Question

a. Discuss the objectives of monetary policy.

b. What are the target variables and tools of monetary policy.

Answer 1

The primary goals of monetary policy are the regulation of inflation or unemployment and the preservation of currency exchange rates.

1) Monetary policies should target inflation. Low inflation is perceived to be safe for the economy. If inflation is high, this problem can be resolved by a programme of contraction.

2) Monetary policy can influence the level of unemployment in the economy. For example, expansionary monetary policy usually lowers unemployment, since higher money supply increases economic practises that contribute to the expansion of the labour market.

3) Using its fiscal power, the central bank may control the exchange rate between domestic and foreign currencies. For example, the central bank can increase the money supply by issuing more money. In such a situation, the domestic currency is cheaper than its foreign counterparts.

2) Tools of monetary policy

central bank uses different tools for moentary policy some of the are :

Interest rate adjustment - The central bank can control interest rates by adjusting the discount rate. The discount rate (base rate) is the interest rate charged by the central bank to the bank for short-term loans. For example, if a central bank raises the discount rate, the cost of borrowing for the banks raises. Subsequently, the banks would increase the interest rate paid to their clients. As a result, borrowing costs in the economy will increase and the supply of money will decrease.

Change reserve requirements - Central banks typically set a minimum number of capital to be retained by a commercial bank. By adjusting the amount needed, the central bank will affect the availability of money in the economy. If monetary authorities raise the required reserve number, commercial banks would have less capital available to lend to their clients and hence reduce the money supply. Commercial banks can not use funds to make deposits or to finance investments in new companies. As this reflects a missed opportunity for commercial banks, central banks pay interest on the reserves. Interest is referred to as IOR or IORR (interest on deposits or interest on required reserves).

Open market operations -  The central bank can purchase or sell securities issued by the government to influence the money supply. Central banks , for example, may buy government bonds. As a result , banks will get more money to boost credit and money supply in the economy.