What is monetary policy?
These are the steps taken by a country’s central bank to influence the money supply to achieve long-term economic growth.
Monetary policy instruments include:
1. Open market operations – This is where they buy and sell government and treasury bonds with their member banks. This has an effect on the amounts of reserves in the banks.
2. Treasury reserve requirements – Where the central banks tell their member banks how much money they must have each night in their reserves.
3. Discount rates – This is how much the central bank charges member banks to borrow from its discount window. It raises the rates to reduce liquidity and lowers the rates to reverse it.
Monetary policy is determined by the correlation between a country’s economic interest rates, or the cost of borrowing, and the cumulative supply of money. Monetary policy utilizes various techniques to influence growth in the economy, inflation, currency exchange rates, and unemployment.
The roles of monetary policy
A monetary policy has several objectives to accomplish in the country’s economy. The main ones are:
- To enhance the sustainability of the Gross Domestic Product.
- To attain and maintain low unemployment rates among the citizens.
- To sustain predictable foreign exchange rates with other countries.
- To promote moderate and long-term interest rates in the economy.
Categories of Monetary policy
Expansionary policy, also known as loose policy, is a macroeconomic policy that aims to stimulate economic growth. The expansionary policy could either be monetary policy or fiscal policy, or a combination of both. Monetary policy relates to central banks’ efforts to achieve macroeconomic policy goals and objectives, whereas fiscal policy refers to the national government’s decisions on taxes and spending policies. It is a part of Keynesian economics’ overall policy prescription to be applied during economic downtimes and recessions to alleviate the downside of economic cycles.
The expansionary policy works by quickly increasing the money supply or reducing short-term lending rates. Central banks implement it through open market operations, deposit requirements, and interest rate setting.
The disadvantage of expansionary policy
Despite its popularity, the expansionary policy could also result in considerable costs and risks, including macroeconomic, microeconomic, and political economy concerns. These include the uncertainty of deciding when to indulge in expansionary policy, how far to go, or when to stop. Excessive expansion can result in negative consequences such as rising inflation or even an overheated economy. Also, there is a delay from when a policy change is implemented and when it is felt in the economy.
Contractionary monetary policy refers to when a central bank utilizes its monetary policy tools to combat inflation. It is the bank’s method of slowing economic growth. Inflation indicates an overheated economy. Since it restricts money supply, it is also known as a restrictive monetary policy. To achieve this, the government raises the required reserves for banks, and as a result, banks have reduced lending power.
Contractionary policies are generally implemented during periods of high inflation or after rising speculation and capital expenditure fueled by previous expansionary policies.
Contractionary policy which restricts crowding out in capital markets could have a stimulating effect by increasing the private sector of the country.
The disadvantages of contractionary monetary policy
- The upsurge in unemployment is one undesirable consequence of a contractionary monetary policy. Businesses hire fewer people as a result of the slowing down of the economy and lower production. As a result, the economy’s rate of unemployment soars.
- If it is implemented too vigorously, contractionary monetary can result in an adverse situation like a depression.
Considerations for monetary policies
To put in place monetary policies, governments consider several factors such as:
- Short term interest rates
- Long term interest rates
- Exchange rates.
- Private sector vis a vis government savings and spending
- Large-scale international capital flows of money.
- Bonds and equities.