Economic Stabilisation: Monetary Policy

INTRODUCTION

• Monetary policy is a key instrument of macroeconomic policy and is formulated and implemented by the Central Bank of a country. In India, the Reserve Bank of India works under the broad guidance of the Government, whereas in the USA the Federal Reserve System operates with greater independence.

• The main objectives of monetary policy are to achieve full-employment or potential output, ensure price stability and promote economic growth.

• Monetary policy operates by changing the supply of money and the rate of interest to influence aggregate demand and stabilise the economy.

• During recession, the Central Bank adopts expansionary measures by increasing money supply and lowering interest rates to stimulate investment and aggregate demand.

• During inflation, contractionary measures are adopted by reducing money supply or raising interest rates to curb aggregate spending.

• In developing countries like India, monetary policy has an additional responsibility of promoting economic growth in both industrial and agricultural sectors.

• Thus, the major goals of monetary policy in developing economies are ensuring economic stability at full-employment level, maintaining price stability, and promoting sustained economic growth.

• The Reserve Bank of India has emphasized the objective of growth with price stability as the guiding principle of its monetary policy.

TOOLS OF MONETARY POLICY

There are four major tools or instruments of monetary policy which can be used to achieve economic and price stability by influencing aggregate demand or spending in the economy. They are:

1. Open market operations;
2. Changing the bank rate;
3. Changing the cash reserve ratio; and
4. Undertaking selective credit controls.

• Monetary policy uses various tools to influence aggregate spending, output, employment and prices in the economy.

• During recession or depression, the Central Bank adopts expansionary monetary policy (easy money policy) to increase money supply and lower interest rates, thereby raising aggregate demand and stimulating economic activity.

• During inflation or excessive expansion, the Central Bank adopts contractionary monetary policy (tight money policy) to reduce money supply or raise interest rates, thereby lowering aggregate demand and achieving price stability.

• Thus, monetary policy functions as a demand-management tool aimed at stabilising the economy by adjusting liquidity and credit conditions according to economic circumstances.

EXPANSIONARY MONETARY POLICY TO CURE RECESSION OR DEPRESSION

• During recession or cyclical unemployment caused by fall in aggregate demand, the Central Bank adopts expansionary monetary policy to increase money supply and lower interest rates in order to stimulate economic activity.

• One key measure is open market operations, where the Central Bank buys government securities from the public and commercial banks. This increases bank reserves and currency in circulation, enabling banks to expand credit and promote private investment, thereby shifting aggregate demand upward.

• The Central Bank may also reduce the bank rate or discount rate, which is the interest rate charged on loans to commercial banks. A lower bank rate encourages banks to borrow more, expand credit and offer loans at lower interest rates, increasing investment and output.

• Another effective tool is reducing the Cash Reserve Ratio (CRR), which releases additional funds for lending by lowering the proportion of deposits banks must keep as reserves. This expands credit and raises investment, output and employment.

• Similarly, lowering the Statutory Liquidity Ratio (SLR) increases banks’ lendable resources by reducing the proportion of deposits required to be held in specified liquid assets such as government securities, thereby increasing credit availability to the private sector.

• All these measures increase bank reserves and liquidity, forming the basis for credit expansion and growth in money supply.

• By increasing credit availability and reducing borrowing costs, expansionary monetary policy stimulates private investment and helps restore full-employment equilibrium.