Understanding Monetary Policy

How often have you come across the lines “Government has decided to deploy a new monetary policy”? Yes, in today’s article we are going to uncover the mysteries of
monetary policy and explain why it plays such an important role in the economy.
To begin with, what is the monetary policy? Monetary policy, the demand side of economic policy,refers to the actions undertaken by a nation’s central bank to control money supply to achieve macroeconomic goals that promote sustainable economic growth. So, there are a lot of questions buzzing as to who makes them, what precisely are the goals and how do they achieve these goals? Broken down, a few money controlling authorities of the nation implement certain steps to make sure that economy is stable. The stability is measured in terms of inflation rate and unemployment rate,foreign exchange and inflation rates. The policy which dictates these steps form the monetary policy. Monetary policy can be used in combination with or as an alternative to fiscal policy to manage the economy. Importantly, the central bank, currency board, or other competent monetary authority of a country that controls the quantity of money in an economy and the channels by which new money is supplied are the authorities who frame such policies. They draft, announce and implement the plan of action.The actions are centred around management of money supply and interest rates.

What are its objectives?

Monetary policy is aimed at achieving macroeconomic objectives such as controlling
inflation, consumption, growth, and liquidity. These are achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating foreign
exchange rates,and changing the amount of money banks are required to maintain as reserves.

This policy is formulated based on inputs such as macroeconomic numbers like GDP and inflation, industry/sector-specific growth rates and associated figures, geopolitical developments in the international markets (like oil embargo or trade tariffs), concerns raised by groups representing industries and businesses, survey results from organizations of repute, and inputs from the government and other credible source Now that we have seen as to who formulates them and what does the policy aim to achieve, let us see its types. There are two main types namely, expansionary and contractionary.

During slowdown and recession, the money supply in the economy declines. In order to promote investment and consumer spending, monetary authority impose Expansionary Monetary Policy. One of the most common steps taken up is to lower the interest rates, which make money hoarding and saving less attractive. Lower interest rates mean that businesses and individuals can take loans on convenient terms to expand productive activities and spend more on big ticket consumer goods. An example of this expansionary approach is the low to zero interest rates maintained by many leading economies across the globe since the 2008 financial crisis. In an expansionary monetary policy, the aim is to increase money supply in market and lowering interest rates is a general way to accomplish it.

It is important to point out that increased money supply increases inflation rates too. Increased inflation rate would mean raising the cost of living and cost of doing business. The Contractionary Monetary Policy aims to bring down the inflation rate. This is achieved by increasing interest rates and slowing the growth of the money supply. Though it slows economic growth and increases unemployment, yet it is often required to control inflation. A classic example is the early 1980s when inflation hit record highs and was hovering in the double-digit range of around 15 percent, the Federal Reserve raised its benchmark interest rate to a record 20 percent. Though the high rates resulted in a recession, it managed to bring back the inflation to the desired range of 3 to 4 percent over the next few years.Having said that, the monetary policy aims to have an optimum inflation rate while maintaining low unemployment rate at the same time. To do this, it juggles between expansionary and contractionary mode from time-to-time.