MONETARY POLICY
1. definition:
- Monetary policy is a central bank’s activities and communications that
manage the money supply.
2. Objectives/ goals of MP:
- managing inflation
- reducing unemployment
- promoting moderate long-term interest rates
3. Tools of MP: 3 tools:
- reserve requirements:
+ definition: reserve requirements are the certain percentage of deposits
required by the Central Bank to keep as reserve.
+ Significance: RR plays an important role in how much money banks
have to lend out
+ When RR increases, money supply decreases
+ When RR decreases, money supply increases
- discount rate:
+ definition: Discount rate is interest rate on loans offered by Central
Bank to other banks
+ Significance: DR determines the rest of loans from the central bank
that banks will have to lend out, so DR has influence on the money
supply.
+ When discount rate increases, money supply decreases.
+ When discount rate decreases, money supply increases.
+ Why RR and DR not used in day-to-day operations? (only to make
major changes): They are used mainly for major changes because
just a little percentage is changed, it can make a big problem to the
economy.
- open market operations (OMO):
+ definition: Open market operation is where governments buy and sell
their securities such as Treasury bonds.
● Central banks buy securities, money supply increases.
● Central banks sell securities, money supply decreases
+ If buying G. securities: It pumps more money in the circulation leading
to the MS will increase
+ If selling G. securities: It collects money from the circulation, so the
MS will reduce
+ Often used in daily operations of the Central Bank: Central Bank is
allowed by law to buy or sell government bonds in any quantities. So it
is easier to regulate the MS by using open market operations.
4. CONTROL OVER THE MONEY SUPPLY OF C.B/ CONDUCTING OF MONETARY
POLICY:
- Expansionary money policy:
+ definition: monetary policy is expansionary when the central bank reduces RR
or DR or buys government bonds.
+ Monetary policy should be expansionary when the economic growth rate is
low or unemployment rate is high.
+ Why?: For example, when the central bank reduces reserve requirement, or
discount rate or buys government bonds, this will increase the bank lending
capacity or increase money in the circulation. The increased money supply
encourages spending, leading to more investment and production of goods
and services, the economy then tends to grow.
+ Objectives of expansionary money policy:
- Restrictive monetary policy:
+ definition: Monetary policy is restrictive when the central bank increases RR
or DR sells government bonds.
+ Monetary policy should be restrictive when the economy is overheating or
inflation rate is high.
+ Why?: For example, when the central bank increases reserve requirement, or
discount rate or sells government bonds, these actions will reduce the bank
lending capacity or reduce the money supply, leading to reduced investment
and consumption. When the aggregate demand reduces, the prices of goods
and services tend to reduce, and inflation rate is likely to reduce.
+ Objectives of restrictive monetary policy: