Monetary policy : Objectives and tools
Monetary policy is a demand-side economic policy that is accomplished by the central bank (in USA, Federal Reserve Bank) to…
monetary policy tools
Tools are used by Central Bank in its monetary policy activities.
The central bank of a country especially uses three kinds of methods to influence monetary activities. They are, make adjustments to the interest rate, change statutory reserve requirements, and engage in open market operations. When there is an inflation situation in the economy, the central bank uses a contractionary monetary policy to reduce inflation. When there is a deflationary situation (recession) in the economy, the central bank uses expansionary monetary policy to increase the output level. Also, if there is no inflation and deflation situation in the economy, the central bank applies a neutral monetary policy to continue the current economic performance. I will explain how a central bank can use above mentioned methods according to the economic situation.
1. Make adjustments to the interest rate
The central bank does adjustments to the interest rate by influencing the discount rate. Discount rate means the interest rate which is charged by the central bank when it gives short-term loans to the banks and financial institutions. As an example, if there is an inflationary situation in the country, the central bank increases the discount rate. Then banks and financial institutions also increase the interest rate when they give loans to the people. Increasing interest for the loans means increasing the cost of the loans. People will reduce the demand for loans. This will reduce the money supply of the nation. Then, aggregate demand will be contracted. The inflation of the country will be reduced. In Malaysia, the discount interest rate for March 2021 is 1.82 percent. (www.bnm.gov.my, n.d.)
2. Change statutory reserve requirement (SRR) ratio.
SRR ratio means the proportion required to maintain as deposit liabilities by a commercial bank according to the instructions of the central bank. It helps to manage the liquidity level of a country. (www.bnm.gov.my, n.d.). It is important to understand how the SRR ratio can be used to influence the money supply of an economy. Assume that there is a deflationary situation in the nation. Then government wants to increase the output level by increasing the money supply of the nation. So central bank of the country reduces the SRR ratio. Then there is a lower requirement of deposit liabilities for the commercial banks. Commercial banks can issue more loans. So, the money supply of the nation will be increased. People use this increased money supply to buy goods and services. In other words, aggregate demand will be increased as illustrated in the graph 1(the aggregate demand curve shift to the rightward). The equilibrium of the real output level will be expanded and the deflationary situation will be reduced.
3. Engage in open market operations.
The central bank can sell or purchase the government securities which are on the public hand. This can influence the money supply. For example, If the economy is in an inflation situation, the central bank sells the government securities such as treasury bonds and treasury bills to the people. Then the central bank can reduce the money supply in the economy. This will help to reduce the inflation situation in the economy. On the other hand, If the economy is in a recession situation, the central bank purchases the government securities from the people. Then the central bank can increase the money supply in the economy. This will help to reduce the recession situation in the economy