What is Monetary Policy?

Monetary policy refers to the policy which is enforced by the central bank of the country to control the money supply and economic development of the country. The main aim of monetary policy is to manage inflation, consumption, and growth of the economy. The central bank influences interest rates to manage the money supply. In monetary policy, the central bank may revise the interest rate to increase and decrease the flow of money.

Classifications of monetary policy

Monetary policies are classified into expansionary monetary policy and contractionary monetary policy for achieving economic balances and controlling inflation.

Expansionary monetary policy

Central banks stimulate the economy by monitoring macroeconomic factors and are implementing expansionary monetary policy. When the government needs to revive the economy at the time of recession, the central bank implements expansionary policy. Central banks implement expansionary policies to increase the money supply and borrowings by reducing interest rates, reserve requirements, and purchasing government securities. If the interest rate is lower, people and business organizations borrow money for their investment and business purposes. When interest rates decline, the demand for borrowing increases. An increase in borrowings results in higher investments and purchases. Thus, the economic growth will increase. During expansionary policy, the economy of the nation gets expanded due to low-interest rates and increased cash circulation. Expansionary monetary policy also increases inflation. This policy is implemented to control unemployment, control inflation, and improve the economy in its struggling period. This policy is otherwise known as the easy money policy.

Contractionary monetary policy

When the government needs to control economic growth and inflation, the central bank implements a contractionary policy. To achieve contractionary monetary policy, the central bank reduces cash circulation by increasing interest rates. If the cost of a loan is higher, people and organizations will not seek borrowings. Capital investments and purchases will fall due to a reduction in borrowings. Increment in interest rates and reduction in consumption & capital investments reduces economic growth and inflation. The negative side of this policy is that the country has to face increased unemployment. This policy is otherwise called a tight monetary policy.

Tools used in monetary policy

Federal Reserve utilizes the following policy tools to determine monetary policy:

Management of interest rates

Federal Reserve has the power to manage monetary policies by altering interest rates. If the central bank wants banks to lend more, it will lower the interest rate and vice versa. When the interest rate on borrowing declines, people and business organizations increase their borrowings. Higher borrowings encourage spending and purchases. An increase in purchases and investments increases the Gross Domestic Product (GDP) of the nation.

Adjustment of reserve requirements

Central banks require other commercial banks to keep a minimum amount of funds as reserves. This fund is known as reserve requirements. When Federal Reserve reduces reserve requirements, banks have more money to lend and vice versa. The Federal Reserve influences reserve requirements to achieve monetary policies. In expansionary policy, Federal Reserve reduces the reserve requirement to increase cash circulation. To achieve contractionary policy, Federal Reserve increases the reserve requirement to reduce cash circulation.

Open market operations

In open market operations, Federal Reserve is involved in the trading of government securities, treasury notes, and bonds. When the economy needs to revive at the time of recession, Federal Reserve buys government securities. When the Federal Reserve purchases securities and bonds from banks, banks receive money. Banks can lend this money to individuals and business organizations. Cash circulation in the economy increases when banks' lending capacity increases. To reduce the cash circulation in the economy, Federal Reserve sells securities to banks.

Discount rate

A discount rate is the rate of interest that is charged for interbank borrowings. When commercial banks need money, they will borrow either from other banks or from the central bank. Central bank offers short-term borrowings to commercial banks at a standard discount rate. The discount rate is one of the important policy tools used in monetary policy. When the discount rate decreases, commercial banks will borrow more from other banks and vice-versa. When the borrowings of commercial banks increase, it will increase the money supply in the economy and vice versa.

Factors influencing interest rates

Federal Reserve raises interest rates to achieve contractionary policy and reduces interest rates to achieve expansionary policy. Interest rates play an important role in economic growth. The following economic factors influence the interest rates:

Demand for money

People and business organizations need money to invest in capital assets, working capital, and personal use. They borrow money for their investment and personal purposes. When demand for borrowing increases, the interest rate also increases and vice versa. An increase in interest rates affects the investments of the nation.

Supply of money

The supply of money increases when banks have more money to lend. When people and business organizations invest in deposits and savings accounts with banks, money available for lending increases. When banks have more money, it increases the supply of money at lower interest rates. When the supply of money increases, interest rates decrease and vice versa. When the money supply increases, it increases the liquidity in the economy and increases the purchases.

Inflation

The price of the commodities in the markets is determined based on inflation. Inflation hikes the price of commodities. When the price of commodities is higher, investors are investing in deposits, securities, and bonds instead of consumptions. They expect to receive a high rate of return for their investments as they give up consumption for investments. Therefore, inflation rates are used in the calculation of interest rates. The increase in inflation will result in higher interest rates and vice versa.

Federal Reserve

Federal Reserve influences interest rates to control inflation. Federal Reserve influences interest rates by influencing money circulation. If the Federal Reserve buys government securities, banks will have more money to lend. Hence, the money available for lending increases with the banks. When the money lending increases, interest rates fall. If the Federal Reserve sells government securities in open market operations, banks do not have money to lend. When the lending capacity of banks decreases, interest rates increases.

Federal Open Market Committee (FOMC)

FOMC is the authority to set monetary policy, manage inflation level, and review the financial positions of the nation. FOMC determines the short-term and long-term interest rates, and minimum reserves to be kept by commercial banks and open market operations. FOMC stabilizes the economy by influencing the reserve balance, interest rates, discount rates, and open market operations. Investors, banks, and business organizations should follow the decision of the FOMC.

Context and Applications

This topic is significant in general studies, professional exams, and also for both undergraduate courses, and postgraduate courses, and competitive exams, especially for

• Bachelors of Business Administration (Finance)
• Masters of Business Administration (Finance)
• Bachelors in Economics
• Masters in Economics

Practical Problems

Question 1: When the government needs to revive the economy and at the time of the recession Federal Reserve implement which policy?

1. Contractionary policy
2. Expansionary policy
3. All of the above

Answer: Option (b) is correct.

Explanation: When the government needs to revive the economy and at the time of the recession central bank implement expansionary policy. Central banks implement expansionary policy to increase the money supply and borrowings by reducing interest rates, reserve requirements, and purchasing government securities.

Question 2: What is known as tight policy?

1. Expansionary monetary policy
2. Contractionary monetary policy
3. None of the above

Answer: Option (b) is correct.

Explanation: Contractionary monetary policy is named a tight policy. When economic growth and inflation increase, the central bank executes a contractionary monetary policy to control the growth and inflation.

Question 3: Which policy tool is used in monetary policy?

1. Reserve adjustments
2. Loanable funds
3. All of the above

Answer: Option (a) is correct.

Explanation: Federal Reserve uses reserve adjustments as a policy tool to determine monetary policy. When the reserve requirement is lower, cash circulation in the economy will increase. This will increase the purchases. When the purchases and borrowings increase, economic growth will increase.

Question 4: What is FOMC?

1. Federal Open Market Committee
2. Federal Operation Market Committee
3. Federal Open Management Committee

Answer: Option (a) is correct.

Explanation: The full form of FOMC is for Federal Open Market Committee. FOMC is the authority to set monetary policy, manage inflation levels, and review the financial positions of the nation.

Question 5: What are the factors influencing interest rates?

1. Inflation
2. Federal Reserve
3. All of the above

Answer: Option (c) is correct.

Explanation: Inflation of the economy and the Federal Reserve are the important factors that influence interest rates. The inflation rates are used in calculating the interest rates. The increase in inflation will result in higher interest rates and vice versa. Federal Reserve influences interest rates by selling or purchasing government securities from open market operations.