Concept of Monetary Policy

There are two major types of macroeconomic policies. These are fiscal policy and monetary policy. Of the two, monetary policy is concerned with the management of money and money supply in an economy. Monetary policy is a sister strategy to a fiscal policy that formulates policies to facilitate economic policies guided and taken by the fiscal policy. The monetary policy of any country is formulated and controlled by the central bank (Nepal Rastra Bank in the case of Nepal). It is concerned with the management of money and stabilization of the financial sector of the economy by the central bank.

Key Definitions

Defined By	Definition
Paul Sizing	“Monetary policy includes all monetary decisions and measures irrespective of whether their aims are monetary or non-monetary and al non-monetary decisions and measures that aim at affecting the system”
Johnson	“Monetary policy implies central bank’s control of the supply of money as an instrument for achieving the objective of general economic policy”
G.K. Shaw	“Monetary policy refers to any conscious action undertaken by the monetary authorities to change the quantity, availability or cost of money”

From the above discussion and definitions:

• Monetary policy should be understood as a macroeconomic policy formulated and controlled by the central bank of a country.
• It is concerned with the money and money supply in the economy.
• It is an assisting policy to fiscal and general economic policy which aims for financial sector stability and sustainability to facilitate the economic growth of a country.

Types of Monetary Policy

There are two types of monetary policy. These two types of monetary policies have been discussed below:

1. Expansionary (Ease or Cheaper) Monetary Policy: Expansionary monetary policy refers to the actions taken by the central bank to increase the monetary base or its rate of growth. It is using different monetary tools, either individually or together, to increase the money supply in the economy. As a part of expansionary monetary policy, the central bank can use tools like purchasing treasury bills or bonds in an open market, decreasing the bank rate or discount rate and reducing the required reserve ratios.
2. Contractionary (Tight or Dearer) Monetary Policy: Contractionary monetary policy is exactly the reverse of expansionary monetary policy. It is the action taken by the central bank to decrease the monetary base or its rate of growth. For this different tools can be used either individually or combinedly. Tools like selling treasury bills or bonds in an open market, increasing the bank rate or discount rate and increasing the required rate of reserves are key measures under the contractionary monetary policy.

Instruments of Monetary Policy

There are different instruments of monetary policy which is used by the monetary authority or central bank to direct the monetary actions towards certain goals or targets. The use of such instruments depends upon the need and requirement for the monetary management of a country. Some of the key instruments of monetary policy have been mentioned below:

1.    Quantitative or General or Indirect Instruments

These are the instruments used to control the volume or amount of credit supply. Such control is made without discrimination in terms of kinds, directions, areas, purposes, uses etc. of the credit supply. Such instruments are most effective only when the economy is highly elastic or responsible for a change in the cost of credit. The major quantitative or indirect instruments of monetary policy are as follows:

1. Open Market Operation: This is an essential quantitative indirect or general instrument of monetary policy. Open market operation means buying and selling government securities of the central bank in the open market. By using this instrument, the central bank maintains the liquidity level or monetary base of the economy at the required level. When the central bank sells the securities, the money from the public comes into the hand of the central bank resulting in the contraction of the monetary base or money supply. On the other hand, if the central bank buys the securities from the public, it increases the money supply.
2. Bank Rate or Discount Rate: Bank rate refers to the rate at which commercial banks can borrow funds from the central bank against the security of the government and other approved securities. It is also called discount rate as it is the rate used to buy or rediscount government securities, other approved securities and bills of exchange. A high bank rate means a high cost of borrowing from central banks resulting in a rise in the lending rate of commercial banks. On the other hand, low bank rates mean a low cost of borrowing from central banks resulting in a low lending rate of commercial banks.
3. Minimum Reserve Requirement Ratio: Reserves are compelled holdings out of the total deposit by the commercial banks. The number of reserves cannot be loaned out by the banks. Banks are forced to keep a certain portion of their deposit as a reserve with the central bank or in their own hands through certain legal provisions. When this ratio is decreased, more money is available for banks to expand credit and vice versa. Such reserve could be in the form of Cash Reserve Ratio, Statutory Liquidity Ratio, Minimum Holding Ratio etc.

2.    Qualitative or Selective or Direct Instruments

These are the instruments of monetary policy which are discriminating in nature. Thye tries to impact differently in different areas. Their function is to affect the uses and directions of credit. They have a certain quality that can be imposed or withdrawn. Some forms of qualitative instruments of monetary policy are listed below:

1. Margin  requirement while rediscounting or lending
2. Moral suasion for accepting directives by the commercial banks
3. Direction regarding lending and investment policies of commercial banks
4. Use of differential rediscounts rates for the different bills according to the purpose
5. Rationing of credit and its control
6. Spread rate ceiling 
7. Consumer credit regulation, classification and provisioning
8. Portfolio of bank investment regulation and monitoring

Objectives of Monetary Policy

Monetary policy is an important macroeconomic policy of a country. It aims to support and facilitate the successful implementation of the economic policy of a country. The main objectives of monetary policy are discussed below:

1. Price Stability: Monetary policy aims for the stability of the general price level. This means it tries to avoid the situation of inflation or deflation. The situation of inflation can be avoided through contractionary policy. Similarly, deflation can be managed with the help of expansionary policy. The price stability objective of monetary policy tries to remove the fluctuation of the general price level in the economy.
2. Full Employment: Another objective of monetary policy is to achieve a full-employment level of economic resources. According to J.M. Keynes, unemployment is caused due to deficiency of investment and the level of employment can be increased by increasing investment to the level that exceeds saving. Thus, expansionary monetary policy can be used which increases the money supply and reduce the rate of interest resulting in the attainment of full employment level.
3. High Economic Growth: High economic growth can be achieved through expansionary monetary policy. Under such policy, the central bank increases the money supply which reduces the rate of interest. The reduction in the rate of interest induces investment which results in an increase in production, employment and economic level and thereby economic growth of a country.
4. Reduction of Economic Inequality: Another important objective of monetary policy is to support the reduction of economic inequality. To reduce economic inequality policies like financial accessibility, subsidized lending, priority sector lending, deprived sector lending etc. can be designed and implemented ted to facilitate the need of marginalization and inequality suffering people or communities.
5. Balance of Payment Equilibrium: Monetary policy focuses on a balance of payment equilibrium. Due to an increase in money supply by the central bank, the supply of domestic currency increases in the foreign exchange market. This excess supply of domestic currency in the foreign exchange market depreciates the domestic currency. This makes import items more expensive than domestic items. It makes the export of domestic items cheaper than import items. This increases the export and thus corrects the adverse balance of payment equilibrium.
6. Stability of Foreign Exchange Rate: Monetary policy also aims for the stability of the foreign exchange rate. For a stable exchange rate, the expansion of the money supply should not exceed the specified limit.