The monetary policy was made by central banks to achieve many macroeconomic goals such as controlling inflation, consumption, etc. It manages the supply and demand for money by using the interest rate as a tool. It is used by the central bank of a country to achieve macroeconomic goals. Monetary authorities work on them to control the payable interest rate. Central banks used the key concepts of monetary policy to expand the economy such as they reduce the discount rate, decrease the reserve ratio, and purchase government security.
Main objective of Monetary Policy
The main objective of this policy is to attain the stability of prices. The goal is achieved when the domestic economy has the lowest possible and sustainable prices. GDP (Gross Domestic Product) growth can be increased in long term by using monetary policy.
Importance of Monetary Policy
Monetary policy is important to change the supply of money and the interest rate to stabilize the economy at full-time employment or output by influencing the aggregate demand. In many countries, the central banks work on the decisions of the government and broad guidelines by the government. In some developed countries such as the USA, the Central banks are free to work; they are independent to pursue policies on their own. Just like fiscal policy, monetary policy also focuses on stability and promotes economic growth. At the time of downturn, the involvement of monetary tools and methods increases the money supply and lowers the interest rates to sustain aggregate demand in the economy. It also contrasts the aggregate spending at the time of Inflation by raising the interest rate. In the developing countries, despite attaining equilibrium in the economy the monetary policy also promotes the economic growth in agriculture and the industrial sector of the economy.
Monetary Policy Tools
Four tools are available to achieve stability in prices which influences the aggregate demand. These tools are:
At the time of downfall, the monetary policy phenomenon is adopted which at the time raises aggregate demand and stimulates the economy. When the economy faces a downfall or continues unemployment, the central bank tries to cure such conditions. Central banks expand the monetary policy in the economy and reduce the level of interest rates which then helps to stimulate the economy. In an economy, demand full inflation occurs when the demands sharply rise due to investment of expenditure and consumption. Besides this, Inflation pressure is asserted on the economy when there, too much money is created. The tight monetary policy works in countries when there is demand-pull Inflation. The use of credit control which is qualitative, an important inflationary measure can raise minimum margins to obtain loans from banks against their stock such as oil-seed, vegetable oil, and cotton.
Interest Rates Management
By the change in discount rates, the central banks can influence the interest rates. The central bank charges an interest rate for short term loans is the discount rate. For example, if the discount rates are increased by central banks, then the borrowing costs of the commercial bank increases. The bank then increases the interest rates which they charge to their customers. The economic cost of borrowing also then increases and the supply of money will decrease.
Change of Reserve Requirements
A minimum amount of reserves have been set up by the central banks, when the required amount is changed the money supply of the economy can be influenced by central banks. If the reserved amounts can be increased by monetary authorities, then there is less amount of money for commercial banks to lend to their clients and the supply of money then decreases.
Open market Operations
The securities which are issued by the government can be either purchase or sell by central banks which affect the supply of money. For example, the government bonds can be purchased by the central government which in results, more money is obtained by the bank, and money supply and money lending increases in the economy.
Direct Credit Control:
The Central Bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio, and issue credit guarantee to preferred loans. In this way, the available savings is allocated and investment directed in particular directions.
Objectives of Monetary Policy
The primary objectives of monetary policy are to manage unemployment, inflation, and to manage the exchange rate of the currency.
Inflation levels can be target by monetary policy. Low inflation levels can be healthy for the economy. Contractionary policies can be used to solve the issues of the high Inflation rate.
The unemployment level of the economy can be influenced by monetary policies. For example, the unemployment level is decreased generally by the expansionary monetary policy because of the high supply of money stimulate business activities and expand job markets.
The exchange rates can be regulated by central banks for foreign and domestic currencies. For example, the money supply may be increased by the bank and more currency issued. In this type of case, the domestic currency will become cheap with its foreign counterparts.
Effects of Monetary Policy
Through the rise and fall of interest rate, the monetary policies that affect the economy are as follows:
In the declining phase of interest rates, the financial institutes can cure the funds a low amount of interest rates. They reduce the lending rate of firms on loans. It creates a link in different financial markets but there is a downturn, not only in financial rates and money lending rates but also to the firm’s borrowing rate from the market directly which is mainly in the form of bonds.
In this type of scenario, the working capital is made easier by the firms in which salaries and input costs are included. The funds for households to borrow also become easier. Consequently,
the economy is stimulated and the prices also have upward pressure. The policies and measures that are used to stimulate the economy are called monetary easing.
In this case, if there is a rise in interest rates, the financial institutions then procure funds at large amounts of interest rates. They rise their lending rates of loans on the household and firms and it is difficult for households and firms to borrow loans due to which their economy get sluggish. It then overheats the economy and pressure on money and prices is downward. The policies interventions contain in the overheating of the economy are termed as the monetary contraction.
The interest rates of the market are not associated with the demand for services and goods which is known as the nominal rate, it relates with the interest rates that are real, which means that the expected Inflation rate will be minus from the nominal rate. The change in interest rates which are real then affects the demand of services and goods for people mainly by the cost of borrowing, by the bank loans availability, the household’s wealth, and the exchange rates by foreign investors. For example, if the real interest rates start decreasing then the cost of borrowing becomes lower and the businesses spending on investments increases and the households can buy many durable goods in which housing and automobiles are included. In the addition to this, if the economy is healthy and real estate is low then the banks are willing to lend money to households and businesses. Due to this, spending increases mainly by small borrowers who have a very little amount of resources than banks. Common stock is made by the lower real rates and investments become more attractive than bonds etc. For which the price of the common stock rises. In the household which has common stock in portfolios finds the value of holding is higher and the wealth increases to spend more. Businesses are attracted to the higher price of the stock.
Economy and inflation are affected by the long term action of the monetary policy. Almost a two or three years span has a major effect on the output.
Role of Federal Reserve and Economic Policy
Open market operation is used by federal power to affect the supply of reserves of banks. This tool contains federal sales and purchase of financial instruments by the United Nations issued security. When the reserves have increased by federal, the securities are increased and deposits are made by the primary dealers. By the trade security, the bank’s reserves amount has been influenced by the Federal Reserve and the fund’s rate has been influenced by the number of bank reserves. The federal fund rates are influenced highly by the change in the amount of demand-supply in the bank’s amount of reserves which provides a good indicator for the economic availability of the credit.
The nation’s monetary policy is formulated by the federal open market committee, there are seven different members of voting in the federal open market committee for the board of governors. All the president for reserves participates in the policy discussions of the federal market whether they are the members who can vote or not. The federal market committee is governed by the chairman of the board of governors. In a year, the committee typically meets eight times in Washington. In the meeting, the senior officials have discussions about foreign exchange and finances with detailed activities of domestic and foreign training. The senior staff present financial and economic forecasts, senior staff includes the board of governors. The monetary affairs director discusses the options of monetary policy without any recommendations. Then the policy preferences were discussed by the members of the federal open market committee and then finally the committee voted.
The conclusion of the committee generates a statement that includes target funds rates, the discussion’s final statement and explanation, the voter’s name, and preferred actions. The change in monetary policies has been made during this meeting as they discuss regional economies in the meeting. In the monetary policy, open markets can not intend to change the policy. On the daily basis conducted operations of the open market effects the fund rates from target rates.
Monetary Policy vs Fiscal Policy
To influence a nation’s economy, the most important and recognized tools that are used are the monetary policy and fiscal policy Monetary policy is concerned primarily to manage rates of interest and the money supply in circulation and it is carried out generally by the central banks I.e. federal reserve. Fiscal policy is the term collectively used for taxing and government actions of spending. In the United Nations, the determination of legislative and executive branches is the determinant of national fiscal policy. The fiscal policy has impacted greatly on a consumer than the monetary policy, as it is to increase employment and income. The monetary policy sparks the activities of the economy but the fiscal policy addresses the overall spending, the composition of spending, or both. Both policies, monetary and fiscal policies play a huge role to manage the economy and have both indirect and direct impacts on households and personal finances. The decisions of taxes and spending are the fiscal policy which is finalized by the government, it has a greater impact on the individual tax payments and bills and then provides them employment for the projects of the government. On the other hand, the central banks set up the monetary policy to boost the spending of the consumer through reduced interest rates due to which the borrowing becomes cheap on the use of credit cards to mortgages.
The fiscal policy has no specific targets but it affects the government budgets. The monetary policy has targets the Inflation rates and it affects the exchange rate and housing market.
If the government feels that the high rate of Inflation is a problem then it creates deflationary policies to control economic growth. In recent years the monetary policy becomes most popular because it reduces political influences. There are more side effects of supply in fiscal policy on the wider economy. For example, it reduces the Inflation rate, increases tax, and lower spending. The low spending reduces public services. It is easy and quick to implement monetary policy, interest rates can be adjustable monthly which is a decision to increase spending of government and decides where to spend the money and where not to.
Types of Monetary Policy
Expansionary Monetary Policy
This is the type of monetary policy that increases the supply of money in an economy by the reduction of interest rates, purchase securities of government with the help of central banks, lower the requirements of bank reserves. It also lowers unemployment and stimulates consumer activities and bank spending. Its important goal is to fuel the growth of the economy. But it can lead to possibly too high rates of inflation. The federal reserve of the US national bank is an example of this type of monetary policy working. To boost the economy, it uses important three tools. The fourth tool which is the reserve requirement rate Is rare to use. The open market operation is the most important tool which is used frequently, it is a commonly used tool. By exchanging credit and treasury notes, the federal reserve allows lending more money. By reducing the lending rate, they lend excess cash which makes the loan easy for homes, autos, and schools easier and less expensive. The interest rates on credit cards are also reduced. All these factors combine and boost the spending of consumers.
Contractionary Monetary Policy
The primary goal of the contractionary monetary policy is the reduction of the money supply in the economy. By increasing interest rates it can be achieved or by selling the government bonds also by increasing the reserves of banks. When the government needs and wants to control the level of inflation then the contractionary method of monetary policies can be used. The main target of contractionary monetary policy is inflation. In the economy, by reducing the supply of money the policy maker’s target is to reduce the inflation rate and to stabilize the price in the economy.