Monetary policy is the management of money supply and interest rates by central banks to influence prices and employment. Monetary policy works through expansion or contraction of investment and consumption expenditure.
The Reserve Bank issues the Statement on Monetary Policy. This statement assesses current economic conditions and the prospects for inflation and output growth.
Uses of monetary policy
- Monetary policy cannot change long-term trend growth.
- There is no long-term tradeoff between growth and inflation. (High inflation can only hurt growth).
What monetary policy , at its best , can deliver is low and stable inflation, and thereby reduce the volatility of the business cycle.
When inflationary pressures build up:-
- raise the short-term interest rate (the policy rate)
- which raises real rates across the economy
- which squeezes consumption and investment
Instruments of monetary policy in India
- Net loans to central government (i.e. open market operations)
- Net purchase of foreign currency assets
- Change in cash reserve ratio
- Changes in repo rate and reverse repo rate
- Bank rate
Contractionary monetary policy
- A rise in interest rates
- Individual loans more expensive
- Assets lose value. The wealth effect reduces spending.
- Firms can hold less inventories
- Borrowing for investment is more expensive
- Reduction in aggregate expenditure.
Expansionary monetary policy
- With a cut in interest rates, monetary policy is expansionary.
Thus it is observed that Monetary policy is used more as a stabilization device rather than as a development tool.