Objectives of Monetary Policy

• Price stability,• Maintenance of full employment, and• The economic prosperity and welfare of the people of the economy.
Price stability, that is controlled price level, is the imperative condition for the constant economic growth, once accomplished leads to full employment and economic prosperity. Price stability develops investor’s confidence – boosting investments, causing acceleration of economic activity and achievement of full employment.
Thus, the significance of monetary policy is to achieve the inflation target (set by the central bank for required economic growth), and as a consequence, to accelerate strong and sustainable economic growth. Achievement of inflation target directs strong currency valuation in terms of other foreign currencies, resulting as favorable balance of payments.
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Tools of Monetary Policy

In order to attain the objectives discussed above, the central bank uses three tools: open market operations, the discount rate and reserve requirements.
• Open Market Operations: The most effective and major tool the central bank uses to affect the monetary supply in the economy is open market operations – that is, the buying and selling of government securities (usually bonds or T-bills) by the central bank.If the central bank decides to increase monetary base in the economy it buys securities from the open market and pays for these securities by crediting the reserve amounts of banks involved in selling. This will increase the reserve amount the banks hold, such that banks have more money to lend, interest rates my fall, leading to increase investment spending and as a result economic growth.Conversely, in order to tighten the monetary base in the economy, the central bank sell the government securities, as a result collect payments from banks by reducing their reserve accounts. Having less money in these reserve accounts the opportunity cost of lending money decline, such that interest rates may increase, resulting a drop of investment spending, that is – the slow down of economic activity.• The Discount Rate: the rate at which financial institutions may borrow funds for short-term directly from the central bank.When the central bank reduces the discount rate, financial institutions must pay to borrow from the central bank; financial institutions become more willing to borrow, to make more money available for lending to businesses and households at low interest rates. This would initiate more consumption and investment spending and generate economic activity in the economy. The reverse would be the effect in case of increased discount rate.• Reserve Requirements: the proportion of the total assets that banks must hold in reserve with the central bank. Financial institutions only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets (like loans and mortgages). The monetary policy can be implemented by altering the proportion of these required reserves. Increasing the proportion of total assets to be held as liquid cash increases the amount of money available to banks as loanable funds, thus mean the broader monetary base in the economy, vice versa.