What is Monetary Policy ?


Monetary policy refers to the use of a set of instruments by the central bank to influence the level of money supply in an economy. There are two types of tools or instruments of monetary policy, viz., (i) quantitative, and (ii) qualitative. Quantitative instruments are also known as general instruments. They relate to the quantity or volume of money supply in the economy. Thus these policy instruments do not discriminate across sectors of the economy or social groups. The important tools in this category are a) interest rate, b) open market operations, c) cash reserve ratio, and d) statutory liquidity ratio. Qualitative instruments are also called selective tools. They are used for discriminating between different uses of credit. The important selective credit control instruments are a) selective credit controls, b) margin requirements, c) credit rationing, d) moral suasion, and e) direct actions. 

These days, the main instrument at the disposal of central banks is the interest rate. You may have seen people in the business as well as bankers waiting for the announcement of monetary policy by the Reserve Bank of India (RBI). In an open economy, the challenges before the central bank are too many. In fact, in the modern era, financial stability has become an important consideration of the central banks. Till the 1970s, it was believed that the central bank would be able to control the supply of money in the economy. Even then, there were economists who expressed doubts on the ability of the central bank to do so. 

However, during the period 1986-2006, there was stability in ‘economic growth and inflation’ in most developed countries. This period is often teermed as the ‘great moderation’ as it was somehow believed that we have mastered the art of controlling the economy. Extreme economic volatility was thought to be a thing of the past, till the world encountered the global financial crisis during 2007-2009. Subsequent to the financial crisis, since 2010, many countries have resorted to ‘protectionism’, which has influenced globalisation adversely. The importance of monetary policy worldwide has resulted in heads of the central banks (for example, Governor of RBI in the case of India) receiving importance. 

Most of the central banks are governed by their legal mandates, not just to control the level of inflation, but also maintain a lower level of unemployment. In fact, in earlier days (up to 1980) most central banks were pursuing multiple objectives including price stability, employment and economic growth. Since the 1980s, however, the focus has been more on inflation targeting. This focus on inflation targeting to the exclusion of other priorities is usually ascribed to the Federal Reserve System of the United States (US) for its role played in the 1980s. In the aftermath of the oil crisis during the 1970s, United States was witness to an unprecedented inflation of sorts. Paul Volcker, the then President of the Federal Reserve System, administered a large hike in the interest rate. Even though the level of output contracted as a result of the increase in interest rate, the rate of inflation declined. It is in this context that inflation targeting gained acceptability in the policy circles of central banks. Volcker’s disinflation strategy of hiking interest rate towards reducing price levels gained wide recognition. Since the 1980s, the focus among central bankers has been more on inflation targeting to the exclusion of the objective of employment generation. You should note that the increase in interest rate in the United States Monetary Policy resulted in a number of Latin American countries (such as Brazil, Argentina and Mexico) defaulting on their international debt obligations. Many Latin American countries had borrowed huge amounts during the 1960s and 1970s for industrialization of their countries. When the rate of interest increased during the 1980s these countries had to pay huge sums to service their debts. Students of economics and history would know that the international debt crisis in the 1980s had a harmful effect on the economic growth in Latin America. This had much to do with the disinflation strategy pursued by the United States and European Countries. In the recent years too, you would have noticed that developing economies witnessed capital flights (outflow of foreign capital) from financial markets in response to increases in interest rate by the developed economies

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