Question

Compare conventional and unconventional monetary policy. Explain what types of policy tools can be used for conventional and unconventional monetary policy. Explain when unconventional monetary policy is used. (Need to address all of them.)

Answer 1

Monetary policy is the process in which the central financial/monetary authority of the country aims to control the monetary base of the country by controlling the interest rates of loans available and quantum of money in the market.This helps in maintaining financial stability by stablising currency,keeping inflation rates,unemployment and GDP etc in control,so that desired positive results can be obtained for the growth and development of the national economy.They can be classified as conventional and unconventional.

During normal functioning of the economy,the central bank uses three main policy instruments for controlling the money supply and cost of borrowing/interest rates in the economy.They are:-Open market operations,Discount rates and lender of last resort and Reserve requirements.Under open market operation,the authority sale or purchase financial securities/instruments in the market economy.The sale of security leads to contraction of credit and purchase of security leads to expansion of credit.This is because,while doing so money is either squeezed from the economy or added to it.This is flexible and precise,easy to implement,provides central bank full control over volume of money and helps in achieving desired results.When a commercial bank faces financial crisis,when there is great rush of demand for cash,the depositors might loose confidence in the credibility of the bank,the central bank rescues the bank,acting as a lender of last resort and supply of credit by restoring the required liquidity by providing funds at a fixed rate of interest.This is known as discount rate.As per the reserve requirement,the central bank makes it obligatory for the commercial banks to keep a certain amount of reserve in the form of vault cash,liquid assets etc.This determines the amount of money left with banks to give away as loans.This way the amount of credit in the market can be determined.

When the economy is in the state of stress or financial crisis,heading towards depression and other severe issues,when the interst rates are at 0% or nearby and concerns of deflation hovers around,the monetary policy acts as additional monetary stimulus and helps the economy to bear the economical shocks,keeping the developments under control to achieve desired results.This mainly includes Liquidity Provisioning and Asset purchases.These are in other forms also known as credit easing,quantitative easing,signalling etc.Under liquidity provisioning,the central bank enhances,improves credit availability in the market.Signaling lowers the market expectations for further lowered interest rates in the future.Under the credit reasoning and asset purchase,the central bank aims at altering the balancesheet of the bank and addressing the liquidity shortages in the market.It purchases corporate bonds,commercial papers and asset backed secrities.Often it aims at purchasing private securities and assets to a achieve desired results in the economy.