The policy undertaken by the monetary authority particularly the central bank in order to manage the supply of money is called the monetary policy. The Bank of England in 1694 with the responsibility of printing notes and back it with gold was the first one to get an idea to introduce monetary policy independently.
For many centuries, only two forms of monetary policy were prevalent which were to decide about coinage, and to create credit by printing paper money and the authority of monetary policy was only with the seigniorage. Moreover, during that time, a gold standard system was also prevalent under which the price of a country’s currency is measured in gold bars and it is kept constant by the government’s promise to either buy or sell the gold at a fixed rate in terms of the base currency. However, as of now, this policy is no longer used.
The main role of this macroeconomic policy is to govern inflation and reduce unemployment after controlling it and in addition to it, stabilize the Gross Domestic Product (GDP) and maintain predictable interest rates with other countries. In the developed country, this policy is framed differently from the fiscal policy and points out taxation, government spending, and association borrowing.
Monetary policy is divided into two main parts. These are:
- Contradictory Monetary Policy: This policy is used to rule over inflation by increasing the interest rates and selling government securities through open market operations.
- Expansionary Monetary Policy: The main function of this policy is to cut down the unemployment rates to fall especially during the period of recession. To reduce the interest rates, the central bank buys government securities and uses other tools like bank rate policy, reserve system, credit control policy, moral persuasion and many other instruments to increase the supply of money.
The Reserve bank of India increases the supply of money by purchasing government bonds through open market operations and in addition to that reduces the interest rate.
There are a few tools of monetary tools that are helpful to all central banks. They are:
- Reserve Requirement:
This tool tells the bank how much of their money is required for the reserve which is mostly 10%. In its absence, a bank would lend all of its cash and face an acute cash shortage during peak demands.
- Interest Rate:
According to this tool, banks charge different rates of interest in order to store their excess cash. This rate has a major effect on bank loan rates and mortgage rates.
- Discount Rate:
This tool refers to the number of interest banks charge to commercial banks for all the short-term loans.
- Open Market Operations:
It refers to the purchasing and selling of securities like treasury bills, company bonds or foreign currencies from member banks by impacting the reserve amount. However, it has no effect on the reserve requirement. If it doesn’t give the desired results, changing the interest rate is often helpful.
- Inflation Targeting:
This tool sets an expectation that inflation is going to occur which in turn leads people to buy goods and services.
In this way, both fiscal policy and monetary policy are very important in the functioning of the economy.