Every government has to implement policies to create and maintain economic growth. Two main policies are the monetary policy and fiscal policy. Monetary policy is the actions that are taken by the central bank to control the money supply of the economy to achieve defined macroeconomic goals. Monetary policy is implemented to promote sustainable economic growth in the country.
Monetary policy controls either the interest rate payables for short-term borrowings or the money supply of the economy. It is intended to reduce the interest rate of the country or the inflation to create price stability. These will also help to stabilize the currency of the economy.
Even though both monetary and fiscal policies are concerned about the macroeconomic perspective on the economy, there are significant differences in both policies. Fiscal policy is concerned about controlling the government income (taxes and borrowings)and expenditure. But the monetary policy is concerned about the money supply to the economy and contributing to the stability of the Gross Domestic Product (GDP) of the country.
Apart from that, the monetary policy helps to maintain a predictable exchange rate with other currencies in the world, to reduce the unemployment level, to control inflation, growth, and consumption in the economy. The government will achieve these by implementing actions such as regulating the foreign exchange rates, buying or selling government bonds, fluctuating the interest rates, and by fluctuating the reserve requirements in the banks.
Monetary policy can be considered as the demand side of the economic policy. It can be identified as an expansionary policy or the contractionary policy.
Expansionary monetary policy
When an economy goes through a recession, the monetary authorities implement expansionary monetary policy. They use their tools to encourage the economy to engage in financial activities. The expansionary policy uses short-term interest rates at a lower rate than usual or they would increase the money supply to the economy and they will provide money rapidly than usual to the economy. This will motivate business opportunities and help to reduce unemployment and increase the overall demand for goods and services in a particular economy. Allowing more money circulation in the economy will diminish the value of the currency compared to the global and it will attract more foreign investments to the economy.
However, it is also argued that the increase of the money supply can create adverse effects in the economy such as a higher level of inflation, an increase in the cost of living, and an increase in the cost of starting or maintaining businesses.
Contractionary monetary policy
In a situation where the inflation has gone up due to excess money supply to the economy, the monetary authorities have to reduce the money supply to the economy. The short-term interest rates will be increased than the usual level and the money supply rate will also be reduced than the usual level. This contractionary policy can increase the unemployment level in the economy, decrease the consumption spending, and discourage new business investments. This will slow the growth of the economy and reduce the savings of the individuals as well as businesses.
Even though the contractionary monetary policy is implemented as a way of maintaining economic stability, this can lead to economic recessions if it’s not maintained properly.
Several tools are used to implement the monetary policy in any economy.
- Buying and selling of short term bonds. This is also known as open market operations. Newly created bank reserves will be used for this.
- Change the reserve requirements. The central bank can decide the reserve requirements the banks should maintain. They can change the reserve requirements to fluctuate the money supply to the economy based on the economic condition.
- Change the interest rates and collateral requirements. The central bank can fluctuate the interest rates based on the economic condition and change the required collateral demand for emergency loan facilities.