Definition: The Monetary Policy is a programme of action undertaken by the central banks and other regulatory bodies to control and regulate the money supply to the public and a flow of credit, so as to ensure the stability in price and trust in the currency by targeting the inflation rate and the interest rate.
Simply, the process by which the monetary authority, generally the Central Bank controls the money supply in the economy is called as the monetary policy. There are two types of Monetary Policy:
- Expansionary Monetary Policy: The expansionary monetary policy is adopted when the economy is in a recession, and the unemployment is the problem. The expansion policy is undertaken with an aim to increase the aggregate demand by cutting the interest rates and increasing the supply of money in the economy. The money supply can be increased by buying the government bonds, lowering the interest rates and the reserve ratio. By doing so, the consumer spending increases, the private sector borrowings increases, unemployment reduces and the overall economy grows. Expansionary policy is also called as “easy monetary policy”. Although the expansionary monetary policy is useful during the slow period in a business cycle, it comes with several risks. Such as the economist must know when the money supply should be expanded so as to avoid its side effects like inflation. There is often a time lag between the time the policy is made and the time it is implemented across the economy, so up-to-the-minute analysis of the policy is quite difficult or impossible. Also, the central bank and legislators must know when to stop the supply of money in the economy and apply a Contractionary Policy.
- Contractionary Monetary Policy: The Contractionary Monetary policy is applied when the inflation is a problem and economy needs to be slow down by curtailing the supply of money. The inflation is characterized by increased money supply and increased consumer spending. Thus, the Contractionary policy is adopted with an aim to decrease the money supply and the spendings in the economy. This is primarily done by increasing the interest rates so that the borrowing becomes expensive.
Thus, these are the monetary policies applied by the monetary authority to control the inflationary or recessionary pressures in the economy.