Monetary Policy: Objectives

• Monetary policy involves a central bank controlling the money supply to achieve macroeconomic stability.
• According to Harry G. Johnson, monetary policy is when a central bank controls the money supply to achieve macroeconomic stability.
• Economic policy includes both fiscal and monetary policy.

Objectives of Monetary Policy

• Monetary policy seeks to create economic growth.
• Economic growth increases an economy's capacity to produce goods and services.
• Monetary policy fosters economic growth by adjusting interest rates and money supply.
• Central banks aim for sustainable growth without causing high inflation, ensuring long-term productivity and health.
• Employment is a central focus of monetary policy to maintain high employment levels.
• Central banks manipulate interest rates, borrowing, and spending, impacting job creation and unemployment rates to promote price stability and ensure employment.
• Foreign exchange stability involves monetary policy, it affects international trade and investment.
• By managing exchange rates, central banks can reduce volatility, prevent abrupt capital flows, and foster investor confidence.
• Sector-specific targeting involves monetary policy focusing on spurring growth in vital industries, ensuring economic resilience
• Maintaining price stability minimizes inflation and promotes a predictable economic environment.
• Central banks use tools to maintain stable prices over the medium term.
• Inflation bias causes central banks to prioritize short-term gains over long-term stability, raising inflation expectations.

Types of Monetary Policy

• There are two types of monetary policy: expansionary and contractionary.
• Central banks use contractionary monetary policy to reduce inflation by raising rates and selling securities.
• They use expansionary monetary policy, to lower unemployment and avoid recession, lowering rates and buying securities to increase liquidity.
• Expansionary policy increases aggregate demand and economic growth by increasing the money supply and lowering interest rates.
• Contractionary policy contracts the money supply and reduces economic activity by raising interest rates, reducing purchasing power.

Monetary Policy Tools

• Instruments/tools are used for implementing monetary policy, which includes both quantitative and qualitative measures.
• Quantitative methods focus on controlling the total amount of credit.
• Qualitative methods control the type of credit and the specific sectors receiving it.

Quantitative Measures

• Quantitative measures are tools that control the amount of credit available, including open market operations (OMO), discount rate/bank rate, and cash reserve ratio (CRR).
• Open Market Operations (OMO), which involves a central bank selling or buying government securities to manage liquidity.
• When the central bank securities, then liquidity (stock of money) decreases in the economy.
• It reduces the money supply available to banks which further decreases the funds available for lending.
• Selling of bonds by Central Bank increase interest rates which lowers demand for credit.
• When the central bank buys securities, the money supply increases.
• OMOs are ineffective if commercial banks have excess liquidity.
• The popularity of government bonds affects OMO effectiveness due to their low return rates.
• In underdeveloped countries with banking systems , OMOs have limited effectiveness.
• OMO is ineffective in an unstable market economy because of lack of demand for credit.
• The bank rate is the rate at which the central bank provides loans to commercial banks.
• Central Bank changes this rate – depending on expansion or contraction of credit flow.
• A fall in Bank Rate is an expansionary policy and a rise in Bank Rate is a contractionary policy
• The Statutory Liquidity Requirement (SLR) is a reserve, requires commercial banks to maintain liquid assets like cash, gold, and government bonds.
• The measure prevents commercial banks from liquidating assets when CRR is raised.
• All commercial banks must hold a percentage of their deposits in cash with the central bank, which is the Cash Reserve Ratio (CRR).
• Cash Reserve Ratio (CRR) prevents shortage of cash and also controls money supply.
• In Contractionary policy the bank raises the CRR, and in expansionary policy bank reduces the CRR.
• A hike in CRR will lead to high interest rates and a huge decline in investment and employment.

Qualitative Measures

• Qualitative measures include credit rationing, changes in lending margins, moral suasion, and direct controls.
• Credit rationing occurs when priority industries face a shortage of funds.
• Central banks do credit rationing by imposing upper limits on credit and higher rates on bank loans beyond a limit.
• Changes in Lending Margins are the gap between mortgage property value and advanced amount.
• Central banks determine the lending margin to control speculative activity.
• Moral Suasion uses persuasion to influence commercial banks to avoid loans for speculative purposes.
• In contrast, to counteract deflation, central banks persuade banks to extend credit for different purposes.
• Direct action is only applied when moral suasion fails.
• The central bank then gives clear directives to banks to carry out their lending activity in a specified manner.

Instruments of Monetary Policy

• Instruments of monetary policy include direct and indirect instruments
• Direct instruments operate under regulations impacting interest rates/credit volume, , affecting money supply.
• Setting interest rate ceilings or specific lending limits for banks, is an example of a tool.
• Indirect instruments influence market conditions, , impacting liquidity and rates.
• Central bank actions that influence markets or rate fluctuations are examples of tools
• Intermediate targets are for monitoring variables like money supply and long-term rates,.
• Intermediate money supply figures and long-term interest serve as indicators of the overall effectiveness of monetary policy.
• Indicator variables give insight into aggregate demand and inflationary pressures, signaling monetary policy adjustments.
• Indicator variables help central banks gauge policy effectiveness and adapt strategies based on economic conditions.
• Operating targets are immediate goals set by central banks to influence economic behavior, like reserve money and short-term rates.
• Management of broader financial stability is achieved by controlling the level of reserve money and short-term interest rates.
• Countries have modified monetary policy to align with domestic and international economic conditions.
• These changes include inflation targeting, and hybrid approaches using direct and indirect instruments.