Monetary Policy refers to those actions and decisions undertaken by the Central Bank to create appropriate monetary conditions in line with the economic objectives of the country. Monetary policy is used to make changes to the money supply in the economy to correct for recessionary and inflationary problems. This means that the authorities will make decisions to alter the money supply based on the state of the economy. If the economy is in recession, the government can implement expansionary monetary policy in order to increase money supply to create economy activity in order to bring the economy out of the recession. On the other hand, if the economy is in an inflationary mode which is beyond full employment, the Central Bank can carry out contractionary monetary policy in order to reduce the money supply in order to bring the economy back at the full employment level. In many countries, monetary policy is undertaken by the Central Bank.
Instruments of Monetary Policy
1. Reserve Requirement Ratio
The reserve requirement ratio is the percentage of the annual deposits that financial institutions are required to hold with the Central Bank (or local financial regulator). When the economy is growing or when there is inflationary pressure, the Central Bank will increase the reserve requirement ratio so that more of the banks’ deposits will be held with the Central Bank and less will be available for lending by the commercial banks to their customers. This will have the effect of reducing the money supply in the economy. This can reduce the inflationary position.
On the other hand, when there is a downturn in economic activity or a recession, the Central Bank reduces the reserve requirement ratio thereby allowing the banks to hold less deposits with the Central Bank and have more money to lend and invest. This will have the effect of increasing the money supply and the level of economic activity and bring the economy out of the recession.
2. Open Market Operations
Operations market operations is the buying and selling of government bonds in order to manipulate the money supply. The government sells bonds to the public when there is too much money in circulation or an inflationary situation in the financial system as in the case of full employment and economic boom. When the Central Bank sells bonds to the public on behalf of the government, this will have the effect of taking money away from the public. This will mean that the public will have less money in their possession to spend and so the money supply available to the public will be reduced.
On the other hand, when there is too little money in the financial system as in the case of a recession, the government tries to stimulate economy activity by buying back bonds from the local investors. The government will be exchanging the money back for the bonds (or taking back the bonds and giving back money to the public) from the public. Therefore, the public will now have more money in their possession to spend and so the money supply in the economy would have increased and so too would be the level of economic activity.
3. Discount Rate
The discount rate is the rate at which financial institutions can borrow from the Central Bank. When there is too much economic activity, the Central Bank increases the discount rate thereby making borrowing difficult by the commercial banks. Therefore, the banks will have less money to lend. This will have the effect of reducing the money supply and reducing some of the economic activity in the economy. On the other hand, when there is too little economic activity or too little money supply in the economy, the Central Bank can reduce the discount rate thereby making borrowing by commercial banks from the Central Bank easier. These commercial banks will now have more money available to lend to their customers. This will have the effect of increasing economic activity.