Question

Discuss what monetary policy is. Discuss different instruments of monetary policy. Discuss the impact of expansionary and contractionary monetary policy, specifically the change in interest rate and credit availability, and the process by which these changes impact business’s decision making process.

Answer 1

Part 1: A monetary policy is the macroeconomic policy laid down by the central bank of a country. It is aimed at reducing inflation, sustain high growth, or provide liquidity in the markets among other things. The monetary policy seeks to achieve the aforementioned marcoeconomic objectives through the supply of money in the economy. TRhe central bank, through its various instruments, can either follow an expansionary monetary policy (expanding money supply) or a contractionary monetary policy (contracting money supply).

Part 2: The three main instruments of monetary policy are:

1. Bank Rate: The bank rate is the minimum rate at which the central bank gives loans and advances to the commercial banks or rediscounts the approved first-class bills of exchange and government securities held by the commercial banks. The central bank controls the volume of credit by making changes in the bank rate. The bank rate and the rate of interest charged by commercial banks on their loans from their customers are interrelated. A change in the bank rate also brings about corresponding change in the lending rates of commercial banks; which, in turn, determines the total amount of bank credit borrowed from them to undertake investment in the economy. Depending upon the needs of the economy, changes in the bank rate can be made by the central bank to achieve its targets.
2. Open Market Operations: Open market operation is another quantitative instrument to control the volume of bank credit in an economy. Open market operations refer to the sale and purchase of government and other approved securities by central bank in the money and capital markets. It is a direct and deliberate sale and purchase of government and other eligible securities by the central bank of a country to influence the cash reserves with the commercial banks and, thereby, their power to create credit. During the period of boom when the economy faces inflationary pressure, the central bank sells the government and other approved securities making the commercial banks to reduce the amount of credit. Buyers of these securities pay the central bank by drawing cheques on their cash deposits in the banks reducing the cash holdings of the commercial banks. This forces the banks to reduce their advances and loans. Similarly, when the central bank aims at an expansion of credit during the period of recession it pursues the policy of purchase of securities from the commercial banks and other components of money and capital markets, injecting additional cash into the system.  As a result, the cash reserves of banks will increase and make them able to extend more loans.
3. Cash Reserve Ratio: Cash reserve ratio is the minimum percentage of the total deposits with the commercial banks which they are required to maintain in the form of cash reserves with the central bank. This is known as the statutory minimum reserve, and the excess over this statutory minimum reserve is the excess reserve. It is on the basis of this excess reserves that commercial banks are able to create credit. An increase in the reserve ratio means that commercial banks are required to keep more cash with the central bank. Consequently, the size the excess reserves with the commercial banks is reduced and their capacity create credit is squeezed. Therefore, the commercial banks will be in a position to create only a smaller volume of credit. Similarly, a fall in the reserve ratio will enable the commercial banks to expand their credit because banks will have more cash balance with them.

Part 3: Monetary policy can affect the aggregate demand level by increasing or decreasing the money supply, which affects the interest rates; that in turn affects the credit availability. For instance, an open market purchase by the central bank shifts the LM curve to the right, given the IS curve, reducing the equilibrium interest rate and increrasing credit availability. Or, an open market sale by the central bank shifts the LM curve to the left, given the IS curve, increasing the equilibrium interest rate and reducing the credit availability. This is represented in the figure given below:

In case of an expansionary monetary policy: Suppose a market for loanable bank funds, shown in the figure below. The markets are initially at an equilibrium (E₀) with an interest rate of 8% and a quantity of funds loaned and borrowed of $10 billion. An open market purchase by the central bank will shift the supply of loanable funds to the right from S₀ to S₁, leading to a new equilibrium (E₁) with a lower interest rate of 6% and a quantity of funds loaned and borrowed of $14 billion. Thus, an expansionary monetary policy reduces the interest rate and increases the availability of credit. While in case of a contractionary monetary policy: An open market sale by the central bank system will shift the supply of loanable funds to the left from initial S₀ to S₂, leading to another new equilibrium (E₂) with a higher interest rate of 10% and a quantity of funds loaned and borrowed of $8 billion. Thus, a contractionary monetary policy increases the interest rate and reduces the availability of credit. This is represented in the figure given below: