Monetary Policies are set of rules implemented by the government of a country to regulate money supply, being base money (MO) within an economy. Monetary policy actions usually aim to either increase or decrease the money supply in the economy. An increase in money supply is termed “expansionary monetary policy’’, while a decrease in money supply is known as “contractionary monetary policy’’
Monetary policies are administered by monetary authorities of a country (usually, the central bank), through several tools of which includes:
OPEN MARKET OPERATION (OMO): This is a mechanism deployed by monetary authorities to buy and sell government securities, such as bonds, treasury bills, in a bid to manage the liquidity levels within the economy. It buys in the case of expansionary monetary policy in order to increase money supply (i.e. increase the money in circulation); and it sells (to commercial banks) in the case of contractionary monetary policy in order to decrease the amount of money circulation.
RESERVE REQUIREMENT: Also known as Cash Reserve Ratio [CRR]. This is the proportion of deposits held by commercial banks that is required to be kept in cash reserve with the central bank authority. To expand the economy, the central bank may simply reduce the reserve with the ratio of commercial banks, which will increase their ability to create loans, and thereby increase money supply.
INTEREST RATES: This is called Indicative Rates in most economic jurisdiction. It serves as the bench mark that determines the rates of lending in the inter-bank market and ultimately, the cost of borrowing by the deficit sector of any economy.
DISCOUNT WINDOW LENDING: This is the rates at which the central bank lends short term funds to commercial banks. It however, does not explicitly serve as a monetary policy tools, but only comes into play when the commercial banks indicate need for such funds etc.
[Note that these are not the only m-p tools]
Monetary policy tools are means to an end and not an end in itself. Thus, the channels by which these tools affect economic activities and the general price levels in the economy are known as the “Transmission Mechanism of Monetary Policy’’ (T-M-M-P). The T-M-M-P is hinged on interest rates and it explains the channels through which decisions about the bench mark interest rates is used to achieve desired economic growth, unemployment level and inflation targeting.
ECONOMIC GROWTH: These measures the increase in goods and services produced in an economy within a period of time. Economic growth is computed as a percentage change in the gross domestic product [GDP] in a period, compared to the previous corresponding period, usually quarterly or yearly.
In the short run, GDP growth is cause by an increase in aggregate demand which may arise from several sources. One of such sources is the implementation of an expansionary monetary policy stance.
INFLATION TARGETING: policy makers in most economies often announce a target inflation rate, which it would achieve through policy actions. When the actual inflation rate is higher than the target rate, the central bank may increase its benchmark interest rates in a bid to contract the economy, which leads to an increase in cost of fund with this increase in the cost of funds, with this increase in cost of funds, commercial banks would in turn increase their lending rates, making funds more expensive for investors and therefore less attractive. Inflation targeting is primarily implemented by the use of interest rate to direct impact money supply.
Note that is the general rise in the price of goods and services, and is largely believed to worsen the standard of living of the people in an economy by reducing their purchasing power, especially when it is not matched by increased income or growth in GDP.
UNEMPLOYMENT LEVEL: Generally, one of the main economic objectives of any country/economy is to reduce their unemployment level to the barest minimum. Thus, most monetary policy actions of a country are geared towards enabling the business environment of the economy to provide for more job opportunities within the economy. This is sometimes done by lowering the prevailing interest rates to enhance the productive capacity of the economy.
Note that unemployment as explained by the INTERNATIONAL LABOUR ORGANIZATION (ILO) is the situation prevalent when the employable people within a geographical location remained unemployed for a minimum period of four weeks. It is calculated as the percentage of unemployed individuals in relation to all the individuals currently in the labour force.