What Is a Monetary Policy in Economics?

There is no telling when financial barriers, such as unemployment, recession, stock market crash, etc., will appear and affect a country's economy. Thus, the central bank decides the country's monetary policy to regulate the money supply in the economy.

The monetary authority of each country streamlines its economic structure through the control of commercial banks' credit and by organising appropriate and pertinent financial approaches for the betterment of the economy. If you are still wondering what monetary policies are, keep reading.

Monetary policy refers to a set of strategies pre-set by the central bank to manage a country's overall money supply, thereby facilitating economic growth. These strategies include currency exchange rates, changing interest rates on loans, bank reserve requirements, etc.

This policy is a powerful tool that normalises macroeconomic variables like inflation, unemployment, recession, etc. Doing so brings economic steadiness within a country and ensures proper circulation of money and credit in an economy.

1. Contractionary Policy

The central bank implements contractionary monetary policies to manage economic situations such as inflation, unemployment, recession, etc., by decreasing the money supply in a country's financial system.

For this, a monetary authority or central bank sells off short-term government securities and increased borrowing rates or bank reserve requirements. The contractionary monetary policy aims to restrict borrowing for organisations infrequently. As a result, it reduces the market pace, thereby hindering money supply.

2. Expansionary Policy

During an economic slowdown, the central bank executes different expansionary policies, such as dropping borrowing rates, purchasing short-term government securities, and lessening reserve requirements. People and businesses can borrow at an economical rate with a reduced discounting rate.

This diminishing interest rate affects people's interest in government bonds and savings accounts. Consequently, it encourages investors towards risk assets. This policy aims to elevate the money supply in an economy to boost consumer spending and reduce unemployment. However, it could cause an inflationary situation.

Some of the most important goals of monetary policy in India are as follows:

• In India, the principal goal of monetary policy is managing price stability, focusing on the nation's economic growth. This price stability has been a vital precondition for long-term growth.
• In the Official Gazette, the Central Government has passed a notice setting a 4% Consumer Price Index (CPI) from 5th August 2016 to 31st March 2021, with an upper limit of 6% and a lower limit of 2%.
• The Reserve Bank of India (RBI) Amendment Act, 2006 also declares that the Indian Government has collaborated with the Reserve Bank to figure out the inflation target on a quinquennial basis.
• On 31st March 2021, the Central Government of India stated the inflation target and tolerance limit for a 5-year period, from 1st April 2021 to 31st March 31, 2026.
• In May 2016, the Reserve Bank of India (RBI) Act, 1934, was brushed up to pass a legal basis for flexible inflation pursuing framework's execution. Before the modification of this act, this flexible inflation framework was managed by a Monetary Policy Framework Agreement between the Indian Government and the RBI.

In India, the Reserve Bank of India (RBI), adopt several measures to execute monetary policies. These extensively utilised policy tools comprise:

• Interest Rate Adjustment: The Reserve Bank of India (RBI) can affect interest rates by fluctuating discount rates. The central bank charges this interest rate to commercial banks for short-term credit. In case the bank escalates the rate of discount, it ultimately impacts other rates alongside those on business loans. Subsequently, with increased business loan rates, the borrowing cost will start to increase, thereby reducing the money supply in the economy.
• Change Reserve Requirements: In India, the Reserve Bank of India (RBI) typically pre-set the minimum number of reserves to be held by commercial banks. This way, by changing the amount required, the RBI can deeply impact the supply of money in the nation's economy. If the central bank raises the reserve amount needed, commercial banks face problems lending credit, reducing money supply. As it creates an obstacle for commercial banks, the monetary authority pays them interest on reserves. This interest rate is referred to as Interest on Reserves (IOR) or Interest on Required Reserves (IORR).
• Open Market Operations: The Reserve Bank of India (RBI) can either buy or sell securities offered by the government to influence the money supply in the economy. For instance, central banks may avail government bonds, making commercial banks obtain more funds to increase their lending rate and money supply in the economy. Furthermore, if the monetary authority aims for recession, it will buy securities from a bank, increasing its cash flow.