It is a policy implemented by the Monetary Authority of a country to regulate the money supply or interest rate mature on short term borrowing frequently aiming inflation to ensure public trust in currency and price stability.
In other words, it is a fiscal policy which primarily focuses on government spendings, government borrowing and taxation. At the same time, monetary policy objects to influence the money supply by printing more money or reducing the money supply by removing the excess reserves or changing interest rates.
Another main objective of monetary policy is to maintain a low level of unemployment, maintain expected exchange rates with other currencies and add the steadiness of gross domestic products in the economy. In developed nations, monetary policy is shaped distinctly from fiscal policy.
The monetary policy is broadly categorized as either expansionary or contractionary.
Expansionary Monetary Policy – it occurs when monetary authority aimed to stimulate the growth of the economy. The expansionary policy raises the total supply of money in the economy or lowers the interest rate than usual. This practice is used to fight unemployment by decreasing the interest rate with an expectation that, the less expensive loan will induce businesses into escalating. The expansionary policy generally reduces the worth of currency comparative to other currencies.
Contractionary Monetary Policy – it occurs when monetary authority reduces the supply of money than usual and increases short term interest rate than expected. This type of policy may lead to depressed borrowing from individuals and businesses and increased unemployment. If the system is applied too forcefully, it may ultimately result in an economic recession.
The monetary policy is based on three main tools, open market operations, interest rate and reserve requirements. A free market operation is the most important tool with which monetary authority affect the economic base. If the country market is well settled for its government bonds, this involves the circulation of money through buying and selling of several pecuniary instruments such as company bonds, treasury bills or foreign currencies. All these deposits in the form of bonds or currencies are convertible to a national currency.
Due to an increase in the number of buying and selling, the commercial and central banks have enough money to lend at a lower interest rate. This practice makes the loan less expensive. Thus companies lend loan to expand business in order to keep up with consumer demands. Ultimately the rate of employment increases. The open market operation tool is enough to stimulate businesses and drive economic growth to a healthy pace.
If the open market operation does not lead the economy to desire result, then the second tool is used, the interest rate. The central bank increase or decrease rate of interest according to economic condition. If the second tool fails to get desire result, then the third alternative is reserve requirements. It is a total portion of liabilities that banks keep in central banks or valets. It is a small amount of cash available for immediate withdrawal, while the rest is invested in illiquid assets like loans and mortgages. The change in the reserve requirements creates uncertainty in central bank planning; due to this, the open market operation is preferred over reserve requirements.