If you’ve ever asked yourself, “what is the meaning of the monetary policy,” this article is for you! This article aims to explain the ins and outs of monetary policy in a simple, easy-to-understand way.
As the name suggests, monetary policy concerns an economy’s monetary aspects. It manages/controls the overall supply of money in an economy. The monetary policy covers a set of tools governed by the central bank and is used to control two major variables of an economy: inflation and unemployment.
In India, monetary policy is governed by the central bank of India, i.e. Reserve Bank of India. RBI controls liquidity in the Indian economy using various instruments, thus bringing stability to the country.
Objectives of Monetary Policy
The primary objectives of the monetary policy in India include:
- Inflation: Controlling inflation is one of the main objectives of monetary policy, as neither too much nor too little inflation is ideal for an economy. Hence, the monetary policy of an economy can be employed to maintain healthy inflation levels in the country.
- Unemployment: An expansionary monetary policy focuses on increasing the country’s money supply, production, and employment opportunities.
- Exchange rates: Exchange rates also get affected due to changes in monetary policy. An expansionary monetary policy increases the money supply in the economy and makes domestic currency cheaper in the foreign market.
Tools of Monetary Policy and How They Work
The central government employs several monetary policy tools to manage the money supply in the economy. These instruments of monetary policy are:
Open Market Operations:
Open market operations refer to when the central bank buys or sells securities from/to private banks. Banks’ cash reserves rise when they buy securities, and so does their ability to lend. This is done when monetary policy is to be expanded. When central banks sell securities, liquidity is soaked, and it is often done when a tight policy is needed.
Statutory Liquidity Ratios(SLR):
SLR can be described as a minimum percentage of liquid funds (cash, gold, government securities, etc.) to be mandatorily held by commercial banks. To increase liquidity in the economy, the central bank will reduce the percentage of minimum funds to be held by banks. If the central bank wishes to tighten the money supply, it will raise the liquidity ratio.
Repo Rate:
Repo rate refers to the rates at which the central bank lends funds to commercial banks for short-term needs against collateral (treasury notes and treasury bills). Suppose the central bank wishes to combat inflation. In that case, it will increase the repo rate as it will discourage commercial banks from arranging funds from the central bank, and thus lesser funds are available with the central bank to disburse as loans. As a result, it aims to curb spending and keep inflation within a range.
Reverse Repo Rate:
It refers to the rates at which a central bank borrows money from commercial banks of an economy. An increase in the reverse repo rate will help in combating inflation/reducing the money supply as it will encourage banks to park funds with RBI. Alternatively, a reduction in the reverse repo rate is used to increase the money supply in the economy.
Marginal Standing Facility:
This facility is often used when interbank liquidity dries up. In such emergencies, banks can borrow funds from RBI against securities.
Types of Monetary Policy
Based on the objectives of the monetary policy can be divided into two types: Expansionary and Contractionary
Expansionary Monetary Policy
The expansionary policy aims to expand or increase an economy’s overall money. The policy is usually implemented to boost the country’s economic growth by increasing the money supply, employment, and overall production in the economy. This can be done by lowering repo rates for commercial banks, purchasing securities from banks, or decreasing statutory liquidity ratios. The other aspect of expansionary policy is that it can lead to inflation in the country.
Contractionary Monetary Policy
The contractionary policy aims at reducing the money supply in an economy. This policy is adopted when the government wants to control inflation in the economy. The same can be achieved by increasing the repo rates for commercial banks, selling securities to the banks, or increasing statutory liquidity ratios.
Difference Between Monetary Policy and Fiscal Policy
Both monetary and fiscal policies are policies of the central government aiming to bring stability to the country and boost economic growth. However, these two have basic differences as below.
Meaning:
Monetary policy refers to the central government’s policy to regulate the economy’s overall money supply.
Fiscal policy refers to the policy concerned with the government’s tax revenue and expenditure for economic growth.
Management:
The RBI is in charge of monetary policy. Fiscal policy is operated by the Ministry of Finance of India.
Concern:
Monetary policy is concerned with banks and credit control. Fiscal policy is concerned with the government’s revenue and expenditure.
Aim:
Monetary policy aims for economic stability, and fiscal policy focuses on overall economic growth.
Nature:
Monetary policy meetings occur at regular intervals, and decisions are taken when the need arises. Fiscal policy, on the other hand, changes every year.
Conclusion
Monetary policy is the act of controlling the amount of money in circulation. It involves controlling interest rates, adjusting reserve requirements, and using government spending (government spending stimulates the economy because when the government spends, it adds to the money supply).
Leave a Reply