Monetary policy is the policy the Central Bank of the country follows to regulate the supply of money and credit in the economy in order to promote economic growth, control inflation and maintain price stability. Monetary policy can be accommodative or restrictive. It is said to be accommodative when the central bank adopts an expansionary stance and takes action to increase the supply of money and credit in the economy. Conversely, the monetary policy is said to be restrictive when the central bank adopts a contractionary stance and takes action to reduce the supply of money and credit in the economy.
As against this Fiscal policy is the policy of the government for managing the budget. Read all about fiscal policy here below;
Monetary Policy tools
To implement the monetary policy central banks use various monetary policy tools that it has at its disposal. The three main tools are listed below;
Some countries administer the monetary policy through the Repo rate. Repo, also known as Repurchase Agreement is an agreement to borrow money against securities with an understanding that the borrower will buy back the securities from the lender at maturity. Under the central bank repo, the central banks lend funds to banks against securities at the Repo rate. If the central bank wants to increase the supply of money in the economy, it will lower the repo rate. This reduces the banks cost of funds and infuses them with more funds for on lending at lower interest rates. Conversely, when the central bank wants to reduce the supply of money and credit in the economy, it will hike the repo rate. The Bank of England uses this method.
The Reserve Bank of India also uses the Reverse Repo Rate along with the Repo Rate under the Liquidity Adjustment Facility mechanism. The Reverse repo rate is the rate at which banks can lend to the central bank, i.e. banks can place the excess funds with them with the central bank at the reverse repo rate. Therefore the reverse repo rate is the central bank’s borrowing rate. Between them, the Repo and reverse repo rate from a band, with the repo rate (lending rate) being at the higher end of the spectrum and the reverse repo rate (borrowing rate) at the lower end. The interest rates in the economy are expected to be within this range.
In the United States, we have the Federal Funds Rate also known as the Fed rate. Banks are required to place cash balances with the central bank as a buffer or reserve. Banks lend the excess cash balances to each other at the fed rate. Therefore the fed rate is a market determined interbank rate and the central bank moves this rate to signal its monetary policy stance. The United States also has the discount rate, which is the rate at which banks can borrow from the Federal Reserve. Therefore like the reverse repo rate in India, the discount rate serves as the higher end of the interest rate spectrum.
Reserve requirements are the second monetary policy tool that central banks use. Banks are required to maintain reserves as buffer against losses and bad times. In India, we have the Cash reserve ratio and Statutory Liquidity Ratio. Cash Reserve Ratio is the cash balances that banks have to maintain with the Central Bank. Statutory liquidity ratio also known as SLR is a percentage of the demand and time deposits that has to be maintained in the form of liquid assets like gold and government securities.
The central bank regulates the supply of money in the economy by increasing or decreasing the reserve requirements. By increasing the reserve requirement, the central bank reduces the funds available with banks for on lending which pushes up interest rates. By decreasing the reserve requirement, the central bank increases the funds available with banks for on lending which lowers the interest rates. Money supply in the economy is increased or decreased with the ultimate purpose of controlling the credit supply and interest rates in the economy. Interest rates are hiked to control inflation and they are lowered to spur economic growth.
Open Market Operations
‘Open market operations’ is the third monetary policy tool available with central banks. Through the open market operations the central bank buys from and sells government securities and t-bills to the market to increase or decrease the supply of money in the economy. When the central bank wants to infuse liquidity into the markets it will buy securities. This will ultimately have the effect of lowering the interest rates. When the central bank wants to suck out liquidity it will sell securities to the market which will have the effect of pushing up the interest rates.
Monetary Policy Transmission
Monetary policy transmission refers to the ways in which changes in the monetary policy, specially the monetary policy rate, are transmitted to the end consumers. We will consider the following four channels;
Short term rates:
An increase in the monetary policy rate will increase the short term lending rates. This will reduce demand for goods and services as consumers will borrow less for spending and thus reduce inflation. An increase in the lending rates will also reduce new investments. A decrease in the policy rate will have the opposite effect on interest rates and demand for goods and services and spur economic growth.
An increase in the monetary policy rates reduces the prices of bonds as yield and prices of bonds move in opposite directions. It will also decrease the prices of stocks as the discounting factor will now be high. Reverse is true for a decrease in policy rates.
An increase in interest rates also stimulates savings leading to wealth creation.
Currency exchange rate
An increase in monetary policy rates attracts foreign investment. People dump their currency to buy our domestic currency which causes it to appreciate and grow stronger. A stronger currency makes exports expensive and imports cheaper. Opposite is true for a reduction in interest rates. When interest rates are reduced, foreign money flows out to countries with relatively higher interest rates. This causes the domestic currency to depreciate. A weaker currency makes exports cheaper thus stimulating economic growth.
Read all about currency exchange rates below;
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For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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