Monetary Policy - The Basics

- The way the Government regulates the amount of money in circulation in a nation's economy in order to achieve Macroeconomic Goals.

There are two types of Monetary Policy:

Expansionary:

        - Aimed at increasing economic growth, and expanding economic activity.

        - If a country is facing high unemployment rates during a slowdown or a recession. 

                    - Lowering interest rates.

                    - Businesses/individuals can take loans to expand productive activities and consumer spending.

                    - To promote spending and discourage saving.

                    - Leads to an increased money supply.

Contractionary: 

        - Aimed to bring down inflation - although it can increase unemployment and slow economic growth.

        - By increasing interest rates and slowing the growth of money supply.

        - Monetary policy helps ensure the price stability of a country. 

        - To avoid both prolonged inflation or deflation.

Simply put, the motive of the two policies (expansionary and contractionary), amongst many others is to reach an equilibrium. 

Money Supply = Money Demanded

Tools: What are the different tools/instruments used by the Government to implement Monetary Policy?

1. Open Market Operations (O.M.O.)

       - The sale and purchase of the Government securities and treasury bills by the central bank to influence money supply by manipulating interest rates.

       - To control the amount of money in the reserve of the central bank. 

                - Expansionary: If central bank purchases securities, the money in the reserves increase, making it easier to take loans and decreasing interest rates. 

                - Contractionary: If central bank sells securities, the money is removed from the reserves, making it harder to take loans (as loans become more expensive) and increasing interest rates.

2. Collateral

       - Collateral: "An asset that a lender accepts as a security for a loan". - Investopedia

       - Expansionary: Banks require less collateral, easier for individuals/businesses to get a loan.

       - Contractionary: Banks require more collateral, cautious with lending - making it harder to get loans. 

3. Reserve Requirements

        - Reserve Requirements: the amount of funds at a bank must have on hand each night.

        - Expansionary: Lowering the reserve requirements releases more capital (money) for the banks to offer loans.

        - Contractionary: Increasing the reserve requirements have the reverse effect - releases lesser capital as banks must now own more money per night.

3. Discount Rate

       - Discount Rate: "Discount rate, also called rediscount rate, or bank rate, is the interest rate charged by a central bank for loans of reserve funds to commercial banks and other financial intermediaries" - Britannica

       - Expansionary: Lowering the discount rate.

       - Contractionary: Increasing the discount rate.

       - Raising or lowering the discount rate affects the bank's costs to borrow money, subsequently affecting the rates that the banks charge on loans.

       - It is also used to deal with the B.O.P. (Balance of Payments) deficits, by regulating international movement of capital (money).

Did You Know?

    -  When the Central Bank decreases the supply of money (contractionary monetary policy), small businesses are the ones most affected, compared to large companies. Smaller businesses depend on lines of credit to finance their activities. 

   - However, increased lending/loans (expansionary monetary policy) significantly increases economic activity for smaller businesses, compared to larger companies.