To control GDP (gross domestic product)
4. To control fiscal policy

Answer: a

Explanation: The monetary policy focuses on maintaining price stability and their maintenance for growth.

5. Monetary policies target _____________ levels.

1. Employment
2. Depression
3. Inflation
4. Income

Answer: c

Explanation: Monetary policies target inflation levels. These policies aim at reducing product prices while increasing their supply.