Monetary Policy Definition, Types, Tool, and Objectives

Monetary Policy Definition Types Tool and Objectives

Monetary policy, in essence, is the central bank of a country’s intentional management of the money supply to drive the economy. It employs a variety of tools to achieve certain goals, such as reducing inflation or promoting economic growth.

You may have observed a recent post-pandemic price increase, which the Bank of England hoped to reduce by raising interest rates to 0.5% in February 2022. This is an illustration of monetary policy. Monetary policy, in essence, is the central bank of a country’s intentional management of the money supply to drive the economy.

It employs a variety of tools to achieve certain goals, such as reducing inflation or promoting economic growth. In this post, we’ll look at the definition, tools, and goals of monetary policy, as well as analyze several sorts of policies with real-world examples to help you comprehend.

Monetary policy definition

Monetary policy refers to a central bank’s operations to control the supply of money and interest rates in an economy to achieve macroeconomic goals such as stable inflation, low unemployment, and economic growth. These actions may include raising or lowering interest rates, purchasing or selling government securities, or modifying reserve requirements for commercial banks.

Definition

Monetary policy is the set of activities and techniques used by a central bank to govern an economy’s money supply, interest rates, and credit availability to promote long-term economic growth, price stability, and low unemployment.

Example

Consider the 2015 situation in Brazil. Inflation was high in the country, reducing people’s purchasing power and disrupting the economy. In response, the Central Bank of Brazil increased the Selic, its benchmark interest rate, to a record high of 14.25%. This action increased the cost of borrowing, deterring excessive expenditure and lowering the economy’s money supply. This program helped to reduce inflationary pressures in Brazil over time.

Understanding Monetary Policy

Monetary policy is the regulation of the amount of money accessible in an economy as well as the routes through which new money is provided.

Economic statistics such as GDP, inflation, and industry and sector-specific growth rates all have an impact on monetary policy strategy.

A central bank may change the interest rates it charges on loans to the country’s banks. Financial organizations modify rates for their customers, such as corporations and property buyers, as interest rates rise or fall.

It may also buy or sell government bonds, set foreign exchange rates, and modify the amount of cash that banks are required to keep as reserves.

Types of Monetary Policy

Monetary policies are classified as either expansionary or contractionary based on the extent of economic growth or stagnation.

Contractionary

Expansionary

1. Contractionary

A contractionary policy raises interest rates and limits the outstanding money supply to halt development and prevent inflation, which occurs when the prices of goods and services in an economy rise and the buying power of money decreases.

2. Expansionary

An expansionary policy boosts economic activity during a downturn or a recession. Saving becomes less appealing when interest rates fall, while consumer spending and borrowing rise.

Monetary Policy UK

Before 1997, the Treasury Department in the government, along with the Bank of England, was in charge of monetary policy. However, since 1997, the Bank of England has been in control of the operational tasks as well as the nation’s monetary policy, while the Treasury just sets a ‘goal’.

It is critical to identify the Bank of England from other financial institutions such as Barclays and HSBC.

The Bank of England is a central bank with the authority to change interest rates, exchange rates, and the money supply. Banks such as Barclays and HSBC are commercial banks whose primary goal is to create a profit for their shareholders.

A central bank, the Bank of England, supervises the banking sector and administers monetary policy on behalf of the government.

Monetary policy objectives

Maintaining price stability, managing inflation, stabilizing the financial system, and encouraging long-term economic growth are all monetary policy objectives.

Inflation

Unemployment

Currency exchange rates

1. Inflation

Inflationary policies can be targeted. A low amount of inflation is thought to be beneficial to the economy. When inflation is high, a contractionary policy can help.

2. Unemployment

Monetary policies can policy/instruments fully alter the degree of unemployment in the economy. For example, an expansionary monetary policy generally reduces unemployment because increased money supply increases economic activity, which leads to job market expansion.

3. Currency exchange rates

A central bank can control exchange rates between local and foreign currencies by using its budgetary authorities. The central bank, for example, may raise the money supply by issuing additional currency. In such a circumstance, the native currency becomes less expensive in comparison to its international counterparts.

Tools of Monetary Policy

To conduct monetary policy, central banks employ a variety of methods. Among the most commonly used policy instruments are:

Interest rate adjustment

Change reserve requirements

Open market operations

1. Interest rate adjustment

By adjusting the discount rate, a central bank can impact interest rates. A central bank’s discount rate (base rate) is the interest rate charged to banks for short-term borrowing. For example, if a central bank raises the discount rate, banks’ borrowing costs rise. As a result, banks will raise the interest rates they charge their consumers. As a result, the cost of borrowing in the economy will rise, while the money supply will contract.

2. Change reserve requirements

The minimum amount of reserves that a commercial bank must hold is normally established by central banks. The central bank can influence the economy’s money supply by adjusting the required amount. When monetary authorities raise the required reserve level, commercial banks have less money to lend to their clients, and so the money supply falls.

The reserves cannot be used by commercial banks to issue loans or fund investments in new firms. Because it represents a missed opportunity for commercial banks, central banks pay them interest on reserves. IOR or IORR stands for interest on reserves or interest on needed reserves.

3. Open market operations

To influence the money supply, the central bank can either buy or sell government assets. Central banks, for example, can buy government bonds. As a result, banks will have more money to lend and raise the economy’s money supply.

Expansionary vs. Contractionary Monetary Policy

Monetary policies can be expansionary or contractionary, depending on their objectives.

Expansionary Monetary Policy

Contractionary Monetary Policy

1. Expansionary Monetary Policy

This is a monetary policy that tries to enhance the economy’s money supply by lowering interest rates, purchasing government assets from central banks, and lowering bank reserve requirements. An expansionary strategy reduces unemployment while increasing corporate activity and consumer expenditure. The overarching purpose of expansionary monetary policy is to stimulate economic development. However, it may also result in higher inflation.

2. Contractionary Monetary Policy

A contractionary monetary policy seeks to reduce the economy’s money supply. It is possible to achieve this by boosting interest rates, selling government bonds, and increasing bank reserve requirements. When the government wishes to keep inflation under control, it employs a contractionary strategy.

How Often Does Monetary Policy Change?

What are the four main tools of monetary policy?

Social Science. Define monetary policy instruments such as reserve requirements, discount rates, open market operations, and interest on reserves.

What are the macroeconomic objectives of monetary policy?

Monetary policy refers to the exercise of control over the money supply and interest rates to influence demand. There are several macroeconomic goals, including stable inflation, high employment, economic growth, a neutral balance of payments, equality, and environmental protection.