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The monetary policy manages the supply of money in the country through the Central Bank. The supply of money includes cash, checks, credit, as well as money market mutual funds. Monetary policy will increase liquidity in order to promote economic growth and it will reduce liquidity to help prevent inflation. The Central Bank uses interest rates and bank reserve requirements in addition to government bonds held by the banks. These tools work together to dictate the amount that banks can lend because the volume of the loan will affect the money supply. 

Man holding dollar bills
The monetary policy manages the supply of money in the country through the Central Bank.

Objectives of Monetary Policy

There are three crucial objectives of the policy. The first is to manage inflation in the country. The second objective is to generate employment and the third is to keep a check on the long-term rate of interest. The U.S. Federal Reserve has certain targets and in order to achieve the same, it has to make changes to the monetary policy. The overall idea of the policy is to promote a healthy growth of the economy. 

Types of Policy

There are two main types of monetary policy- Contractionary and expansionary. 

Contractionary monetary policy

The Central bank will use the contractionary monetary policy to control and bring down the rate of inflation. Inflation means an increased money supply and a rise in consumer spending. Thus, this policy does the opposite for the economy. It is aimed at reducing the supply of money in the country and restricting spendings in the economy. The bank does this by reducing the money supply and it reduces the amount of money that banks can lend. Banks will apply a higher rate of interest and loans will become more expensive. This will reduce the borrowing in the country which will ultimately slow down growth. 

Expansionary monetary policy

The bank uses an expansionary monetary policy to reduce unemployment and to avoid recession. It will do this by increasing liquidity in the country. When banks have excess money to lend, they reduce the interest rates and loans become cheaper. Businesses start to borrow more in order to purchase equipment, hire personnel, and to expand the operations. Similarly, individuals will borrow to buy more homes, appliances, and cars. It leads to an increase in demand and helps with economic growth. Expansionary policy is also known as an ‘easy monetary policy’. It is

useful in the slow period of a business cycle but it comes with many risks. Hence, the economist must know when the supply of money should be expanded in order to avoid side effects like inflation. The Central bank also knows when to stop the supply of money in the economy. 

Tools of Monetary Policy

There are three monetary policy tools with the Central Bank. They use open market operations where they engage in the purchase and sale of government bonds and other securities from the banks. It will change the reserve that banks currently hold. High reserve means that the banks lend less, which is the purpose of the contractionary policy. 

Another tool is the reserve requirement. Using this, the banks inform their members of the amount of money they need to maintain on reserve every night. Nobody requires the money every day, so banks lend it. This way, there is adequate cash on hand to handle the redemption demands. If the bank wishes to restrict liquidity, it will increase the reserve requirement. This will leave the banks with less money for lending purposes. If the bank wants to increase liquidity, it will lower the requirement and the banks will have excess money for lending. 

The last tool is the discount rate. It is the amount that the central bank will charge the members to borrow funds from the discount window. The bank will increase the rate to discourage borrowing from banks and it will slow down the economy. With a low discount rate, there will be an increase in borrowing and it will lead to growth. 

Key Takeaways

  • The Monetary Policy is used to manage economic growth, inflation, and unemployment in the country.
  • The policy has an impact on prices, production, demand, and employment.
  • There are two types of monetary policies- expansionary, and contractionary.
  • The expansionary monetary policy will increase the growth of the economy and the contractionary policy will slow it down. 
  • The main purpose of the monetary policy is to control inflation, manage employment levels, and maintain the long term rate of interest. 
  • Monetary policy is implemented through open market operations, discount rates, reserve requirements, inflation targeting, and federal funds rate. 

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