Economics Fundamentals

What is Monetary Policy?

Monetary policy is a short-run tool used by the central bank to persist sustainable economic growth (in the long-run) by controlling the money supply through open market operations, discount lending and reserve requirements.
Before focusing on the significance for and affects of monetary policy on the economy of the country, first we discuss what monetary policy is? And how it is used by the central bank?“Monetary policy is the process of managing a nation's money supply to achieve specific goals—such as constraining inflation, achieving full employment or more well-being. Monetary policy can involve setting interest rates, margin requirements, capitalization standards for banks or even acting as the lender of last resort or through negotiated agreements with other governments”.
A wide variety of policy systems are possible to conduct monetary policy operations, but in the current international scenario, we have two broad groups of countries:
The first one is the group of those countries (like Hong Kong, Zambia, and China, etc.), whose monetary policies are focused primarily on the exchange rate. They either have exchange rates fixed to a major international currency (usually U.S. dollar) or in some kind of target band and monetary policy involve the management of that exchange rate.
The second is the group of countries with floating exchange rates (like the United States of America, Japan, Pakistan and Australia, etc.) and monetary policy involves the management of short-term interest rates by central banks to pursue the macroeconomic objectives of the economy.
The central bank uses monetary policy in two ways: that is contractionary monetary policy or expansionary monetary policy.
The Central Bank designs Contractionary policy in order to constrain the growth of money (i.e. increasing inflation) and credit in the economy. This is done by an increase in interest rates and a decrease in bond prices, such that higher interest rates lead to lower levels of capital investments, and leading the demand for bonds (domestic) to rise. The appreciation of domestic currency causes exchange rate to rise so there would be an increase in the demand for domestic currency and fall in demand for foreign currency. Thus a higher exchange rate causes a decline in exports and the imports get dearer in the country.
In the present international scenario, due to hike in inflation internationally, most of the countries adopted contractionary policy, like Pakistan recently has increased interest rate by 0.5 percent and set 10 percent short-term interest rates, and it is expected that the Reserve Bank of Australia (RBA) would increase short-term interest rates from 6.25 percent to 6.50 percent.
On the other hand Expansionary policy is used as a tool by the central bank to broaden the monetary base and credit in the economy by reduction in interest rates and increase in bond prices. The reduced interest rates attract capital investments and increased bond prices reduces its demand and the demand for foreign bonds to rise. The exchange rate also lowers down as a result of fall in the demand for domestic currency and a rise in demand for foreign currency leading currency to depreciate, resulting imports to decline and export to accelerate.
In 1999, Ecuador adopted the expansionary monetary policy in, but failed to achieve the required economic growth.