To check the demand-pull inflation which has been a major problem in India and several other countries in recent years the adoption of contractionary monetary policy which is popularly called tight monetary policy is called for. 29.3 It will be seen from Fig. Monetary policy is also concerned with maintaining a sustainable rate of economic growth and keeping unemployment low. Thus, money supply increase may sometimes exceed the growth of output and sometimes fall short of it and as result may cause sometimes demand-pull inflation and sometimes recessionary conditions. It may however be noted that in a developing country such as India, in addition to achieving equilibrium at full employment or potential output level, monetary policy has also to promote and encourage economic growth both in the industrial and agricultural sectors of the economy. Monetarists have asserted that monetary authorities have tried to control the interest rates to stabilise the economy. How tight money policy helps in checking inflation is graphically shown in Fig. Similarly, when the economy is going into recession, it will result in lowering aggregate output and prices. Monetary policy can offset a downturn because lower interest rates reduce consumers’ cost of borrowing to buy big-ticket items … As a result, money supply in the economy will shrink. On the other hand, in times of inflation and excessive expansion, contractionary monetary policy or what is also called tight money policy is adopted to control inflation and achieve price stability through reducing aggregate demand in the economy. Thus, according to moneterists, it is not the presence of certain inherent destabilising factors in a free-market economy but the monetary mismanagement by the discretionary monetary policies which is the root cause of economic instability that has been existing in the free market economies. It should be further remembered that in our analysis of the successful working of the tight monetary policy it is assumed that demand for money curve (i.e., liquidity preference curve) is fairly steep so as to push up the rate of interest from r1 to r2 and further that investment demand curve II in panel (b) of Fig. How Expansionary Monetary Policy Works: Keynesian View: Now, it is important to understand how expansionary monetary policy works to cause increase in output and employment and thus help the economy to recover from recession. Thus, steps taken to stabilise the interest rate cause instability in the economy rather than removing it. Key Takeaways The Federal Reserve uses monetary policy to manage economic growth, unemployment, and inflation. Economic Stagflation in a Historical Context, Ph.D., Business Administration, Richard Ivey School of Business, B.A., Economics and Political Science, University of Western Ontario. Image Guidelines 5. The Central Bank may lower the bank rate or what is also called discount rate, which is the rate of interest charged by the central bank of a country on its loans to commercial banks. Expansionary monetary policy which produces the effect after 6 to 8 months may, therefore, actually intensify the inflationary situation. This action will reduce the reserves with the banks and liquid funds with the general public. The reverse of this is a contractionary monetary policy. Increasing money supply and reducing interest rates indicate an expansionary policy. The price stability goal is attained when the general price level in the domestic economy remains as low and stable as possible in order to foster sustainable economic growth. Fourthly, an important anti-inflationary measure is the use of qualitative credit control, namely, raising of minimum margins for obtaining loans from banks against the stocks of sensitive commodities such as food-grains, oilseeds, cotton, sugar, vegetable oil. II. Stable economic growth. It waited to lower the fed funds rate. But it becomes impotent in deep recessions. 3. Suppose during a recession, stock of money is equal to MS1 and money demand curve is given by Md. As rate of interest falls, it becomes profitable to invest more in producing or buying capital goods. He teaches at the Richard Ivey School of Business and serves as a research fellow at the Lawrence National Centre for Policy and Management. The Central Bank sells the Government securities to the banks, other depository institutions and the general public through open market operations. But it is worth mentioning that there are several weak links in the full chain of increase in money supply achieving a significant expansion in economic activity. 29.2 shows that at a higher interest rate r2, private investment falls from I2 to This reduction in investment expenditure shifts aggregate demand curve C + I2 + G2 downward to C + I1+ G2 and in this way inflationary gap is closed and equilibrium at full-employment output level YF is once again established. "Monetary policy decisions appropriately target aggregate measures – inflation and maximum sustainable employment – while being attuned to equity considerations of our policy actions. Monetary policy has great importance. It thought the subprime mortgage meltdown would only affect housing. By controlling the interest rate it has actually destabilised the economy. 29.1. Once the interest rate hits zero, there's not much more the Federal Reserve can do in terms of monetary policy to help the economy. 5,000 crores for the banks and thereby would significantly increase their lending capacity. 29.2.Now, if due to a large budget deficit and excessive creation of money supply, aggregate demand curve shifts to C + I2 + G2; inflationary gap of E1H comes to exist at full-employment level. Monetary policy is used to influence the employment situation and to manage inflation. The growth of output of an economy will absorb the extra money supply created as per this rule, without generating inflationary or recessionary conditions, and will thus ensure stability in the economy. But if the monetary authorities have chosen to stabilise the interest rate, they would adopt tight monetary policy to prevent the interest rate from going up. This influence exerted by the policy helps in curbing inflation, increasing employment and most importantly it helps in maintaining a healthy value of the currency. (3) To promote and encourage economic growth in the economy. This leads to more private investment spending which has an expansionary effect on the economy. On the basis of his study of monetary history of the United States, he contends that faulty decisions regarding changes in money supply, made by the monetary authorities, are responsible for a lot of instability that prevailed during the period of his study. Monetary policy is tricky. With greater reserves, commercial banks can issue more credit to the investors and businessmen for undertaking more investment. The approach uses quan- According to the monetary rule suggested by Friedman, money supply should be allowed to grow at the rate equal to the rate of growth of output. In some countries such as India the Central Bank (the Reserve Bank is the Central Bank of India) works on behalf of the Government and acts according to its directions and broad guidelines. This will not only make credit cheaper but also increase the availability of credit or money supply in the economy. This will have a direct effect on the contraction of money supply in the economy and help in controlling demand-pull inflation. The interaction between these two determines r0 rate of interest. Monetary and Fiscal Stability Taken together, fiscal and monetary policies create an investment environment. Our approach has in commonwithDiTella(2016)thatweallowcompletemarkets;theequilibriumallocationof They prescribe a rule for the growth of the money supply to achieve economic grow with stability. 2. The Economic Times defines monetary policy as "the macroeconomic policy laid down by the central bank," which manages interest rates, money supply, and functions as the demand side of economic policy to affect inflation, consumption, growth, and liquidity. As discussed in Challenges Associated with Using Rules to Make Monetary Policy, there are important limitations that argue against mechanically following any rule. Thirdly, the central bank may reduce the Cash Reserve Ratio (CRR) to be kept by the commercial banks. A monetary policy is a process undertaken by the government, central bank or currency board to control the availability and supply of money, as well as the amount of bank reserves and loan interest rates. The central bank undertakes open market operations and buys securities in the open market. In line with the above goals of monetary policy it has often been asserted by Governors of Reserve Bank of India that growth with price stability is the goal of monetary policy of the Reserve Bank of India. Besides Cash Reserve Ratio (CRR), the Statutory Liquidity Ratio (SLR) can also be increased through which excess reserves of the banks are mopped up resulting in contraction in credit. According to monetarists, there are two important sources of monetary mismanagement. Monetary policy is important in decisions the United States government makes about economic practices and regulations, but equally important are the fiscal policies, which government spending and tax reform are geared toward in stimulating the economy. Such adjustments can be made quickly, and monetary authorities devote considerable resources to monitoring and analyzing the economy. What Is Deflation and How Can It Be Prevented? An important question in this literature is why the financial sector is so exposed to certain aggregate shocks. Undertaking selective credit controls. The most important anti-inflationary measure is the raising of statutory Cash Reserve Ratio (CRR). Thus, appropriate monetary policy at times of recession or depression can increase the availability of credit and also lower the cost of credit. The research is part of what might be called "new normative macro- economic research." Similarly, if the supply of money does not rise at a more than average rate, any inflationary increase in spending will burn itself out for lack of fuel.”. It is worth noting that it is the Central Bank of a country which formulates and implements the monetary policy in a country. However, surprisingly, enough, the most monetarists do not advocate the use of discretionary monetary policy, namely, an expansionary or easy money policy, to lift the economy out of recession and tight monetary policy to check inflationary boom and thereby correct the ‘downs’ and ‘ups’ of the business cycles. This will tend to reduce their liquidity and also induce them to raise their own lending rates. It is generally agreed that a high degree of transparency and an effective communication of policy are necessary for the successful performance of central bank tasks. Monetary policy is important in decisions the United States government makes about economic practices and regulations, but equally important are the fiscal policies, which government spending and tax reform are geared toward in stimulating the economy. Therefore, modern Keynesians and other economists now believe that monetary policy can play a useful role in stabilising the economy at full employment level. Monetary policy is another important instrument with which objectives of macroeconomic policy can be achieved. When the economy begins to falter, then you will see interest rates being cut or reduces with this policy, which makes it less expensive to take on debt while increasing the supply of currency. We examine below both these sources of monetary mismanagement: First, there is a problem of variable long time lags that occur for changes in money supply to bring about desirable effects on nominal income. To sum up, Keynesian view of how expansionary and contractionary (tight) monetary policies work to achieve the twin goals of price stability and equilibrium at full-employment level of output is shown in the accompanying box.Liquidity Trap and Ineffectiveness of Monetary Policy: Keynes and his early followers doubted the effectiveness of monetary policy in pulling the economy out of depression. In countries like India, this is a more effective and direct way of expanding credit and increasing money supply in the economy by the central bank. UK target is CPI 2% +/-1. Note that tight or restrictive money policy is one which reduces the availability of credit and also raises its cost. Copyright 10. Its other goals are said to include maintaining balance in exchange rates, addressing unemployment problems and most importantly stabilizing the economy. (1) Variable time lags concerning the effect of money supply on the nominal income and (2) Treating interest rate as the target of monetary policy for influencing investment demand for stabilising the economy. For instance, liquidity is important for an economy to spur growth. In times of recession or depression, expansionary monetary policy or what is also called easy money policy is adopted which raises aggregate demand and thus stimulates the economy. They think that liquidity preference curve is not flat and further that investment demand is fairly sensitive to the changes in the rate of interest. The empirical studies show that demand for money (liquidity preference) never becomes flat and instead it falls throughout. Report a Violation, Monetary Policy: Meaning, Objectives and Instruments of Monetary Policy, Monetary Policy of India: Main Elements and Objectives, Public Expenditure: Meaning, Importance, Classification and Other Details. To quote Ritter and Silber, “such a rule would eliminate the major cause of instability in the economy—the capricious and unpredictable impact of counter cyclical monetary policy. It does this to influence production, prices, demand, and employment. Content Guidelines 2. Thus, when Reserve Bank of India lowers statutory liquidity Ratio (SLR), the, credit availability for the private sector will increase. At a lower bank rate, the commercial banks will be induced to borrow more from the central bank and will be able to issue more credit at the lower rate of interest to businessmen and investors. As long as the money supply grows at a constant rate each year, be it 3, 4 or 5 per cent, any decline into recession will be temporary. Therefore, modern Keynesians equally advocate for the adoption of discretionary monetary policy as for the discretionary fiscal policy to get rid of recession. the inflation rate) naturally falls within the remit of monetary policy makers. As the Federal Reserve conducts monetary policy, it influences employment and inflation primarily through using its policy tools to influence the availability and cost of credit in the economy. In fact, Friedman, the chief exponent of monetarism, contends that, historically, far from stabilishing the economy, discretionary changes in money supply or rates of interest have a destabilising effect on the economy. Before publishing your articles on this site, please read the following pages: 1. The tax should be based on the taxable capacity of the citizens of the country.From the social point of view, the burden of tax should be equal on all citizens. Since reserves are the basis on which banks expand their credit by lending, the increase in reserves raises the money supply in the economy. Regulations, therefore, are important to maintaining a status quo across all states wherein each citizen is guaranteed their rights to life, liberty, and the pursuit of happiness. Monetary policy has an important effect on both actual GDP and potential GDP. This fall in aggregate output and prices will cause a decline in the transactions demand for money. Fiscal and monetary policies go hand in hand in the federal legislature, where annual budgets dictate government spending in certain economy-stimulating areas as well as the creation of jobs through social welfare initiatives. They therefore emphasized the role of fiscal policy for fighting severe recession. Plagiarism Prevention 4. Expansionary monetary policy increases the growth of the economy, while contractionary policy slows economic growth. Monetary policy involves the use of central banks to manage interest rates and the overall currency supply for the economy. Monetary policy—adjustments to interest rates and the money supply—can play an important role in combatting economic slowdowns. Now, it will be seen from panel (a) that if tight money policy succeeds in reducing money supply from M2 to M1 the rate of interest will rise from r1 to r2. With lower reserve requirements, a large amount of funds is released for providing loans to businessmen and investors. It has been argued that the Central Bank cannot simultaneously stabilise both the interest rate and money supply. In panel (a) of Fig. The government needs adequate revenue to fulfill responsibilities.The state cannot fulfill its duties in case of a shortage of money but excessive taxes cannot be imposed for increasing revenue. Basically, the United States—or any governing body—can, in times of need, enact aggressive fiscal policy to combat market stagnation. 2. 2. To prevent this fall in interest rate, if money supply is increased, it will generate inflationary pressures in the economy. In April 1996, when Reserve Bank lowered the CRR from 14 per cent to 13 per cent, it was estimated that this would release funds equal to Rs. Similar to the Cash Reserve Ratio (CRR), in India there is another monetary instrument, namely, Statutory Liquidity Ratio (SLR) used by the Reserve Bank to change the lending capacity and therefore credit availability in the economy. Interest Rate as a Wrong Target Variable: The second source of money mismanagement is the wrong target variable chosen by the monetary authorities. New Normative Macroeconomic Research Empirical research on monetary-policy rules has recently begun to focus on this important exchange-rate question. The role of monetary policy in achieving economic stability at a higher level of output and employment will be discussed below and its role in promoting economic growth in a developing country with special reference to India will be explained. Role and importance of monetary policy transparency and communication . In the long run, monetary policy only has an influence on monetary variables; this means that steering the increase of price levels (i.e. 3. Thus, because of several weak links in the process or chain of expansion in money supply bringing about expansion, Keynes remarked that there are many a slip between the cup and the lip. Fiscal policy h… It may be noted that the use of all the above tools of monetary policy leads to an increase in reserves or liquid resources with the banks. Tight Monetary Policy to Control Inflation: When aggregate demand rises sharply due to large consumption and investment expenditure or, more importantly, due to the large increase in Government expenditure relative to its revenue resulting in huge budget deficits, a demand-pull inflation occurs in the economy. Monetary policy is concerned with changing the supply of money stock and rate of interest for the purpose of stabilising the economy at full-employment or potential output level by influencing the level of aggregate demand. Thus, fall in the rate of interest raises the investment expenditure which is an important component of aggregate demand.