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Monetary policy is one of the tools by which a Govt, a Central Bank, or a monetary authority of a country uses to control the supply of money, availability of money, and the cost of money or rate of interest to attain a set of objectives towards the growth and stability of an economy. Monetary theory provides insight into how much to craft optimal monetary policy.
Monetary policy rests on the relationship between the rates of interest in an economy and the total supply of money. Monetary policy uses a variety of tools to either one or of these, influence the outcomes like economic growth, inflation, exchange rates with other currencies, and unemployment. Inflation is one of the major issues faced by any country. Inflation is the decline of purchasing power of money. Today’s paper and plastic money can easily lose their value as the money should be backed up by the same amount of gold reserve. When the gold reserve is low or there is an excess of paper money in the market then it will lead to inflation and in the worst cases bankruptcy of banks. So, considering these issues, the Govts. all over the world have adopted monetary policies which try to control the supply of money, availability of money, and the rate of interest of money.
Monetary policy is referred to as being expansionary policy or a contractionary policy. In expansionary policy the supply of money increases in the economy. And in contractionary policy, the supply of money decreases.
Expansionary policy is adopted by Govts to encourage the growth rate of the economy. If there are any issues faced by a country lately and the level of economic activity has gone low then the government adopts the expansionary policy to rejuvenate the economy so that things get back to normal and the level of economic activity increases. This will increase the level of employment as businesses are given incentives, more and more companies are established and more and more people are given work. This type of monetary policy is particularly helpful in those countries which have faced problems like worse natural disasters, wars, famines, and drought or suffered recession or depression.
Contractionary Policy is adopted by the Govts to decrease the money supply in the economy. When there is a higher amount of inflation in the economy and the purchasing power of money is rapidly falling, then the Govt resorts to such a practice. The amount of money flowing into the economy can be controlled by certain simple measures. These measures can increase the rate of interest for the money borrowed and this will discourage people from borrowing from banks. And banks might have to increase their reserves in the Central bank, thereby reducing the money with the banks.
Compared to fiscal policies where the taxes have to be increased to control the flow of money, many Govts prefer to use contractionary policy to curtail the rate of inflation.
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