Monetary Policies: Definition, Objectives, Types and Tools


What is Monetary Policy?

Monetary Policy is an economic policy, which is controlled by central banks to manage the size and growth rate of money supply within an economy. It is considered as a powerful tool through which macro-economic variables can be regulated such as inflation, unemployment and currency exchange rates.

Where money supply refers to each type of money such as cash, checks, money-market mutual funds and credit (loans, bonds and mortgages). To manage money-supply, central banks do increments and decrement within liquidity. When central bank increases liquidity up to a certain limit then it has mean that central bank wants an economic growth within the economy. While, if central bank reduces the liquidity, then it prevents inflation. There are also other factors which affected except inflation which affects the economy and are used to perform various tasks.

To perform all these tasks, central banks use interest rates, reserve requirements, and the number of government bonds that banks must hold.

Objectives of Monetary Policies

There are mainly three objectives of monetary policies, in which its first objective is to manage inflation, its second objective is to reduce unemployment (although central banks give first priority to manage inflation only, after that they consider unemployment), and the last but not least objective is to maintain currency exchange rates.

  1. Inflation: Usually, inflation of an economy is considered good up to 3%, and The Federal Reserve or The Fed is really successful to maintain its inflation rates within past decades including the global financial crisis. Whenever a central bank feels that there are lower interest rates within commercial banks, and people are consuming goods and lending money so much, they feel an economic growth but till a certain limit. And when they feel that they have to prevent the economies from the higher inflation rates they follow contractionary monetary policy and reduce money supply.
  2. Unemployment: When a central bank reduces interest rates within banks, other commercial banks offer enough loans to the businessmen, proprietorship owners, students and other personal loans including mortgages. And when these businesses run, people get employment but till a certain limit. But why? Because each economy contains limited number of resources including its population. Central banks try to keep efficiency within the economy. Rather when central banks feel that there is an inefficient use of money is going on within the economy, they reduce money supply and inflation but it increases unemployment on the extra hand.
  3. Currency Exchange Rates: It can also be considered as the rate applied within international trades. International trades refer to the exchange of goods and services between domestic and foreign economies. But how do central banks manage the currency exchange rates? When central banks observe that the money liquidity or the cash reserve has increased and the domestic currency’s value is decreased due to enough offers to the foreign entities. Central banks reduce their money supply by issuing less currency to control the value of their respective economy’s currencies. If central banks do increase in their money supply by issuing more currency, then they feel a decrement within the currency exchange rates.

Types of Monetary Policies

There are mainly two types of monetary policies, which vary according their objective. And these two policies are

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  1. Expansionary Monetary Policies: Expansionary monetary policy is good but till a certain limit because it aims to perform an economic growth of a country. Expansionary monetary policies can be performed by decreasing interest rates, purchasing government securities by central banks, and lowering the cash reserve requirements for other commercial banks to have a good money supply. And due to this enough money supply and lower interest rates, businesses and people take enough loans to run their businesses, purchasing cars, homes and other things. And eventually, this policy results more goods and services consumption and creates employment.
  2. Contractionary Monetary Policies: Contractionary monetary policy is considered as just opposite of expansionary monetary policy. Its main objective is to reducing money supply within the economy to prevent the economy from higher inflation rates, inefficient use of money, and avoiding decrement of domestic currency’s value within the international markets. These objectives can be fulfilled by raising interest rates, increasing the cash reserve requirement for commercial banks, and offering the government bonds to other entities.

Tools of Monetary Policy

  1. Open Market Operations Open: Market Operations or OMOs refer to a tool which is used by the central banks of their respective economies. Using this tools, central banks buy and sell government bonds and other securities. To increase money supply, central banks buy government bonds or other securities from commercial banks and in return other commercial banks get a chance to increase its lending power at lower interest rates. While to decrease money supply, central banks sell government bonds or other securities to get enough money, which results commercial banks become unable to offer huge amount of loans and do increase in their interest rates.
  2. Change Reserve Requirements: Central banks decide the minimum amount of money reserves that must be held by a commercial bank. If central banks increase reserve requirements for commercial banks, then they will be unable to give huge number of loans at lower interest rates. Which support contractionary monetary policy. Rather if central banks take a decision to reduce reserve requirements for commercial banks. Commercial banks will be able to lend money at lower interest rates and it will increase the money supply to the economy. And expansionary monetary policy will be encouraged through this decision.
  3. Discount Rates Adjustments: A monetary authority or central bank can manipulate interest rates by discount rate manipulation techniques. Where discount rate refers to the interest rate at which the monetary authority or central bank gives short-term loans to other commercial loans. If discount rate increases, then interest rates offered by commercial banks also increases because this is how the commercial banks make their profits. While if central banks want a good money supply, they reduce the discount rates for commercial banks.

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