Central banks create and implement monetary policy to ensure the economy functions smoothly. They manage the money supply and interest rates, employing this demand-side economic policy to achieve macroeconomic goals such as controlling inflation, promoting consumption and growth, maintaining liquidity, and ensuring overall stability.
Background of Monetary Policy
- Back in 1934, the Reserve Bank of India (RBI) laid the foundation for monetary policy under the RBI Act. The main goal of monetary policy is to regulate the amount of money circulating in the market, catering to the diverse needs of different sectors and fostering economic growth.
- Several economic factors, such as the gross domestic product (GDP), inflation rate, and specific growth rates in various industries and sectors, play a crucial role in shaping the decisions and strategies of monetary policy.
- The RBI, entrusted with the responsibility of conducting monetary policy in India, operates under the amended RBI Act of 2016. The primary objective is to maintain price stability while concurrently promoting overall economic growth.
- To execute monetary policies effectively, the RBI utilizes various instruments, including open market operations, bank rate policies, reserve systems, credit control policies, moral persuasion, and other relevant tools.
- Traditionally, in India, monetary policy announcements occurred twice a year – once during the lax season (April-September) and once during the busy season (October-March). However, the RBI, following the recommendation of the Urjit Patel Committee, shifted to issuing bi-monthly Monetary Policy Statements starting from 2014.
Objectives of Monetary Policy
The objectives of monetary policies are the management of inflation or unemployment rates and the maintenance of currency exchange rates as well.
- Sometimes, the government tries to control inflation, which is basically the increase in the prices of things we buy. They use different strategies.
- If they want to lower inflation, they might use something called “contractionary monetary policy.” This involves reducing the amount of money floating around in the economy.
- On the flip side, if they want to boost inflation, they use “expansionary policy” to increase the money circulating in the economy.
- The government can also influence how many people have jobs.
- When they want to reduce unemployment (meaning more people working), they use an “expansionary monetary policy.” This means there’s more money available, and it encourages businesses to grow, creating more jobs.
- On the other hand, if they’re concerned about too many people having jobs and want to slow things down a bit, they might go for a “contractionary monetary policy.”
- The value of our money compared to money from other countries (exchange rates) can be affected too.
- Imagine the government decides to print more money. Well, this could make our money less valuable compared to foreign money.
- In other words, our currency becomes cheaper in the global market.
Types of Monetary Policy
Monetary policy is typically categorized into two parts based on the specific type of money supply needed within a country.
Contractionary Monetary Policy: When a country adopts a contractionary monetary policy, it means that the authorities are taking steps to increase interest rates and limit the money supply. This is done to slow down economic growth and reduce inflation. The rationale behind this policy is to counteract rising prices of goods and services, which erode the purchasing power of money for consumers.
To implement a contractionary monetary policy, the central bank typically engages in actions such as selling off short-term government securities, raising borrowing rates, or increasing reserve requirements for banks.
Expansionary Monetary Policy: On the flip side, an expansionary financial policy is geared towards boosting the money supply in the economy. This is achieved by lowering interest rates, having the central bank purchase government securities, and reducing reserve requirements for banks. The primary goal is to stimulate economic activity, lower unemployment rates, and encourage both business activities and consumer spending.
This type of policy is particularly useful during periods of economic slowdown or recession, as it helps kickstart growth. By decreasing interest rates, the appeal of saving diminishes, leading to increased consumer spending and borrowing. However, it’s essential to note that while beneficial, an expansionary monetary policy can also have drawbacks, occasionally leading to hyperinflation.
Monetary Policy Committee (MPC)
Section 45 ZB of the amended RBI Act of 1934 marked a significant change by empowering the Central Government to establish a six-member Monetary Policy Committee (MPC).
- The primary responsibility of this committee is to focus on inflation targeting in India, aiming to maintain a healthy and stable economy.
- This marked a departure from the earlier framework where the RBI governor and their internal team had full authority over financial policy decisions.
- The committee consists of six members, with three appointed by the Reserve Bank of India (RBI) from within, and the remaining three nominated by an external selection committee.
Monetary policy serves a crucial role in maintaining the overall health and stability of a nation’s economy. It actively contributes to shaping the government’s decisions and policies, playing a significant part in creating a positive perception of the nation among global investors. The effectiveness of financial policy lies in its careful formulation and widespread acceptance, ultimately contributing to the successful realization of the nation’s economic goals.
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