Monetary Policy

Definition: The Monetary Policy is the plan of action undertaken by the monetary authority, especially the central banks, to regulate and control the demand for and supply of money to the public and the flow of credit so as to achieve the macroeconomic goals.

The goals of the monetary policy are to control the money supply and set the inflation rate and the interest rate at a level such that the price stability and overall trust in the currency are ensured. Also, the monetary policy contributes towards the economic growth and stability, reduce unemployment and maintain a predictable exchange rate with other currencies.

The scope of monetary policy encompasses the area of economic transactions and macroeconomic variables that can be influenced by the monetary authority through its monetary policy. Depending on the effectiveness, the scope of monetary policy depends, by and large, on two factors:

  1. Level of Monetized Economy: In the case of a fully monetized economy, the scope of monetary policy covers the entire gamut of economic activities. This means, all the economic activities are carried out with money as a medium of exchange. Under this situation, the monetary policy works by changing the general price level.

    Thus, it is capable of affecting all the economic activities, Viz., consumption, production, savings, foreign trade, and investments. Also, the monetary policy can affect the macroeconomic variables such as GDP, savings and investments, general price level, foreign exchange, and employment.

  2. Level of Development of Capital Market: Another contributory factor is the level of development in the capital market. Since the change in the supply of money affects the level of economic activities through a change in the price level, the other monetary control instruments Viz. Bank rate and Cash Reserve Ratio work through the capital market.  Where the capital market is developed, the changes in the economic activities are attributed to the changes in the capital market. A market is said to be a developed capital market if it fulfills the following criteria:
  • Most of the financial transactions are routed through a capital market.
  • A large number of financially strong credit organizations, financial institutions, commercial banks, and short-term bill market.
  • The commodity market is highly sensitive to the changes in the capital market.
  • The working of several capital sub-markets is interlinked and interrelated.

Note: It is important to note that the cash reserve ratio and bank rate works through commercial banks and thus, for monetary policy to have a widespread impact on the economy the capital sub-markets must have a strong financial links with the commercial banks.

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