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Definition: The Monetary Policy is a process whereby the monetary authority,

generally the central bank controls or regulate the money supply in the

The goals of the monetary policy are to control the money supply and set the
inflation rate and the interest rate at a level such that the price stability and
overall trust in the currency are ensured. Also, the monetary policy contributes
towards the economic growth and stability, reduce unemployment and maintain
a predictable exchange rate with other currencies.

The scope of monetary policy encompasses the area of economic transactions

and macroeconomic variables that can be influenced by the monetary authority
through its monetary policy. Depending on the effectiveness, the scope of
monetary policy depends, by and large, on two factors:

1. Level of Monetized Economy: In the case of a fully monetized

economy, the scope of monetary policy covers the entire gamut of economic
activities. This means, all the economic activities are carried out with money as
a medium of exchange. Under this situation, the monetary policy works by
changing the general price level.

Thus, it is capable of affecting all the economic activities, Viz., consumption,

production, savings, foreign trade, and investments. Also, the monetary policy
can affect the macroeconomic variables such as GDP, savings and investments,
general price level, foreign exchange, and employment.

2. Level of Development of Capital Market: Another contributory factor

is the level of development in the capital market. Since the change in the supply
of money affects the level of economic activities through a change in the price
level, the other monetary control instruments Viz. Bank rate and Cash
Reserve Ratio work through the capital market. Where the capital market is
developed, the changes in the economic activities are attributed to the changes
in the capital market. A market is said to be a developed capital market if
it fulfills the following criteria:

Most of the financial transactions are routed through a capital market.

A large number of financially strong credit organizations, financial

institutions, commercial banks, and short-term bill market.

The commodity market is highly sensitive to the changes in the capital

The working of several capital sub-markets is interlinked and interrelated.

Instruments of Monetary Policy

1. Quantitative Measures: These are the traditional measures of monetary

control. All the quantitative methods affect the entire credit market in the same
direction. This means their impact on all the sectors of the economy is uniform.
But however it does not take into consideration the objectives of credit control.
The quantitative measure includes the following methods:

Open Market Operations

Bank Rate or Discount Rate

Cash Reserve Ratio

2. Selective Credit Controls: Since the objectives of credit control are not
served by the quantitative methods, the economists rely on selective control
methods to fulfill the purpose. The credit objectives may include rationing the
credit, directing the flow of credit from least important sectors to the most
important sectors, controlling a speculating tendency based on the availability of
bank credit. Thus, these objectives are very well served by the selective control
methods. It includes the following monetary measures:

Credit Rationing

Change in Lending Margins

Moral Suasion

In addition to these measures, the central bank uses a Liquidity Adjustment

Facility, Repo Rate, and Reverse Repo Rate, to control and regulate the
money supply in the economy. The Repo Rate is the rate at which commercial
banks borrow from RBI while the Reverse Repo Rate is the opposite of Repo
rate. It is the rate at which RBI borrows from the commercial banks against the
government securities. The RBI keeps changing these rate at its discretion.
The Repo Rate increases the money supply while the Reverse Repo Rate
decreases the money supply in the economy.
1. Expansionary Monetary Policy: The expansionary monetary policy is
adopted when the economy is in a recession, and the unemployment is the
problem. The expansion policy is undertaken with an aim to increase the
aggregate demand by cutting the interest rates and increasing the supply of
money in the economy. The money supply can be increased by buying the
government bonds, lowering the interest rates and the reserve ratio. By doing
so, the consumer spending increases, the private sector borrowings increases,
unemployment reduces and the overall economy grows. Expansionary policy is
also called as easy monetary policy.

Although the expansionary monetary policy is useful during the slow period in a
business cycle, it comes with several risks. Such as the economist must know
when the money supply should be expanded so as to avoid its side effects
like inflation. There is often a time lag between the time the policy is made
and the time it is implemented across the economy, so up-to-the-minute
analysis of the policy is quite difficult or impossible. Also, the central bank and
legislators must know when to stop the supply of money in the economy and
apply a Contractionary Policy.

2. Contractionary Monetary Policy: The Contractionary Monetary policy is

applied when the inflation is a problem and economy needs to be slow down by
curtailing the supply of money. The inflation is characterized by increased
money supply and increased consumer spending. Thus, the Contractionary
policy is adopted with an aim to decrease the money supply and the spendings
in the economy. This is primarily done by increasing the interest rates so that
the borrowing becomes expensive.