Monetary Policy refers to the actions undertaken by a nation’s central bank to control the money supply in the system to achieve macroeconomic goals that promote sustainable economic growth.

Monetary Policy are largely of two types.

  1. Contractionary Monetary Policy- Decreased money supply in the system.
  2. Expansionary Monetary Policy- Increased money supply in the system.

Tools

Government uses certain instruments to control the supply of money in the economy. The are as follows.

  1. Interest Rates– The RBI can influence the interest rates by controlling the base rate or the repo/reverse repo rate. If RBI increases the base rate, so will the banks and therefore money supply will decrease. Likewise, if RBI decreases the base rate, so will the banks, thereby increasing the money supply
  2. Reserve Requirement– Central banks usually set up the minimum amount of reserves that a commercial bank must hold. By changing the required amount, the central bank can influence the money supply in the economy. Example- Cash Reserve Ratio (CLR) and the Statutory Liquidity Ratio (SLR). Read More Here.
  3. Open market operations- Open Market Operations is when the RBI involves itself directly and buys or sells government securities in the open market. This effectively affects interest rates.

Objectives

Inflation– A Contractionary Monetary Policy curbs high inflation by decreasing the supply of money. This decreases the demand for goods or basket of goods or consumer expenditure. Hence curbs inflation

Unemployment– An Expansionary Monetary policy curbs unemployment rates due to the increase in money supply which stimulates economic activity and thereby helps businesses flourish.

Exchange Rates– The central bank can influence foreign exchange rates by either increasing or decreasing supply in the economy. When the supply of money increases, the currency becomes cheaper and vice-versa.

There can be side effects of a change in monetary policy as well. For Example- When the government reduces the money supply in the economy to curb interest rates, the economic activity also goes down, this causes unemployment to go up. As you can see, the monetary policy is a very important tool for the economy. A slight change in monetary policy can have a huge impact on the economy and therefore needs to be dealt with caution.

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