Monetary policy
Monetary policy refers to the attempts by the government (central bank or monetary
authority) to change money supply and/or the interest rate so as to achieve certain
economic goals.
A. Open market operation
It refers to the central bank’s purchase and sale of government bonds in the market to
affect the level of monetary base and hence money supply.
(Monetary base : currency held by the public + bank reserves)
1. Open market purchases
When the central bank buys government bonds from the market, monetary base
will increase. The currency in circulation will increase. The bank reserves will
also increase. When banks lend out the excess reserves, multiple deposit creation
will occur and money supply will increase further.
2. Open market sales
When the central bank sells government bonds to the market, monetary base will
decrease. The currency in circulation will decrease. The bank reserves will also
decrease. When banks call back loans, multiple deposit contraction will occur
and money supply will decrease further.
B. Discount rate
The discount rate refers to the interest rate that the central bank charges on its loans to
commercial banks.
If the government wants to increase the money supply, the central bank will lower the
discount rate. Since the cost of borrowing is reduced, commercial banks will borrow
more money from the central bank and then lend out to the public. This results in
multiple deposit creation and increase in money supply.
If the government wants to reduce the money supply, the central bank will increase
discount rate. Commercial banks will borrow less money from the central bank.
With less bank reserves, commercial banks can make less loans to the public.
Through multiple contraction of deposits, money supply will decrease.
C. Required reserve ratio
It is the minimum proportion of deposits that banks are required to keep as reserves.
If the government wants to increase the money supply, it will lower the required
reserve ratio. Banks have more excess reserves to lend out. Money supply will
increase because of multiple deposit creation.
If the government wants to reduce the money supply, it will increase the required
reserve ratio. Banks have less excess reserves to lend out. Money supply will
decrease because of multiple deposit contraction.
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D. Printing money
The government can increase the money supply by printing more money to buy
government bonds from the public.
Effect of monetary policy on the level of output and price
When an expansionary monetary policy is adopted, money supply increases and interest
rate decreases. Consumption and investment increase. The increase in aggregate demand
will lead to an increase in output level and price level.
When a contractionary monetary policy is adopted, money supply decreases and interest
rate increases. Consumption and investment decrease. The fall in aggregate demand will
lead to a decrease in output level and price level.
Monetary policy versus fiscal policy
The time lags involved in formulating and implementing monetary changes(changes in
money supply and interest rate) are much shorter than those associated with fiscal
changes (changes in taxation and government expenditure.