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Overview of Monetary Policy

  • Definition of Monetary Policy

    • Monetary Policy refers to the actions taken by a central bank to manage the money supply, interest rates, and credit conditions in the economy to achieve macroeconomic objectives such as controlling inflation, managing employment levels, and stabilizing the currency.

  • Types of Monetary Policy

    • Expansionary Monetary Policy: Used during periods of economic downturn or recession. The central bank increases the money supply and lowers interest rates to stimulate economic activity, boost consumer spending, and encourage investment.

    • Contractionary Monetary Policy: Implemented to control inflation or cool down an overheating economy. The central bank reduces the money supply and raises interest rates to reduce spending and investment.

Objectives of Monetary Policy

  • Price Stability- Managing inflation to maintain the purchasing power of money.

  • Full Employment- Achieving low unemployment levels by influencing economic activity.

  • Economic Growth- Promoting sustainable economic growth.

  • External Stability- Managing exchange rates and maintaining confidence in the currency.

  • Real-World Example-

During the 2008 financial crisis, the Federal Reserve adopted an expansionary monetary policy by lowering interest rates and engaging in quantitative easing to stimulate economic recovery.

Tools of Monetary Policy

  1. Open Market Operations (OMOs)-

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  • Definition- The buying and selling of government securities (bonds) by the central bank in the open market to regulate the money supply.

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  • Impact-

    • Expansionary OMO: Central bank buys government securities, increasing the money supply and lowering interest rates.

    • Contractionary OMO: Central bank sells government securities, decreasing the money supply and raising interest rates.

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Tools of Monetary Policy

2. Discount Rate (Bank Rate)-

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  • Definition- The interest rate charged by the central bank on loans to commercial banks.

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  • Impact-

    • Lower Discount Rate- Encourages banks to borrow more, increasing the money supply and reducing market interest rates.

    • Higher Discount Rate- Discourages borrowing, decreasing the money supply and raising market interest rates.

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  • Real-World Example- The Federal Reserve lowered the discount rate during the COVID-19 pandemic to support economic activity.

3. Reserve Requirements (Required Reserve Ratio)-

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  • Definition- The minimum fraction of deposits that commercial banks must hold as reserves and not lend out.

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  • Impact-

    • Lower Reserve Requirement- Increases the amount of funds available for lending, boosting the money supply.

    • Higher Discount Rate- Reduces the amount of funds available for lending, decreasing the money supply.

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  • Real-World Example- The People's Bank of China reduced the reserve requirement ratio during the 2008 financial crisis to encourage lending.

Tools of Monetary Policy

4. Interest on Excess Reserves (IOER)-​

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  • Definition- The interest rate paid by the central bank on excess reserves held by commercial banks.

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  • Impact-

    • Higher IOER- Encourages banks to hold excess reserves, reducing the money supply.

    • Lower IOER- Encourages banks to lend out excess reserves, increasing the money supply.

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  • Real-World Example- The Federal Reserve uses IOER to influence short-term interest rates and control the money supply.

5. Quantitative Easing (QE)-

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  • Definition- An unconventional monetary policy tool where the central bank purchases longer-term securities to increase the money supply and lower long-term interest rates.

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  • Impact-

    • Increases liquidity in the financial system, encourages lending and investment, and stimulates economic activity.

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  • Real-World Example- The Bank of Japan has used QE extensively since the early 2000s to combat deflation and stimulate economic growth.

Application of Monetary Policy

  • Real-World Examples-

    • Expansionary Policy- The Federal Reserve's response to the 2008 financial crisis and the COVID-19 pandemic involved significant monetary easing measures.

    • Contractionary Policy- The European Central Bank raised interest rates in the early 2010s to combat rising inflation.

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  • Limitations and Challenges-

    • Liquidity Trap- When interest rates are near zero and monetary policy becomes ineffective at stimulating the economy.

    • Time Lags- Monetary policy actions take time to impact the economy, and their effects may not be immediately visible.

    • Uncertainty- The central bank's actions are based on forecasts, and unexpected economic shocks can affect their effectiveness.

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