Monetary Policy: What, Why and Who

Monetary Policy is a tool used by central banks to manage the economy by controlling the money supply and interest rates. The main goal of monetary policy is to promote economic growth, control inflation, and stabilize the economy. In this article, we will discuss the basics of monetary policy and its role in the economy.

Overview of Monetary Policy

Monetary policy is the process by which a central bank, such as the Federal Reserve in the United States, manages the money supply to achieve specific economic goals. This is typically done by adjusting the interest rates at which banks lend to each other, and the amount of money in circulation. The goal of monetary policy is to control inflation, promote economic growth, and stabilize the economy.

Role of Monetary Policy

Monetary policy plays a key role in the economy by controlling the money supply and influencing interest rates. It can be used to address a wide range of economic issues, such as controlling inflation, reducing unemployment, and stabilizing financial markets. By controlling interest rates and the money supply, monetary policy can impact borrowing and spending, which can have a ripple effect on the economy.

Objectives of Monetary Policy

Monetary policy refers to the actions taken by a central bank or monetary authority to regulate the supply, availability, and cost of money and credit to achieve certain economic objectives. The primary objectives of monetary policy include:

1. Price stability: Maintaining price stability is one of the primary objectives of monetary policy. Central banks aim to keep inflation at a low and stable level, typically around 2%, to ensure the purchasing power of money remains stable.
2. Full employment: Monetary policy also aims to achieve full employment, which means that there are enough job opportunities for everyone who wants to work. The central bank may use various tools to encourage economic growth and job creation.
3. Economic growth: Another objective of monetary policy is to promote economic growth by maintaining a stable and predictable monetary environment. This can be achieved through actions such as adjusting interest rates, managing the money supply, and influencing the exchange rate.
4. Exchange rate stability: Central banks may also aim to maintain exchange rate stability by intervening in foreign exchange markets to prevent sharp fluctuations in currency values. This can help to promote trade and investment, as well as support price stability.

Overall, the main goal of monetary policy is to create a stable and predictable economic environment that supports sustainable economic growth, low inflation, and full employment.

Instruments of Monetary Policies in India

The Reserve Bank of India (RBI) uses various monetary policy instruments to achieve its objectives of maintaining price stability, promoting economic growth, and ensuring financial stability. Some of the key instruments of monetary policy in India include:

1. Repo rate: The repo rate is the rate at which the RBI lends money to commercial banks. Changes in the repo rate can influence the cost of borrowing for banks and impact the money supply in the economy.
2. Reverse repo rate: The reverse repo rate is the rate at which banks can lend money to the RBI. Changes in the reverse repo rate can impact the amount of liquidity in the banking system.
3. Cash Reserve Ratio (CRR): The CRR is the amount of funds that banks are required to maintain with the RBI as a percentage of their deposits. Changes in the CRR can impact the amount of liquidity in the banking system and influence the money supply.
4. Statutory Liquidity Ratio (SLR): The SLR is the amount of funds that banks are required to maintain in the form of liquid assets such as government securities. Changes in the SLR can impact the amount of liquidity in the banking system and influence the money supply.
5. Open market operations (OMOs): OMOs involve the purchase or sale of government securities by the RBI in the open market. OMOs can be used to inject liquidity into the banking system or absorb excess liquidity.
6. Marginal standing facility (MSF): The MSF is a borrowing window that allows banks to borrow funds from the RBI in case of emergencies. The interest rate on MSF is higher than the repo rate and is used to manage short-term liquidity issues.
7. The Liquidity Adjustment Facility (LAF): It is a monetary policy tool used by the Reserve Bank of India (RBI) to manage short-term liquidity in the banking system. It consists of two components: the repo rate and the reverse repo rate.

   Under the LAF, banks can borrow funds from the RBI by pledging government securities as collateral. The repo rate is the rate at which the RBI lends money to banks, and the reverse repo rate is the rate at which the RBI borrows money from banks. By adjusting these rates, the RBI can control the amount of liquidity in the banking system.

8. Bank Rate: The Bank Rate is the interest rate at which the Reserve Bank of India (RBI) lends money to commercial banks on a long-term basis. It is also known as the Discount Rate.The Bank Rate is an important tool used by the RBI to regulate credit in the economy. By changing the Bank Rate, the RBI can influence the cost of borrowing for commercial banks, which can then affect the lending rates for consumers and businesses.
9. Market Stabilisation Scheme (MSS): The Market Stabilisation Scheme (MSS) is a monetary policy tool used by the Reserve Bank of India (RBI) to manage liquidity in the economy. The scheme was introduced in 2004 as a way for the RBI to absorb excess liquidity in the market and prevent inflationary pressures.

   Under the MSS, the RBI issues short-term government securities (treasury bills and bonds) to banks and other financial institutions. These securities are issued at a pre-determined interest rate, and the funds raised through the sale of these securities are deposited in a separate MSS account with the RBI.

Overall, these instruments of monetary policy are used by the RBI to regulate the money supply and achieve its objectives of maintaining price stability, promoting economic growth, and ensuring financial stability in the Indian economy.

Types of Monetary Policies

Monetary policy is a tool used by central banks to manage the money supply and interest rates in an economy to achieve certain macroeconomic goals. There are several types of monetary policy that a central bank can employ:

1. Contractionary monetary policy: This type of monetary policy is used to decrease the money supply and raise interest rates to combat inflation. It involves selling government securities, increasing the reserve requirements for banks, or raising the discount rate that banks pay to borrow money from the central bank.
2. Expansionary monetary policy: This type of monetary policy is used to increase the money supply and lower interest rates to stimulate economic growth. It involves buying government securities, decreasing the reserve requirements for banks, or lowering the discount rate.
3. Neutral monetary policy: This type of monetary policy seeks to maintain a stable money supply and interest rates to promote economic stability and growth without causing inflation or deflation.
4. Inflation targeting: This type of monetary policy is used by some central banks to explicitly target a specific level of inflation, usually around 2%. The central bank adjusts interest rates or other policy tools to try to achieve this target.
5. Exchange rate targeting: This type of monetary policy is used by some central banks to stabilize the exchange rate between their currency and another currency, usually the US dollar. The central bank adjusts interest rates or other policy tools to try to achieve this goal.

Examples of Monetary Policy

An example of expansionary monetary policy is the central bank lowering interest rates, which can make it cheaper for businesses and individuals to borrow money, leading to increased investment and spending. An example of contractionary monetary policy is the central bank increasing interest rates, which can make it more expensive to borrow money, leading to reduced investment and spending.

Monetary Policy committee

The Monetary Policy Committee (MPC) is a committee that is responsible for making decisions related to a country’s monetary policy. The committee is typically made up of central bank officials and sometimes external experts.

Conclusion

Monetary policy is a critical tool for managing the economy and promoting economic growth. It is used by central banks to control the money supply and interest rates, which can impact borrowing and spending, and ultimately have a ripple effect on the economy. By understanding the basics of monetary policy, individuals and businesses can make informed decisions about their investments and financial planning.

Important Links

• http://licchavilyceum.com
• https://www.upsc.gov.in