Monetary Policy is the macroeconomic policy being laid down by
the Central Bank towards the management of money supply and interest rate. It
is the demand side economic policy used by the government of a country to
achieve macroeconomic objectives like inflation, consumption, growth and
liquidity. The monetary policy gained its significance after the World War II,
thanks to the initiation made by Milton Friedman, who is associated with the
doctrine of “monetarism” and who received Nobel Prize in 1976. He boldly
announced in his book “Monetary History of the UnitedStates, 1867 – 1960” that
the Great Depression of the 1930’s was largely the outcome of the bungling
monetary policies of the Federal Reserve System.
Expansionary policy is cheap money policy when a monetary
authority uses its tools to stimulate the economy. An expansionary policy
maintains short-term interest rates at a lower than usual rate or increases the
total supply of money in the economy more rapidly than usual. It is
traditionally used to try to combat unemployment by lowering interest rates in
the hope that less expensive credit will entice businesses into expanding. This
increases aggregate demand (the overall demand for all goods and services in an
economy), which boosts short-term growth as measured by gross domestic product
The Contractionary monetary policy is dear money policy, which
maintains short-term interest rates higher than usual or which slows the rate
of growth in the money supply or even shrinks it. This slows short-term
economic growth and lessens inflation. Contractionary monetary policy can lead
to increased unemployment and depressed borrowing and spending by consumers and
businesses, which can eventually result in an economic recession if implemented
The monetary policy in developed economies has to serve the function of stabilization and maintaining proper equilibrium in the economic system. But in case of underdeveloped countries, the monetary policy has to be more dynamic so as to meet the requirements of an expanding economy by creating suitable conditions for economic progress. It is now widely recognized that monetary policy can be a powerful tool of economic transformation.
Economists like Wicksteed, Hayek and Robertson are the chief
exponents of neutral money. They hold the view that monetary authority should
aim at neutrality of money in the economy. Monetary changes could be the root
cause of all economic fluctuations. According to neutralists, the monetary
change causes distortion and disturbances in the proper operation of the
economic system of the country.
Exchange rate stability was the traditional objective of monetary authority.
This was the main objective under Gold Standard among different countries. When
there was disequilibrium in the balance of payments of the country, it was
automatically corrected by movements. It was popularly known as “Expand
Currency and Credit when gold is coming in; contract currency and credit when
gold is going out.” This system will correct the disequilibrium in the balance
of payments and exchange rate stability will be maintained.
It must be noted that if there is instability in the exchange
rates, it would result in outflow or inflow of gold resulting in unfavorable
balance of payments. Therefore, stable exchange rates are advocated.
Economists like Crustave Cassel and Keynes suggested price
stabilization as a main objective of monetary policy. Price stability is
considered the most genuine objective of monetary policy. Stable prices repose
public confidence. It promotes business activity and ensures equitable
distribution of income and wealth. As a consequence, there is general wave of
prosperity and welfare in the community.
But it is admitted that price stability does not mean ‘price
rigidity’ or price stagnation’. A mild increase in the price level provides a
tonic for economic growth. It keeps all virtues of a stable price.
During world depression, the problem of unemployment had increased
rapidly. It was regarded as socially dangerous, economically wasteful and
morally deplorable. Thus, full employment was considered as the main goal of
monetary policy. With the publication of Keynes’ General Theory of Employment,
Interest and Money in 1936, the objective of full employment gained full
support as the chief objective of monetary policy.
Economic growth is the process whereby the real per capita income
of a country increases over a long period of time. It implies an increase in
the total physical or real output, production of goods for the satisfaction of
Therefore, monetary policy should promote sustained and continuous
economic growth by maintaining equilibrium between the total demand for money
and total production capacity and further creating favourable conditions for
saving and investment. For bringing equality between demand and supply,
flexible monetary policy is the best course.
Equilibrium in the balance of payments is another objective of
monetary policy which emerged significant in the post war years. This is simply
due to the problem of international liquidity on account of the growth of world
trade at a more faster speed than the world liquidity.
It was felt that increasing of deficit in the balance of payments
reduces the ability of an economy to achieve other objectives. As a result,
many less developed countries have to curtail their imports which adversely
affects development activities. Therefore, monetary authority makes efforts to
maintain equilibrium in the balance of payments.