Concept of Monetary Policy

Monetary policy is one of the successful macro-economic policies. It has important role for in general economic management and growth. Monetary policy is the work out of the central bank to control over the money supply as a tool for achieving the objectives of universal economic policy. Monetary policies attempt to make different types of good quality economic activities mainly through money and credit supply as well as interest rate. Similarly, monetary policy will be more successful through the period of galloping or hyperinflation.

The process, formulation, completion and estimate of monetary policy are calculated by the central bank under the rules and directives of government of the state as well as increase and development of an economy. Therefore, monetary policy is adopted to achieve different types of economic objectives like accelerated economic growth and progress, full service, price constancy, economic constancy etc. So monetary policy can be defined as the management of the expansion and contraction of quantity of money in movement. So we can say, monetary policy can change quantity, quality, availability and cost of money as well as rate of interest, investment, service, output, revenue etc. for the balance economic growth and development.

According to Edward Shapiro “Monetary policy is the exercise of the central bank’s control over the money supply as an instrument for achieving the objective of general economic policy”. In the words of D.C. Rowen, “The monetary policy is defined as discretionary action undertaken by the authorities designed to influence (a) the supply of money, (b) cost of money or rate of interest, and (c) the availability of money”. According to RP Kent monetary policy is, “The management of expansion and contraction of the volume of money in circulation for the explicit purpose of attaining a specific objective such as full employment”.

Hence, we can say monetary policy is a purposeful effort of central bank to control monetary policy and ratio of credit in an economy for achieving definite objective like economic stability and best allocation of resources. So monetary policy is measured as an important tool of the government to plan various types of economic policies. The main instruments of monetary policy and bank rate, open marketplace operation and required reserve ratio.

Generally, there are two types of monetary policies according to economic arrangement of an economy i.e. expansionary monetary policy and concretionary monetary policy.

(A)  Concretionary Monetary Policy

The usefulness of concretionary monetary policy is appeared through the time of hyperinflation, where prices are rising very rapidly and most of the economic variables start to fall. In such state, monetary policies are formulated to manage money supply and expenditure pattern by lowering the insist for consumption and investment some techniques for concretionary monetary prices are:

(a)  Selling the bonds, securities and treasury bills in the open market.

(b)  Increasing the discount rate.

  • Rising the minimum required reserve ratio.

(A)  Expansionary Monetary Policy

The monetary policy, which normally expands money supply and credit in an economy are called expansionary monetary policy. Usually, to increase various economic activities in increasing countries such as trade, commerce, industry and infrastructure development; the expansionary monetary policies are applied some techniques for expansionary monetary policy are:

(a)  buy of bonds and funds bills in open market.

(b)  Lowering the diminution rate or bank rate.

(c)  Lowering the requisite reserve ratio.

Hence, the monetary policy used by the central bank to fulfill the objective of country’s economic policy which is related to supply of money, credit creation, interest rate, exchange rate etc.

2       Objectives of Monetary Policy

Monetary policy is one of the great tools to stabilize the economic systems. It contains the following objectives:

(i)   Price constancy: The most important objective of monetary policy is to establish internal price stability. Stable price does not means that the average of prices on the general price level should not be allowed to fluctuate beyond certain minimum limit. Price instability creates great disturbances in the economy and helps to create inflation or deflation. Both are economically disturbing and socially undesirable. Both can create problems of production and distribution.

Thus to establish price stability central bank should properly control the quantity of money and credit. So, the monetary policies are designed by central bank through by changing open market operation, bank rate and minimum required ratio. During the period of inflation, government issues different types securities and the selling of securities in open market absorbs bills and excess money. Similarly, central bank increases bank rate and minimum required ratio to control the problem of inflation.

(ii)  Attain complete service: joblessness is the cancer of an economy. Until the joblessness remains the same, economy cannot progress. joblessness is associated with low investment. Monetary policy can help the economy to achieve full employment through the increment of investment. Unemployment is mainly due to deficiency of investment. The main task of monetary policy is the expansion of money provides and the reduction of interest rate to that optimum level which raises the investment, demand and equals it with full employment.

(iii) Replace rate constancy: It is a traditional objective to establish exchange rate stability, but very important objective of monetary policy. Stable exchange rate helps to create international beliefs and for the promotion of smooth trade. Fluctuations in the exchange rates adversely affects in the volume of trade, price levels, production, balance of payment, foreign investment etc.

The objective of exchange rate stability is achieved through establishing equilibrium in the balance of payment. Monetary policy plays an important role in bringing balance of payments balance without disturbing the stable exchange rate. The modern welfare governments are more concerned with establishing internal price stability quite than maintaining exchange stability because of international monetary fund.

(iv) Accelerate profitable progress: One of the major objectives of monetary policy is to accelerate economic development. Economic development involves the increase in the productive capacity of the economy by developing additional economic resources, improving technology and exploiting new investment opportunities. For this, it is necessary to increase the rate of capital formation and investment because the levels of saving and investment are very low. Directly or indirectly monetary policy helps to increase capital formation and investment, through encouraging savings and concept of investment.

(v)  Impartiality of cash: various economists such as Robertson, Hayek and Wicksteed developed the neutrality of money. The policy of neutrality of money seeks to do away with the disturbing effect of changes in the quantity of money on important economic variables, like income, output, employment and prices. According to this policy, money supply should be neutral in such a way that money should be neutral its effects. In other words, the changes in money supply should not change the total volume of output and total transactions of goods and services in the economy.

The policy of neutrality of money is based on the assumption that money is purely a passive factor. It functions only as a medium of exchange. The function of money is only to reproduce the relative values of goods and not to distort them. The exponents of the neutral monetary policy believed that monetary changes are the root case of all economic ills. They bring changes in the real variables such as income, output, employment and relative prices. They cause inequity between demand and supply, consumption and production.

Thus, according to the policy of impartial money, if the money is made neutral and the money supply is kept constant, there will be no disturbance in the economic system. In such a situation, relative prices will change to the changes in the demand and supply of goods and services, economic resources will be allocated according to the wants of the society, and there will be no inflation and deflation. However, this policy is based on classical assumptions. It cannot control the economic insecurity and fluctuations in the economy.

 Importance/Objectives of Monetary Policy in Developing Countries

The implication of monetary policy may be explained as follows:

The citizen like inflation, deflation, lack of employment opportunity, investment, output income etc defines developing country as a country where different types of economical and social harms are facing. In developing countries various types of economical problems are solved through the monetary policy. Monetary policy influences most of all inexpensive variables and activities through change in money supply in circulation and rate of interest.

So suitable monetary is formulated and implemented according to economic structure of an economy. The main importance of monetary policy is developing countries are summarized on following points.

(i)   Progress Role: Monetary policy plays a significant role in developing countries in accelerating economic development by influencing the money supply and rate of interest. Monetary policy is able to create hearten towards investment by the help of scheming inflation and deflation. Similarly, correction of balance of payment plays an important role for over all economic progress. That’s why monetary policy is able to run about development activities through by changing bank rate and minimum required ratio.

(ii)  Stepping up to Economic progress: In developing countries, the monetary policy should aim at promoting economic development. The monetary policy can play a vital role in acceleration to economic development. It influences the supply and uses of credit. Controlling inflation and maintaining equilibrium balance of payment.

(iii) Progress of Banking and Financial organizations: One of the main functions of central bank or primary aim of monetary policy is to establish more banks and financial institutions. Underdeveloped countries lack these facilities. These facilities will help in increasing banking habit, mobilizing voluntary savings of the people, channel zing them into productive uses and raising the rate of capital formation.

(iv) Debt organization: In the developing economy, debt management is one of the main functions of monetary policy. The tools under the aims of debt management are deciding correct timing and issuing of government bonds, stabilizing their prices and minimizing the cost of servicing the public debt. These tools collect the means and sources of economic development. Monetary policy helps it in goal specific way.

(v)  Facilitate to manage price increases: Monetary policy is an effective measure to control inflation. It plays a significant role in checking inflation. Increase in government expenditure on developmental schemes increase aggregate demand but collective supply of consumer’s goods does not increase in the same time. This increases the price level. The monetary policy controls inflationary tendencies by growing saving, checking expansion of credit by banking system and hopeless deficit financing by the government through tightening monetary policy.

(vi) Help to accurate the unfavorable balance of payment: Monetary policy in the form of interest rate policy plays as important role in corrects the balance of payments deficit. In the developing countries like Nepal, there is serious balance of payment difficulties to fulfill the planned targets of development. To develop infrastructure’ such as power, irrigation, transport, etc. and directly productive activities like iron, steel, chemicals, electrical, fertilizers, etc., developing countries have to import capita] equipment, machinery, raw materials, spares and components thereby raising their imports. The exports are almost stagnant. They are high priced due to inflation. As results, an imbalance is created between imports and exports, which lead to misbalance in the balance of payments. Monetary policy can help in decreasing the gap balance of payments deficit through high rate of interest. The high rate of interest attracts the inflow of the foreign investments and help in bridging the balance of payment gap.

(vii) Reduction of Economic Inequality: In an underdeveloped economy, there is wide disparity of income and wealth and absence of an integrated interest rate structure. Monetary policy can play a significant role to maintain equal distribution of income and wealth and a suitable rate of interest rate. The central bank should take effective steps that benefit the poor and to integrate the interest rate structure of the economy. For this, low rate of interest should be fixed for the poor and small farmers, and entrepreneurs and subsidy may be given for them. A suitable interest rate structure encourages savings and investment in economy and discourages unproductive loans and speculative.


  1. Expansionary Monetary Policy to manage Recession or Depression

When the economy is faced with recession or involuntary cyclical unemployment, which comes due to fall in aggregate demand, the central bank intervenes to cure such a situation. Central bank takes steps to expand the money supply in the economy and lower the rate of interest with a view to increase the aggregate demand that will help in stimulating the economy. The following three monetary policy measures are adopted as a part of an expansionary monetary policy to measures are adopted to cure recession and to establish the equilibrium of national increase at full employment level of output.

(i)   Release marketplace process: The central bank undertakes open market operations and buys securities in the open market. Buying to securities by the central bank, from the public, chiefly from commercial banks will lead to the increase in reserves of the banks or amount of currency with the general public. With greater reserves, commercial banks can issue more credit to the investors and businessmen for undertaking more investment. More private investment will cause aggregate demand curve to shift upward. Thus buying of securities will have an expansionary effect.

(ii)  Reduce in Bank Rate: The Central Bank may lower the bank rate or what is also called discount rate, which is the rate of interest charged by the central bank of country on its loans to commercial banks. At a lower bank rate, the commercial banks will be induced to borrow more from the central bank and will be able to issue more credit at the lower rate of interest to businessmen and investors. This will not only make credit cheaper but also increase the availability of credit or money supply in the economy. The expansion in credit or money supply will increase the investment demand, which will tend to raise aggregate output and income.

(iii) Decrease of Cash Reserve Ratio (CRR): Thirdly, the central bank may reduce the Cash Reserve Ratio (CRR) to be kept by the commercial banks. In countries like India, this is a more effective and direct way of expanding credit and increasing money supply in the economy by the central bank. With lower reserve requirements, a large amount of funds is released for providing loans to businessmen and investors. As a result, credit expands and investment increases in the economy, which has an expansionary effect on output and employment.


5       Contraction Monetary Policy to manage Inflation

When aggregate demands rises sharply due to large consumption and investment expenditure or more importantly, due to the large increase in government expenditure relative to its revenue resulting in huge budge deficits, a demand-pull inflation occurs in the economy. Besides, when there is too much creation of money for one reason or the other, it generates inflationary pressures in the economy. The following monetary measures, which constitute tight money policy, are generally adopted to control inflation:

(i)   Promotion rule Securities: The Central Bank sells the Government securities to the banks, other depository institutions and the general public through open market operations. This action will reduce the reserves with the banks and liquid funds with the general public. With less reserve with the banks, their lending ability will be reduced. Therefore, they will have to reduce their demand deposits by refraining from giving new loans as old loans are paid back. As a result, money supply in the economy will shrink.

(ii)  Add to Bank Rate: The bank rate may also be raised which will discourage the banks to take loans from the central bank. This will tend to reduce their liquidity and also induce them to raise their own lending rates. Thus this will reduce the availability of credit and also raise its cost. This will lead to the reduction in investment spending and help in reducing inflationary pressures.

(iii) Adapting Anti-inflationary actions: The most important anti-inflationary measures are the raising of statutory Cash Reserve Ratio (CRR). To meet the new higher reserve requirements, banks will reduce their lending. This will have a direct effect on the contraction of money supply in the economy and help in controlling demand pull inflation. Besides Cash Reserve Ratio (CRR), the Statutory Liquidity Ratio (SLR) can also be increased through which excess reserves of the banks are mopped up resulting in contraction in credit.

(iv) Use of Qualitative acknowledgment manage calculate: Fourthly, an important anti-inflationary measure is the use of qualitative credit control, namely, rising of minimum margins for obtaining loans from banks against the stocks of sensitive commodities such as food grains, oilseeds, cotton, sugar, vegetables oil. As a result of this measure, businessmen themselves will have to finance to a greater extent the holding of inventories of goods and will be able to get less credit from banks.



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