What is monetary policy?

What is monetary policy?

Have you ever asked yourself what is monetary policy? Well, that is what this article is about. Interestingly, you will agree that money is an essential commodity which can never be undermined as it is a medium of exchange. It came to be as a substitute to bartering which was in operation in the early times. Although at that time, it was represented by several items such as cowrie and shell. It was later that the present use of currency was then introduced. As it stands today, there are different policies being used in different countries to manage this resource. Therefore, in this article, we take a look at monetary policy meaning and what those policies entail. Then, we examine the various types of monetary policy tools that operate, among others.

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types of monetary policy
monetary policy meaning

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Monetary policy definition

Monetary policy entails the laid down procedure that the economic authority of a country implements when managing the economy as well as the financial situation of that country. From this monetary policy economics definition, the economic authority is seen or usually represented by the country's central bank or the currency board. The task saddled with this board is usually to ensure that they control the federal funds, monetary base, inflation rate as well as the price stability of their country for the smooth running of their economy.

Types of monetary policy

Basically, there are two types of monetary policy. As such, it means the monetary policy of a country can either be expansionary or contractionary.

1. Expansionary monetary policy

When the policy is expansionary, it means that the aim is to limit or fight unemployment in a situation where a recession occurs. In achieving this, they limit the interest rates so that by this, organisations are lured into expanding their businesses. Similarly, any time there is a rapid increment in the overall supply of currency in the economy, then this policy can be introduced. This method places a higher demand for goods and services thereby enhancing the short-term economic growth while boosting the Gross Domestic Product.

2. Contractionary monetary policy

This monetary policy is the exact opposite of the expansionary policy. What it does is to encourage more of short-term interest rates. Whenever the growth rate in the money supply increases, the policy is used reduce it. By this, there will be a slow rate in short-term economic growth. Although this type of monetary policy lessens inflation, it can, however, bring about an increase in the rate of unemployment. If it is not well handled, it can also cause a low rate in borrowing and expenditure by businesses and customers, thereby leading to economic recession.

Monetary policy tools

The central bank of every country has their peculiar monetary policy that has been designed to aid the economic situation of their country. However it is, there are three main monetary policy tools that exist when trying to maintain a strong economic growth. These are the reserve requirement, the open market operations, and the discount rates.

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1. The reserve requirement

The Cash Reserve Requirement (CRR) are the accounts that the commercial banks of any country have with the central bank. Since the central bank is the governing head of all banks, the commercial banks are required to have an account with them where a specific percentage of their deposit is kept. The transaction of the central bank and the commercial banks through the CRR account ensures the protection of banks by sustaining liquidity. Therefore, when considering economic expansion, the monetary policy rate (MPR) reduces. The MPR is the interest worth at which banks can loan from the central bank.

2. Open Market Operations

The bank uses the Open Market Operations (OMO) to acquire and dispose of debt securities to promote the liquidity situations in the economy. Also, commercial banks can deposit short-term funds with the central bank; they, in turn, use this deposit facility as a policy tool to change liquidity situations in the banking system.

3. Discount rates

Monetary conditions and situations are majorly influenced by the discount rate. The discount rate in this context has to do with the percentage interest that is given to commercial banks whenever they borrow money from the central bank in their country.

Types of money

Comparing money today with what was obtainable in the olden days, one will come to the conclusion that money has moved beyond the currency in recent times. Today, it can be represented by other things such as the financial numbers on the ATM card. From the economic point of view, money is beneficial because it increases the strength of the economy of a given country by reducing the cost of transacting business. Over the years, there have come to be different types of money that operate across the globe. These types are explained below:

1. Commodity money

It is money in form of a commodity or product. An example of this is the gold bar, silver, copper, and salt. Gold is a valuable intrinsic commodity as it has value even outside its use as money. Gold can be transferred and inherited through generations without losing its value.

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2. Representative money

This is a means of exchange being represented by physical tokens such as certificates, token coins and so on.

3. Fiat money

This is the means of exchange declared by the government of any country, that is, the legal tender. Here, the intrinsic worth is lower compared to the face worth. Examples of fiat money are bills and coins.

4. Fiduciary money

This is often replaced with fiat or commodity money. Although it is not declared as a legal tender, it can be used as a means of exchange if the parties involved have confidence in it. Examples of such are cheques, banknotes and bank drafts.

5. Digital or electronic money

Digital money is the recent innovation that came into reality with the development of computers. Here, money is represented digitally.

Then, there are the non-national digital currencies which are the most recent advancement in money and they are gaining momentum. An example is the bitcoin which brought about cryptocurrency.

Having explained that monetary policy has to do with the economic policy that the central government of a country makes in controlling and managing the financial situation of that country, you should bear in mind that there are quite a number of monetary policy examples. Some of these affect the business growth, labour, exchange rates, and commercial bank activities being undertaken in the country. The essence of all these is to help reduce inflation in the country. More so, the monetary policy have proven to veritable in helping a country guide against an economic recession. Then it also helps in reducing employment and also brings about a boost in the economy.

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Source: Yen.com.gh

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