Source: https://corporatefinanceinstitute.
com/resources/knowledge/economics/monetary-policy/
What is Monetary Policy?
Monetary policy is a set of economic policy that manages the size and growth rate of the money
supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation
and unemployment.
Monetary policies are implemented through different tools, including the adjustment of the
interest rates, purchase or sale of government securities, and changing the amount of cash
circulating in the economy. The central bank or a similar regulatory organization is responsible
for formulating monetary policies.
Objectives of Monetary Policy
The primary objectives of monetary policies are the management of inflation or unemployment,
and maintenance of currency exchange rates.
Inflation
Monetary policies can target inflation levels. The low level of inflation is considered to be
healthy for the economy. However, if the inflation is high, the monetary policy can address this
issue.- Interest rate, Reserve Requirement, OMO
https://www.economicsdiscussion.net/inflation/measures-for-controlling-inflation-with-
diagram/4075
Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an
expansionary monetary policy generally decreases unemployment because the higher money
supply stimulates business activities that lead to the expansion of the job market.
Currency exchange rates
Using its fiscal authority, a central bank can regulate the exchange rates between domestic and
foreign currencies. For example, the central bank may increase the money supply by issuing
more currency. In such a case, the domestic currency becomes cheaper relative to its foreign
counterparts.
1. Currency Appreciation:
Jan 2020: $1= 80 Tk
Dec 2020: $1= 75 Tk
Dollar depreciation, Tk Appreciation
2. Currency Depreciation:
Explanation: https://www.economicshelp.org/blog/749/economics/understanding-exchange-
rate/#:~:text=A%20falling%20exchange%20rate%20can,devaluation%20could%20lead%20to
%20inflation.
Dec 2010: 1 dollar= 71.023 tk
Dec 2020: 1 dollar= 84. 837 Tk
Tk…………….. Dollar …………
Tools of Monetary Policy
Central banks use various tools to implement monetary policies. The widely utilized monetary
policy tools include:
1. Interest rate adjustment
A central bank can influence the interest rates by changing the discount rate. The discount rate
(or bank rate) is an interest rate charged by a central bank to banks for short-term loans. For
example, if a central bank increases the discount rate, the cost of borrowing for the banks
increases. Subsequently, the banks will increase the interest rate they charge their customers
(base rate). Thus, the cost of borrowing in the economy will increase, and the money supply will
decrease.
[What Is the Discount Rate aka Bank Rate?
https://www.investopedia.com/terms/d/discountrate.asp
Depending upon the context, the discount rate has two different definitions and usages.
First, the discount rate refers to the interest rate charged to the commercial banks and
other financial institutions for the loans they take from the Federal Reserve Bank
through the discount window loan process, and second, the discount rate refers to the
interest rate used in discounted cash flow (DCF) analysis to determine the present
value of future cash flows.
Base rate is the minimum rate set by the Reserve Bank of India below which banks are not
allowed to lend to its customers. Description: Base rate is decided in order to enhance
transparency in the credit market and ensure that banks pass on the lower cost of fund to their
customers.]
2. Change reserve requirements
Central banks usually set up the minimum amount of reserves that must be held by a commercial
bank. By changing the required amount, the central bank can influence the money supply in the
economy. If monetary authorities increase the required reserve amount, commercial banks find
less money available to lend to its clients and thus, money supply decreases.
3. Open market operations
The central bank can either purchase or sell securities issued by the government to affect the
money supply. For example, central banks can purchase government bonds. As a result, banks
will obtain more money to increase the lending and money supply in the economy.
Expansionary vs. Contractionary Monetary Policy
Depending on its objectives, monetary policies can be expansionary or contractionary.
Expansionary Monetary Policy
It is a monetary policy that aims to increase the money supply in the economy by decreasing
interest rates, purchasing government securities by central banks, and lowering the reserve
requirements for banks. An expansionary policy lowers unemployment and stimulates business
activities and consumer spending. The overall goal of the expansionary monetary policy is to
fuel economic growth. However, it can also possibly lead to higher inflation.
Contractionary Monetary Policy
The goal of a contractionary monetary policy is to decrease the money supply in the economy. It
can be achieved by raising interest rates, selling government bonds, and increasing the reserve
requirements for banks. The contractionary policy is utilized when the government wants to
control inflation levels.
