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Article Contents

I. introduction, ii. the investment multiplier, the marginal efficiency of capital and unemployment, iii. probability, risk, and long-term expectations, iv. monetary policy and the safe interest rate, v. summary and conclusion, keynes's theory of monetary policy: an essay in historical reconstruction.

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Edwin Dickens, Keynes's Theory of Monetary Policy: An Essay In Historical Reconstruction, Contributions to Political Economy , Volume 30, Issue 1, June 2011, Pages 1–11, https://doi.org/10.1093/cpe/bzr001

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Keynes's theory of monetary policy is composed of three concepts—namely, the investment multiplier, the marginal efficiency of capital and the interest rate. By analyzing how these three concepts interact in the short period, Keynes explains why he is opposed to countercyclical monetary policies. And by analyzing how they interact in the long period, he explains why the economy tends to fluctuate around a long-period equilibrium position that is characterized by unemployment. Keynes concludes that the sole objective of the monetary authority should be to use its influence over the interest rate to dislodge the economy from its long-period equilibrium position that is characterized by unemployment and propel it toward a long-period equilibrium position that is characterized by full employment.

Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management ( Keynes, 1936 , p.206).

The paper is organized as follows. In Section II, I use Keynes's concepts of the investment multiplier and the marginal efficiency of capital to specify the long-period equilibrium position of the economy which is characterized by unemployment.

In Section III, in order to explain why the economy fluctuates around a long-period equilibrium position characterized by unemployment, I specify the difference, as well as the relationship, between Keynes's concepts of probability and risk and the orthodox ones.

In Section IV, I use Keynes's concept of the interest rate to explain the effects of monetary policy, both in the short-period and in the long-period.

Lastly, in Section V, I provide a summary and conclusion.

Let N s be the supply of labor and N d the demand for labor, or the actual volume of employment ( n ). We can then define full-employment ( n o ) as N d / N s = 1; unemployment ( n k ) as N d / N s < 1; and the unemployment rate as 1 − n k .

For Keynes (1936 , pp. 25–29 ff. ), n is determined by the aggregate level of output ( Y ) and the productivity of labor ( P ). That is to say, by definition P = Y/N d . Re-arranging terms, N d = Y/P . Substituting into our definition of n , we thus get n = Y/P N s .

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Equation (6) is derived from the law of large numbers and incorrectly assumes that the underlying causal structure that determines the outcome of investment projects is known in the same way that the underlying causal structure that determines the outcomes of coin tosses or turns of the roulette wheel is known. In fact, the underlying causal structure that determines the outcome of investment projects is either knowable but unknown or, as Keynes (1937a , b , c ) argues, unknowable. Following Markowitz (1959 , p. 39 ff. ), orthodox economists take this fact into account by interpreting equation (6) in terms of the principle of non-sufficient reason.

According to the principle of non-sufficient reason, if investors do not have a reason to assign different probabilities to a set of possible outcomes, they must assign them equal probabilities. Therefore, if qualms about factors that are knowable but unknown or unknowable undermine the confidence of investors in their calculations of the outcome of prospective investment projects, orthodox economists instruct them to assign equal probabilities to the outcomes they fear may result from these factors, with the sum of assigned probabilities being equal to one. Orthodox economists thus interpret the expected profit ( E o ) in equation (5) as the mathematical mean of the sum of the products of all possible outcomes of investment projects and their probability. They then interpret the risk of investment projects as the variability (or standard deviation), of the sum of the products of all their possible outcomes and their probability, around the mathematical mean.

Equation (9) can be read as ‘proposition a on the hypothesis h · p o has a probability p k ’. Alternatively, it can be read as ‘the conclusion a can be inferred from the evidence h · p o with a probability of p k ’.

If w ( a|h · p o ) = 1, then the hypothesis h · p o implies the conclusion a with certainty. If w ( a|h · p o ) = 0, then hypothesis h implies that the conclusion a is impossible. If 0 < w ( a|h · p o ) < 1, then there is a probability relation of degree p k between a and h · p o .

In short, Keynes's concept of probability ( p k ), as formulated in equation (9), encompasses the orthodox concept of probability ( p o ), as formulated in equation (6), and the relationship between the two is mediated by Keynes's concept of the weight of arguments ( w ).

For Keynes (1921 , p. 77–80), w measures the vague but pervasive sense of inadequacy that investors feel when they compare what they know with what they think they ought to know in order to make informed investment decisions. If w = 1, then the interpretation of equation 6 in terms of the principle of non-sufficient reason has quelled investors’ sense of inadequacy, p o is completely dominate and equation (9), and p k = p o . If 0 < w < 1, then investors do not suppress the fact that setting w equal to one leads to absurdities (see Dickens (2008 , p. 224–225) for an explanation of why), and the factors making the underlying causal structure determining the outcome of investment projects knowable but unknown or unknowable take the form of propositions in h which weigh against p o 's dominance, so that p k < p o .

Even if w = 1, p k is still less than p o once we add Keynes's concept of risk, as formulated in equation (8), to w as a mediating factor between p k and p o , and thereby obtain equation (7). Keynes (1921 , p. 348) formulates equation (7) in such a way that two conditions are met: If p o = 1 and w = 1, then p k = 1; and if p o = 0 and w = 0, then p k = 0. It follows that, if 0 < w < 1 and/or 0 < p o < 1 (so that q = 1 − p o has a value between zero and one), then p k < p o . Of course, p o = m / z = 1 only if there is apodictic certainty about the underlying causal structure that determines the outcome of investment projects, in the way that there is apodictic certainty about the outcome of tossing a two-headed coin—hardly a relevant case to evaluating prospective investment projects.

If p k < p o , then we know from equations (5), (4), (1), and (2), respectively, that E k < E o → I k < I o → Y k < Y o → 1 − n k > 0. In short, if Keynes's concepts of probability and risk are correct, the long-period equilibrium position of the economy is characterized by unemployment.

The monetary authority directly controls the short-term interest rate. 5 With ‘a modest measure of persistence and consistency of purpose,’ Keynes (1936 , p. 204) asserts that the monetary authority can also influence the long-term interest rate. 6 Orthodox economists (see, for example, Ingersoll, 1989 , pp. 173–178) have accepted Keynes's assertion, taking it to mean that the long-term interest rate is the mathematical mean of the sum of the products of all possible outcomes of the short-term interest rate and their probability. For example, the yield on the 10-year bond allegedly equals the mathematical mean of the expected yields on 3-month securities for the next 10 years, plus an illiquidity premium which reflects the orthodox concept of risk. Unfortunately, orthodox economists ignore the difference between Keynes's concepts of probability and risk and the orthodox ones, and reject the classical long-period method, which Keynes uses to distinguish between the long-period equilibrium values of variables and their short-period values. To reconstruct Keynes's theory of monetary policy, these oversights must be rectified.

For Keynes (1936 , pp. 202, 206 and 313–320), the short-period fluctuations of r a around r s are strictly limited to ‘the difference between the[ir] squares’. 9 In contrast, since the stock market determines the actual expected profit ( E a ) in the short-period, the short-period fluctuations of I a and Y a around I k and Y k are unlimited. 10 Therefore, efforts by the monetary authority to stabilize the short-period fluctuations of the economy are futile for two reasons. First, any drastic changes that the monetary authority makes in the short-term interest rate simply cause a more steeply sloped yield curve as r a reaches the limits of its variability around r s . Second, such drastic changes in the short-term interest rate threaten to shatter the confidence of investors in their calculations of E a . If drastic enough, such changes may thus cause a severe recession as investors contemplate trillions of dollars of losses on their bets in the stock market.

If the monetary authority has the discretion to change the short-term interest rate, investors must take into account the possibility that future investment projects, with lower financing costs, will compete against investment projects undertaken today at higher financing costs. As a result, h 2 weighs more heavily than does h 1 against the dominate proposition for undertaking investments projects ( p o ). That is to say, w 1 > w 2 . It follows from equation (15) that p k1 > p k2 → E k1 > E k2 ; and from equation (16) that r s1 < r s2 .

Looking backward, we observe long-run trends shaping economic events. The confidence to undertake investment projects depends upon our ability to project these trends into the future. The problem is that we know these trends are not governed by natural laws but are instead the result of the series of investment projects undertaken by forward-looking investors in the past. In every short-period situation in which such investment projects were undertaken, the long-run trends of the economy would have taken off in a different direction, if those investment projects had not been undertaken.

For this reason, investors take a two-step approach to the evaluation of prospective investment projects. First, they project long-run trends into the future by assigning probabilities to the likelihood of their continuance, and thereby calculate the expected profit ( E o ). 11 Second, they contemplate the degree to which the principle of non-sufficient reason captures their uncertainty about the degree to which knowable but unknown or unknowable factors may cause the future trends of the economy to differ from past ones, and thereby calculate the expected profit ( E k ).

Monetary policy is a factor that has shaped the long-run trends of the economy. It is thus necessary for investors to assign a probability to the likelihood that the monetary authority will continue to act in the same way that it has in the past, and incorporate it into the calculation of E o . If the monetary authority has the discretion to act differently in the future than it has in the past, investors are compelled to contemplate monetary policy itself as a knowable but unknown or unknowable factor that may cause future trends of the economy to differ from past ones, and thus take it into account as a factor that makes E k < E o . If the monetary authority would make a credible commitment to buying and selling at stated prices gilt-edged bonds of all maturities, this element of uncertainty would be alleviated, thereby reducing the difference between E k and E o . The purpose of this paper has been to show that, as a result, the long-period equilibrium position of the economy would be characterized by less unemployment.

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Ricardo and his successors overlook the fact that even in the long period the volume of employment is not necessarily full but is capable of varying, and that to every banking [monetary] policy there corresponds a different long-period level of employment, so that there are a number of positions of long-period equilibrium corresponding to different conceivable interest policies on the part of the monetary authority ( Keynes, 1936 , p.191).

Keynes applies equation (3) to capital assets rather than investment projects, and thereby obtains his concept of the marginal efficiency of capital. As Garegnani (1983) demonstrates, this application is incorrect because it implies that capital is a factor of production that yields a marginal product when plugged into a (aggregate) production function. However, as Pasinetti (1974 , pp. 37–38) demonstrates, equation (3) still applies to investment projects. To make clear that I am using equation (3) in the valid sense of applying to investment projects, I drop the concept of the marginal efficiency of capital in favor of the concept of net present value.

Dickens (2008 , pp. 224–225) draws upon the literature in behavioral finance to explain why the orthodox concept of expected profit ( E o ) leads to absurdities.

The formulation of Keynes's concept of probability ( p k ) in equation (9) differs from its formulation in equation (7) because, at this point in the argument, we are abstracting from the concept of risk, as formulated in equation (8) . As shown below, equation (7) results from the combination of equations (8) and (9) .

This proposition preempts the analysis of the determination of interest rates by the schedule of liquidity preference and the supply of money.

‘The short-term interest rate’ denotes an index of all market yields on high-quality securities of short maturity and ‘the long-term interest rate’ denotes an index of all market yields on high-quality bonds of long maturity. Using such indexes is legitimate because all short-term market yields move in tandem, as do all long-term market yields. However, the short-term interest rate and the long-term interest rate do not move in tandem. Sometimes the yield curve is positively sloped, sometimes inverted, and sometimes flat.

The owners of wealth will then weigh the lack of ‘liquidity’ of different capital equipments … as a medium in which to hold wealth against the best available estimate of their prospective yields after allowing for risk [ E o ]. The liquidity-premium, it will be observed, is partly similar to the risk-premium [understood as the variability (or standard deviation), of the sum of the products of all possible outcomes and their probability, around the mathematical mean] but partly different;–the difference corresponding to the difference between the best estimates we can make of probabilities and the confidence with which we make them. * When we are dealing, in earlier chapters, with the estimation of prospective yield, we did not enter into detail as to how the estimation is made: and to avoid complicating the argument, we did not distinguish differences in liquidity from differences in risk proper. It is evident, however, that in calculating the own-rate of interest we must allow for both ( Keynes 1936 , p.240).

Tobin's q proposes that the expected profit from investment projects, as determined in the stock market ( E a ), influences long-term expectations ( E k ), and thus the aggregate rate of investment undertaken in long-period equilibrium ( I k ). In contrast, as formulated in equation (1 1), E a influences short-term expectations, and thus the pace at which I k is implemented in the short-period.

For example, if the safe long-term interest rate ( r s ) is 4%, then the actual long-term interest rate ( r a ) is limited to a range of 0.04 − (0.04) 2 = 3.84% to 0.04 + (0.04) 2 = 4.16%. If r s is 2%, then r a is limited to a range of 0.02 − (0.02) 2 = 1.96% to 0.02 + (0.02) 2 = 2.04%.

The short-period fluctuations of n a around n k have an upper bound, given by the supply of labor. However, this does not limit the short-period fluctuations of I a and Y a around I k and Y k ; it simply defines the point at which those fluctuations cause what Keynes (1936 , pp.119 and 303) calls ‘true inflation’. In other words, for Keynes, inflation is a short-period phenomenon.

D'Orlando (2005) also argues that probabilistic, as opposed to deterministic, dynamic models are compatible with the classical long-period method.

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HIGH BAND 6 // MONETARY POLICY ESSAY PLAN

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Britannica Money

monetary policy

monetary policy , measures employed by governments to influence economic activity, specifically by manipulating the supplies of money and credit and by altering rates of interest .

(Read Milton Friedman’s Britannica entry on money.)

The usual goals of monetary policy are to achieve or maintain full employment, to achieve or maintain a high rate of economic growth , and to stabilize prices and wages. Until the early 20th century, monetary policy was thought by most experts to be of little use in influencing the economy. Inflationary trends after World War II , however, caused governments to adopt measures that reduced inflation by restricting growth in the money supply.

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Monetary policy is the domain of a nation’s central bank . The Federal Reserve System (commonly called the Fed) in the United States and the Bank of England of Great Britain are two of the largest such “banks” in the world. Although there are some differences between them, the fundamentals of their operations are almost identical and are useful for highlighting the various measures that can constitute monetary policy.

The Fed uses three main instruments in regulating the money supply: open-market operations , the discount rate , and reserve requirements. The first is by far the most important. By buying or selling government securities (usually bonds ), the Fed—or a central bank—affects the money supply and interest rates. If, for example, the Fed buys government securities, it pays with a check drawn on itself. This action creates money in the form of additional deposits from the sale of the securities by commercial banks. By adding to the cash reserves of the commercial banks, then, the Fed enables those banks to increase their lending capacity. Consequently, the additional demand for government bonds bids up their price and thus reduces their yield (i.e., interest rates). The purpose of this operation is to ease the availability of credit and to reduce interest rates, which thereby encourages businesses to invest more and consumers to spend more. The selling of government securities by the Fed achieves the opposite effect of contracting the money supply and increasing interest rates.

The second tool is the discount rate , which is the interest rate at which the Fed (or a central bank) lends to commercial banks. An increase in the discount rate reduces the amount of lending made by banks. In most countries the discount rate is used as a signal, in that a change in the discount rate will typically be followed by a similar change in the interest rates charged by commercial banks.

The third tool regards changes in reserve requirements. Commercial banks by law hold a specific percentage of their deposits and required reserves with the Fed (or a central bank). These are held either in the form of non-interest-bearing reserves or as cash. This reserve requirement acts as a brake on the lending operations of the commercial banks: by increasing or decreasing this reserve-ratio requirement, the Fed can influence the amount of money available for lending and hence the money supply. This tool is rarely used, however, because it is so blunt. The Bank of England and most other central banks also employ a number of other tools, such as “treasury directive” regulation of installment purchasing and “special deposits.”

Historically, under the gold standard of currency valuation, the primary goal of monetary policy was to protect the central banks’ gold reserves. When a nation’s balance of payments was in deficit, an outflow of gold to other nations would result. In order to stem this drain, the central bank would raise the discount rate and then undertake open-market operations to reduce the total quantity of money in the country. This would lead to a fall in prices, income, and employment and reduce the demand for imports and thus would correct the trade imbalance. The reverse process was used to correct a balance of payments surplus.

The inflationary conditions of the late 1960s and ’70s, when inflation in the Western world rose to a level three times the 1950–70 average, revived interest in monetary policy. Monetarists such as Harry G. Johnson , Milton Friedman , and Friedrich Hayek explored the links between the growth in money supply and the acceleration of inflation. They argued that tight control of money-supply growth was a far more effective way of squeezing inflation out of the system than were demand-management policies. Monetary policy is still used as a means of controlling a national economy’s cyclical fluctuations.

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Policy has tightened a lot. how tight is it.

February 5, 2024

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On May 6, 2022, I first  published an essay  explaining why I focus on long-term real rates to evaluate the overall stance of monetary policy, which includes effects from both the setting of the federal funds rate and changes to the Federal Reserve’s balance sheet. Please see that essay for a discussion of why long-term real rates drive economic activity rather than short rates or nominal rates.

On June 17, 2022 , and September 26, 2023 , I published updates to reflect actions by the Federal Open Market Committee (FOMC) to tighten policy in order to bring inflation back to our target. This essay is an update to those earlier commentaries to assess where we are in our inflation fight and highlight some important questions policymakers face.

Since my last update in September, two significant economic developments have occurred simultaneously: Inflation has fallen rapidly—more rapidly than most forecasters expected—and economic growth has proven remarkably resilient, even stepping up in the latter half of 2023.

The FOMC targets 12-month headline inflation of 2 percent. The fact that core inflation is making rapid progress returning to our target—as demonstrated by six-month core inflation coming in lower than 12-month, three-month coming in lower than six-month, and both now at or below target—suggests that we are making significant progress in our inflation fight (see Figure 1).

At the same time that inflation has made rapid progress toward our goal, real GDP growth has continued to show remarkable strength, as shown in Figure 2.

The labor market, the other half of our dual mandate, has also remained strong with the unemployment rate remaining at a historically low 3.7 percent.

How do we reconcile such strong real economic activity with falling inflation? Typically, if tight monetary policy were the primary driver of falling inflation, we would have seen falling inflation coupled with weak economic growth and a weakening labor market, perhaps including a material increase in unemployment. But that is not what we have experienced in recent quarters.

Instead of monetary policy doing the heavy lifting to bring inflation down, it appears that supply-side increases are boosting output and bringing supply and demand into balance, thus reducing inflation. I previously described  that high inflation was being driven by “surge pricing” dynamics, where demand was hitting the vertical part of the supply curve. By most measures, supply chains that had been disrupted during the pandemic have healed and there has been a strong boost to labor supply, increasing the economy’s potential output and bringing inflation down.

If supply-side factors appear to be contributing meaningfully to disinflation, what role has monetary policy played and how is it affecting the economy now? Monetary policy has played an enormously important role in keeping long-run inflation expectations anchored. It is hard to overstate how important that is for ultimately achieving the soft landing we are all aiming for. But to assess what impact policy is having on inflation going forward, we must first try to determine how tight monetary policy actually is.

Recent public commentary suggests that the real federal funds rate has tightened dramatically over the past several months because inflation has fallen rapidly while the nominal federal funds rate has remained unchanged. While I understand the math of this argument, I believe it overstates changes in the stance of monetary policy.

In prior essays I wrote that the single best proxy for the overall stance of monetary policy is the long-term real rate, specifically the 10-year Treasury inflation-protected securities (TIPS) yield. Focusing on a long-term rate incorporates the expected path of both the federal funds rate and balance sheet, not just the current level of the federal funds rate. Moreover, it adjusts the expected path of policy by expected future inflation—the relevant comparison—rather than by recently realized inflation.

While 12-month inflation has fallen 285 basis points (bps) over the past year—implying that the real federal funds rate has climbed 360 bps—Figure 3 shows that policy as indicated by 10-year TIPS has only increased about 60 bps on net. Now, one reason the 10-year TIPS yield has not moved up much while inflation has fallen is that the expected path of nominal rates has also fallen. If markets instead expected no change in the federal funds rate this year, then, all else equal, real rates would have moved up further.

The concept of a neutral stance of monetary policy is critical to assessing where policy is now and what pressure it is having on the economy. While we cannot directly observe neutral, economists have models to estimate it, which are imperfect even under normal economic circumstances. Our various workhorse models for the economy have struggled to explain and forecast the pandemic and post-pandemic periods given the extraordinary changes and disruptions the economy has experienced. So I also look to measures of economic activity for signals to try to evaluate the stance of policy.

To assess if monetary policy is tight, I start by looking at what are traditionally the more interest-rate-sensitive sectors of the economy for signs of weakness. Start with housing: While home sales are down relative to the pre-pandemic period, overall residential investment was flat in real terms in 2023. Construction employment has not fallen during our tightening cycle and instead continues to climb to all-time highs. While home price growth has slowed, prices have not fallen and are quite high by historical measures, contributing to record household wealth. Even the stock prices of homebuilders are near all-time highs.

Private nonresidential investment was up 4.1 percent in 2023, and consumption of durable goods was up 6.1 percent. And with the backdrop of low unemployment noted above, consumers continue to surprise with robust spending.

These data lead me to question how much downward pressure monetary policy is currently placing on demand.

But the data are not unambiguously positive, and there are some signs of economic weakness that I take seriously, such as auto loan and credit card delinquencies increasing from very low levels and continued weakness in the office sector of commercial real estate.

This constellation of data suggests to me that the current stance of monetary policy, which, again, includes the current level and expected paths of the federal funds rate and balance sheet, may not be as tight as we would have assumed given the low neutral rate environment that existed before the pandemic. It is possible, at least during the post-pandemic recovery period, that the policy stance that represents neutral has increased. The implication of this is that, I believe, it gives the FOMC time to assess upcoming economic data before starting to lower the federal funds rate, with less risk that too-tight policy is going to derail the economic recovery.

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Economic Effects of Higher Interest Rates (Revision Essay Plan)

Last updated 4 May 2019

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Here is an essay plan to this question: "To what extent can a policy of higher interest rates lead to an improvement in macroeconomic performance. Discuss with reference to a country of your choice."

Background (not part of the essay)

Central banks around the world cut interest rates sharply during the 2007-2009 financial crisis. Rates remained at historic lows for many subsequent years close to or below 0% in most developed economies. In the United States, the Federal Reserve has gradually increased interest rates from 0.25% to 2.5% risen against a backdrop of jobs growth and a stronger economy.

KAA Point 1: Controlling inflationary pressures

Higher interest rates might be justified on the grounds of helping to control inflationary pressures. E.g. USA Fed Reserve has been raising rates (from 0.25% to 2.5%) because unemployment is very low (<3%) and therearesignsofanover-heatingeconomy.Low,stableinflationhelps to promote macro stability – keeps domestic economy competitive and reduces business uncertainty. Monetary policy can stabilise the cycle.

EVAL Point 1: Currency appreciation

A counter point is that higher interest rates might cause an inflow of hot money (SR capital flows) into an economy thus causing a currency appreciation. This can make export industries less price competitive which might lead to a slowdown in export sector output, investment and employment as well as a worsening of the net trade balance. Much depends on how open a country is to overseas trade.

monetary policy essay plan

KAA Point 2: Higher returns for savers & retirees

A rise in nominal interest rates improves returns for savers – many of whom have lost out in real terms in the decade since the Global Financial Crisis. Higher savings helps to repay debt, can act as a buffer against macro uncertainty, and increases flow of deposits into commercial banks which (in theory) creates more liquidity to support a rise in bank lending to finance business investment which can increase long run AS.

EVAL Point 2: Risk of a growth slowdown

In evaluation, there is no guarantee that commercial banks will lend out more if returns to savers improve. Indeed a rise in interest rates across the board is likely to lead to a contraction in bank lending and make borrowing more expensive especially for smaller businesses and households who have become dependent on expensive unsecured credit. The risk is that a sharp rise in interest rates could cause a growth slowdown.

FINAL CONCLUSION: Interest rates and smoothing cyclical volatility

The decision by central banks such as the Federal Reserve and the Bank of England to start tightening monetary policy by raising interest rates are often finely balanced. In the UK for example, real GDP growth in 2018 was only 1.4% - the slowest for five years and CPI inflation remains under the 2% target. Even though unemployment is very low, there seems little macroeconomic justification for increasing interest rates at present. The situation in the United States might be different. Growth has been strong, share prices have soared and unemployment has fallen sharply. The ability of a central bank to smooth inevitable cyclical fluctuations depends in part on having room for adjustment. The US might decide to lift interest rates back up to a level closer to 3%, to give them flexibilitytolower rates and stimulate borrowing and investment in the event of a recession.

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Monetary Policy

An economic policy that manages the size and growth rate of money supply

What is Monetary Policy?

Monetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment.

These policies are implemented through different tools, including the adjustment of the interest rates , purchase or sale of government securities, and changing the amount of cash circulating in the economy. The central bank or a similar regulatory organization is responsible for formulating these policies.

Monetary Policy - Objectives

Objectives of Monetary Policy

The primary objectives of monetary policies are the management of inflation or unemployment and maintenance of currency exchange rates .

1. Inflation

Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.

2. Unemployment

Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.

3. Currency exchange rates

Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.

Tools of Monetary Policy

Central banks use various tools to implement monetary policies. The widely utilized policy tools include:

1. Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.

2. Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients, and thus, money supply decreases.

Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).

3. Open market operations

The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds . As a result, banks will obtain more money to increase the lending and money supply in the economy.

Expansionary vs. Contractionary Monetary Policy

Depending on its objectives, monetary policies can be expansionary or contractionary.

Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy by decreasing interest rates, purchasing government securities by central banks, and lowering the reserve requirements for banks. An expansionary policy lowers unemployment and stimulates business activities and consumer spending. The overall goal of the expansionary monetary policy is to fuel economic growth. However, it can also possibly lead to higher inflation.

Contractionary Monetary Policy

The goal of a contractionary monetary policy is to decrease the money supply in the economy. It can be achieved by raising interest rates, selling government bonds, and increasing the reserve requirements for banks. The contractionary policy is utilized when the government wants to control inflation levels.

Related Readings

Thank you for reading CFI’s guide to Monetary Policy. To keep learning and advancing your career, the following resources will be helpful:

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Board of Governors of the Federal Reserve System

The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system.

Monetary Policy

monetary policy essay plan

Monetary policy in the United States comprises the Federal Reserve's actions and communications to promote maximum employment, stable prices, and moderate long-term interest rates--the economic goals the Congress has instructed the Federal Reserve to pursue.

Review of Monetary Policy Strategy, Tools, and Communications

In a review conducted over 2019 and 2020, the Fed took a step back to consider whether the U.S. monetary policy framework could be improved to better meet future challenges. Here are the results.

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Monetary Policy Principles and Practice

Six short notes on the principles of sound monetary policy and central banks' practices in setting and implementing monetary policy

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Policy Normalization

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Monetary Policy: Introduction

Learning objectives.

  • Students will identify the key aspects of monetary policy in the global economy.
  • Students will read a number of fictional scenarios and determine the effect of those scenarios on foreign exchange rates.

Students will complete Part 1 and 2 of the guided reading handout.

  • (5 Minutes) Debrief Homework
  • (10 Minutes) Watch: As a class, watch The Global Role of the U.S. Dollar and complete Part 3 of the Guided Reading Handout. It is important to note that the U.S. dollar plays in the global economy and its use as a “global currency for settling debts”. It is also important to note the advantages this provides to the U.S.
  • (15 Minutes) Read: Students will read and complete Part 4 of the Guided Reading Handout on currencies and exchange rates in order to give them the background needed to work through scenarios in the next step.
  • (15 Minutes) Activity: Have students work in small groups to complete the attached worksheet titled Monetary Policy Scenarios. They should discuss their answers as they work through each scenario. If time, review their answers together.

Homework (or Exit Ticket)

  • Have students write a brief reflection on what they learned. They can consider: Why is monetary policy important? What special role does the U.S. dollar play in the global economy?

centralized financial institution responsible for the monetary policy of a country (or group of countries with the same currency, such as the eurozone).  

a good, typically a raw materials or agricultural products, that can be bought and sold.

what happens when prices continue to rise, meaning a country’s currency is worth less than it was before because it can’t buy as much (also known as a decline in purchasing power).

the percentage of a loan that the person borrowing must pay to the lender on top of paying back the loan itself. 

a vote, typically organized by a government, in which participants approve or reject a certain policy proposal. This is a form of direct democracy, in which citizens themselves (as opposed to elected representatives) make a policy decision.

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Monetary Policy: How Central Banks Regulate The Economy

Benjamin Curry

Updated: Apr 12, 2023, 9:23am

Monetary Policy: How Central Banks Regulate The Economy

Monetary policy is the bedrock of any nation’s economic policy, and everyone from part-time workers to huge financial institutions, both foreign and domestic, are impacted as it shifts. Here’s how managing the supply of money affects you and the rest of the economy.

What Is Monetary Policy?

Central banks use monetary policy to manage the supply of money in a country’s economy. With monetary policy, a central bank increases or decreases the amount of currency and credit in circulation, in a continuing effort to keep inflation , growth and employment on track.

In the U.S., the Federal Reserve is responsible for monetary policy. Congress has tasked the Fed with a “dual mandate” that it pursues with monetary policy: maximize employment and maintain steady prices. In general, that means the Fed aims to keep unemployment low, but not zero, to foster productivity without inciting higher inflation. There’s no official target range, but historically the Fed has focused on keeping unemployment at about 3.5% to 4.5%.

As for inflation, the Fed normally targets average annual price increases of about 2%. When unemployment is low and inflation is around the 2% level, consumers and businesses are in a good position to spend and invest money—as well as save adequate cash reserves—which meets the Fed’s mandate for a highly functioning economy.

“The power of the Fed is derived primarily from its authority over these two prominent aspects of the economy,” says Robert Johnson, professor of finance at Creighton University. “The Fed executes these objectives through its power to control the money supply.” It was given these responsibilities in 1977 through a Congressional dual mandate, and it may enact its powers using a handful of tools.

Monetary Policy Tools

Federal funds rate . Commonly called the fed funds rate, or the fed funds target rate, this is the target interest rate set by the Federal Open Market Committee (FOMC) at its eight yearly meetings. Commercial banks reference the fed funds rate when they lend their excess reserves to each other overnight.

Open market operations. The Fed buys and sells government securities, like Treasury bills and bonds, in the open market. By buying back securities, the Fed effectively increases the supply of money circulating—conversely, selling securities lowers the supply. Historically, open market operations are the most commonly used tool to conduct monetary policy.

Reserve requirements. The Fed keeps a close eye on reserve requirements, or the amount of cash banks must have on hand at any time to comply with banking regulations. Those reserves must either be secured in bank vaults or via a deposit in a qualified Federal Reserve Bank to ensure they have money available should customers need it. By lowering the amount of cash banks are required to keep on hand, the Fed can encourage banks to lend out more money. And by raising that requirement, it can do the inverse.

The Discount rate. This is the interest rate charged by the Fed on short-term loans to financial institutions. Generally, these loans are meant to cover reserve requirements or liquidity issues banks can’t meet through loans from other banks, which offer a lower federal funds borrowing rate. Typically, when the U.S. economy is humming on all cylinders, discount rates are relatively high because the Fed doesn’t need to make borrowing money cheap to incentivize activity. However, when the economy is in a slump, the Fed often lowers interest rates to spur lending and credit to individuals and businesses.

Quantitative easing (QE). With QE, a central bank like the Federal Reserve uses its massive cash reserves to buy up large-scale financial assets like government and corporate bonds as well as stocks. This may sound similar to open markets, but quantitative easing often takes place on a much larger scale in more dire circumstances, involves buying more than just shorter-term government bonds and generally occurs when interest rates are already at or near 0%, meaning the Fed has already fully extended one of its primary weapons. Central banks must be careful with QE, however, because continued large-scale asset purchases can lead to economic conditions monetary policy makers don’t want, like higher inflation and asset bubbles.

Public service announcements. When implementing a nation’s monetary policy, a central bank will announce to the financial markets and the general public its general outlook on the economy and any policy measures its taking. In and of themselves, these PSAs may influence the market and economy in ways that the central bank is hoping for.

Expansionary Monetary Policy vs Contractionary Monetary Policy

Depending on the economic circumstance, monetary policy may be categorized in one of two ways: expansionary monetary policy or contractionary monetary policy.

Expansionary Monetary Policy

Also known as loose monetary policy, expansionary policy increases the supply of money and credit to generate economic growth. A central bank may deploy an expansionist monetary policy to reduce unemployment and boost growth during hard economic times.

It usually does so by lowering its benchmark federal funds rate, or the interest rate banks use when they lend each other money to satisfy any reserve requirements. While in the U.S. the Federal Reserve cannot require a certain federal funds rate, it can set guidelines and influence the rate banks charge each other by altering the supply of money. In turn, this may lower other interest rates, like those banks use when they lend money to consumers, which helps spur consumer spending through increased credit and lending throughout the nation’s economy.

For example, when the U.S. banking system collapsed leading to the Great Recession of 2007-2008, the Federal Reserve cut interest rates to near-zero to jumpstart the U.S. economy, thus “expanding” economic growth. It recently did the same thing to pull the country out of the 2020 Covid-19 recession.

Contractionary Monetary Policy

Also known as tight monetary policy, contractionary policy decreases a nation’s money supply to curb rampant inflation and keep the economy in balance. A central bank will likely hike interest rates and try to slow the growth of money and prices.

At the outset of the 1980s, for instance, when the U.S. inflation rate soared to almost 15%, the Fed aggressively raised interest rates to nearly 20%. While that move led to a nationwide recession, it also brought inflation back to about 3%, helping set the stage for a robust U.S. economy for the remainder of the decade.

Monetary Policy vs Fiscal Policy

When it comes to regulating the economy, a country has two main levers it can pull: monetary policy and fiscal policy .

While they might sound similar—both involve words that suggest money or finance—they’re quite different and are enacted by distinct sectors of the government. Monetary policy is controlled by the Federal Reserve; fiscal policy, on the other hand, is driven by the U.S. government’s executive and the legislative branches.

Practically speaking, this means “fiscal policy deals with taxation and government spending,” says Dr. Guy Baker, CFP , Ph.D., founder of Wealth Teams Alliance, in Irvine, Calif. In contrast, monetary policy involves effecting change by manipulating the monetary supply.

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Essay on the Monetary Policy | India | Economics

monetary policy essay plan

Here is an essay on the ‘Monetary Policy’ for class 11 and 12. Find paragraphs, long and short essays on the ‘Monetary Policy’ especially written for school and college students.

Essay on the Monetary Policy

Essay # 1. introduction to the monetary policy :.

Monetary policy refers to the steps taken by the Reserve Bank of India to regulate the cost and supply of money and credit in order to achieve the socio-economic objectives of the economy. Monetary policy influences the supply of money the cost of money or the rate of interest and the availability of money. One of the most important functions of Reserve Bank is to formulate and administer a monetary policy. Such a policy refers to the use of instruments of credit control by the Reserve Bank so as to regulate the amount of credit creation by the banks. It also aims at varying the cost and availability of credit with a view to influence the level of aggregate demand for goods and services in the economy.

ADVERTISEMENTS:

D. C. Rowan has defined Monetary Policy as “discretionary act undertaken by the authorities designed to influence (a) the supply of money (b) cost of money or rate of interest and (c) the availability of money”.

Objectives of Monetary Policy :

In India, during the planning period the basic objective of monetary policy has been to meet the requirements of the planned development of the economy.

With this broad and basic objective, the monetary policy has been pursued to achieve the following objectives of the economic policy of the government of India:

(1) To Accelerate the Process of Economic Growth :

One of the twin aims of the economic policy is to accelerate the process of economic growth with a view to raise the national income. The Reserve bank has made the allocation of funds to the various sectors according to the priorities laid down in the plans and requirements of day to day development.

(2) Controlled Expansion :

The second objective is to control the prices and reduce the inflationary pressures in the economy. The monetary policy of the Reserve Bank during the planning period is appropriately termed as that of “Controlled expansion”.

Every economy faces two conflicting interests:

(a) Expansion of money supply to finance the process of economic development.

(b) Control of money supply to check inflationary pressure generated in the economy as a result of vast developmental and non-developmental expenditure.

Thus, controlled expansion of money supply was essential for growth with reasonable price stability in the country.

Essay # 2. Measures Adopted by Reserve Bank for the Monetary Policy :

To achieve the objectives of the monetary policy, the Reserve Bank has adopted the following measures:

(A) Measures for expansion of currency and credit.

(B) Measures for controlling of credit.

These measures are discussed in detail as follows:

A. Measures for Currency and Credit Expansion :

For meeting the developmental needs of the economy the continuous expansion of currency and credit was required during the planning period.

This expansion has been achieved by using the following measures:

1. Revision of Open Market Operations :

In October 1956, the open operations policy of the Reserve Bank was revised and it started giving discriminatory support to the sale and purchase of government securities. Initially, the bank made large purchases of government securities. In the subsequent years the bank’s sale of government securities exceeded its purchases. But this excess sales method was discontinued between 1964 and 1969 with a view to expand currency and credit in the economy.

2. Liberalisation of the Bill Market Scheme:

The Reserve Bank has liberalised the bill market Scheme, as a result, the commercial banks receive additional funds from the Reserve Bank to meet the credit requirements of the borrowers. Since 1957, the Reserve Bank has included the export bills also in the bill market scheme, so as to help the commercial banks to provide credit to exporters also.

3. Financing Facilities to the Priority Sectors :

Even though, the general policy of the Reserve Bank is to control credit expansion, still it continues to provide credit facilities to priority sectors such as small scale industries and cooperatives. The Bank has been providing short term Finances to the rural cooperatives also.

4. Refinancing and Rediscounting Facilities :

The Reserve Bank also follows a policy of selective refinance and rediscount facilities. In the recent years, the banks are permitted to refinance equal to one percent of their time and demand liabilities. This is done at the rate of 10% per annum. Refinance facilities are available for providing food procurement credit as well as export credit. The scheduled banks can also get their bills of exchange, promissory notes and hundis rediscounted with the Reserve Bank, but the maximum duration of these bills should not be more than 3 months.

5. Establishment of Various Financial Institutions :

The Reserve Bank has played the main role in the establishment of various financial institutions in the country, through which the Reserve Bank provides medium term and long term credit facilities for development.

Some of these institutions are:

(i) ICICI—Industrial Credit and Investment Corporation of India.

(ii) IDBI—Industrial Development Bank of India.

(iii) IFCI—Industrial Finance Corporation of India.

(iv) IRCI—Industrial Reconstruction Corporation of India.

(v) SFCs—State Financial Corporations.

(vi) ARDC—Agricultural Refinance and Development Corporation.

(vii) NABARD—National Bank for Agriculture and Rural Development.

6. Deficit Financing :

To continuously increase the supply of money in the country, the Reserve Bank has adopted the system of deficit financing for financing the budgetary deficit of the government.

For this the Reserve Bank has made changes in its reserve requirements and made the reserve system more flexible.

The changes made by the Reserve Bank are:

(i) The proportional reserve system which required keeping of 40% reserves in gold and foreign securities have been dropped by the Reserve Bank.

(ii) The minimum reserve system has been modified by the Reserve Bank. Now the bank need keep only gold worth Rs. 115 crores. The requirement of keeping foreign securities of the value of Rs. 85 crores can be waived during extreme contingencies. Thus, in extreme contingencies the bank needs to keep just Rs. 115 crores of reserves in place of Rs. 200 crores.

7. Anti-Inflationary Fiscal Policy :

In the Seventh five year plan, it was preferred that there should be an anti-inflationary fiscal policy in place of anti-inflationary monetary policy. This plan laid mulch emphasis on the positive, promotional and expansionary role for the monetary policy. In the seventh plan the amount of deficit financing given by the Reserve Bank to the government had been fixed at a minimum level, which was just sufficient to generate the additional money supply needed to meet expected increase in the demand for money. If such a fiscal policy continues, it will relieve the Reserve Bank of its anti-inflationary responsibilities so that it can pay more attention to the provision of credit facilities for the development of trade, industry and commerce in the country.

8. Allocation of Credit :

According to this measure, the allocation of credit will be done in accordance with the priorities laid down in the plans. Still the major part of the credit goes to the public sector through statutory requirements and other means. For the priority sector a certain minimum of credit at concessional rates of interest is ensured through selective credit control and the differential rate of interest scheme. The Reserve Bank does not give credit to the private industries directly. These industries can get credit facilities through the public financial institutions.

B. Measures for Controlling of Credit :

The Reserve Bank of India has the responsibility to ensure that money supply is within manageable limits as unlimited expansion of money and credit results in inflation which ultimately affects the poor.

So, the reserve Bank has been using credit control measures which can be classified into two categories:

(I) General or Quantitative measures

(II) Selective or Qualitative measures

(I) General or Quantitative Measures:

These measures are generally adopted by the Central banks in all the countries. These measures adopted by the Reserve Bank affect the lendable sources of the commercial banks which in turn affect the total volume of the credit and hence the total money supply.

So these measures affect the total quantity of credit and the economy in general. General controls include:

1. Bank Rate:

The traditional definition of Bank Rate says that it refers to the rate at which the Central Bank rediscounts the eligible bills. In broader sense “It refers to the minimum rate at which the central bank provides financial accommodation to commercial banks in the discharge of its functions as the lender of the last resort.”

During inflationary periods, the bank rate is increased so as to increase the rate of interest on borrowings.

A change in discount rate:

(i) Makes the cost of securing funds from RBI cheaper or more expensive

(ii) Brings about changes in the structure of market interest rates and

(iii) Serves as a signal to the money market, business community and the public of the relaxation or restraint in credit policy.

The Reserve Bank has changed the bank rate Several times from 4.5% in 1963 to 10% in 1983 and further to 11% in July 1991. It was 12% w. e. f October 8, 1991. The increase in bank rate was adopted to reduce bank credit and control inflationary pressures. w. e. f. April 29, 1998 the bank rate was 9%. In Oct. 2001 it was 6.5% of in 2002 it comes down to 6 per cent.

2. Open Market Operations:

Open market operations refer to the sale and purchase of securities, foreign exchange and gold by the government. The Central Bank seeks to influence the economy either by increasing the money supply or by decreasing the money supply. To increase money supply, the Central bank purchases government securities from banks and public e.g. If the Reserve Bank buys securities worth Rs. 50 crores from the commercial banks, then the reserves of commercial banks will increase by 50 crores and this money will come in circulation. Conversely, when the central bank sells securities to the banks, the deposits in the banks would get reduced resulting in contraction of credit and reduction in money supply.

In India open market operations are mostly in government bonds because of the absence of Treasury bill market in India. RBI has not used open market operations since long. Since 1991, the enormous inflow of foreign funds into India created the problem of excess liquidity with the banking sector and the Reserve Bank undertook large open market operations. In U.S.A. and U.K., unlike in India, open market operations are mostly in treasury bills. In 2001-2002, RBI sold securities worth Rs. 1,063 crore and purchased worth Rs. 49,068 cr.

3. Cash Reserve Requirements:

Commercial banks in every country maintain a certain percentage of their deposits in the form of balances with the central bank which is known as CRR or Cash Reserve Requirement. If CRR is 10%, for example, the maximum amount a bank can lend is equivalent to 90% of total reserves. The method of CRR is the most direct and effective method of credit control. The more is the excess reserve, the greater is the power of the Reserve Bank to create Credit and lower is the power of the commercial banks to create credit. On the other hand, lower is the excess reserve, the lesser is the power of the Reserve Bank to create credit and larger the power of the commercial banks to create credit.

RBI is empowered to vary the CRR between 3% to 15% of total demand and time liabilities. Since 1973, CRR was 7% and 15% in 1991 and again 14% in 1994. The CRR ratio was cut down to 11% w. e. f. August 29, 1998. This reduction is due to the new liberalised policy of the government.

4. Statutory Liquidity Ratio (SLR):

Apart from Cash reserve requirements (RBI Act 1934) all commercial banks are required to maintain, under sec 24 of the Banking Regulation Act 1949, liquid assets in the form of cash, gold and unencumbered approved securities. This is known as statutory liquidity Ratio and it cannot be less than 25% of their total demand and time deposit liabilities. The Reserve Bank of India is empowered to change this ratio. Accordingly it raised the liquidity ratio from 25% to 38% w. e. f. September 1990.

The two underlying reasons for raising the SLR are:

(i) It helps to check the inflationary pressures in the economy by reducing the capacity of the commercial banks to create credit.

(ii) It makes larger resources available to the government.

In view of the Narsimhan Committee report, the government decided to reduce SLR in stages from 38. 5% to 25%. By the end of December 1996, the effective SLR came down to 27%. It has been reduced to 25% in 2002.

5. Refinance Policy:

Refinance given by the Reserve Bank to the Commercial banks affects their credit but this system is changed from time to time to allow or disallow flow by banks. Over the years effectiveness of refinance policy has come down because dependence of commercial banks on Reserve Bank of India for refinance has come down except in case of subsidised refinance of agricultural and rural credit.

(II) Selective or Qualitative Controls:

This control refers to regulations of credit for specific purposes or branches of economic activity. Selective credit controls are considered to be useful supplement to general credit regulations.

Under section 21 and 35-A of Banking Regulation Act 1949, the Reserve Bank has powers to control advances by banks regarding:

(a) The purpose for which advances may or may not be made.

(b) The margins to be maintained in respect of secured advances.

(c) The maximum amount of advance to any borrower.

(d) The maximum amount upto which guarantees may be given by the banking company on behalf of any firm, company etc. and

(e) The rate of interest and other terms and conditions for granting advances.

The Reserve Bank of India has generally adopted the following techniques of selective credit control since 1956 onwards:

1. Regulation of Marginal Requirements on Loans:

The Reserve Bank fixes the minimum marginal requirements on loans for purchasing or carrying securities. Margin is the difference between the market value of the security and the amount lent by the banks against these securities. The basic aim of this method is to restrict the use of credit to purchase or carry securities by the speculators. Minimum requirements of loan is the percentage value of the security which cannot be borrowed or lent or in other words, it is the maximum value of loan which a person can get from the banks against the securities.

The changes in margin requirements regulate and control the demand for speculative credit. These margins are 20% to 100%. The Reserve Bank can control credit by increasing the margins and expand credit by reducing the margin requirements.

2. Regulation of Consumer Credit:

To check the inflationary pressures in the economy, another method of selective credit controls is the regulation of consumer credit. This credit is generally given to the consumers for the purchase of durable goods. The consumer credit schemes which are adopted by the banks require that a certain percentage of the consumer durable goods are paid by the consumer in cash. The balance amount is financed by the bank through bank credit which is re-payable in monthly installments over a period of time. The Reserve Bank can control credit by changing the total amount which can be borrowed by the consumer for the purchase of consumer durable goods and/or the maximum period over which the installments can be extended.

The Reserve Bank can control credit by increasing the down payment and reducing the number of installments. On the other hand, it can expand credit by reducing the down payment and increasing the number of installments.

3. Rationing of Credit:

Rationing of credit is another technique of selective credit control. Under this method, the Reserve Bank fixes the quota for member banks as well as their limits for the payment of bills. The Quota system was first introduced in 1960. If the member banks seek more loans than the quota which is fixed for them, they will have to pay higher rate of interest to the Reserve Bank than the prevailing bank rate.

Rationing of credit is both quantitative as well as qualitative method of credit control. If rationing is done with respect to the total amount of loan, it will be a quantitative control. But if rationing fixes the maximum ceilings for specific categories of loans and advance, it becomes qualitative in nature.

4. Credit Authorisation Scheme (CAS):

Credit Authorisation Scheme, as a selective credit control, was introduced by the Reserve Bank in November 1965. Under this scheme, the commercial banks had to seek authorisation from the Reserve Bank before sanctioning any fresh limit of Rs. 1 crore or more to any single party. The amount of this limit has been changed from time to time. This limit was raised to Rs. 6 crore with effect from April 1986. Since July 1987, this scheme has been liberalised to allow large amount of loans to meet genuine demands of production sector without the prior sanction of the Reserve Bank. However, in such cases, a system of post sanction scruting called Credit Monetary Arrangements (CMA) has been introduced by the Reserve Bank.

The main purpose of CAS is to keep a close watch on the flow of credit to the borrowers. It requires that the banks should tend to large borrowing concerns on the basis of credit appraisal and actual requirements of the borrowers.

5. Directives:

Under this method, the Reserve bank makes extensive use of selective credit controls and issues directives to the commercial banks.

Since 1956, the following directives have been issued by the Reserve Bank:

(i) The first such directive was issued by the Reserve Bank on May 17, 1956 to restrict advances against paddy and rice. Later on, so many other commodities of common use were also included in this list.

(ii) The State agencies, such as the Food Corporation of India and State Trading Corporation have been exempted from the use of selective credit controls.

This method can help a lot in credit regulation and can be quite effective if properly used and implemented by the monetary authorities of the country.

6. Moral Persuasion:

The Reserve Bank has been using moral persuasion as a selective credit control measure. Periodical letters are issued by RBI to banks urging them to exercise control over credit in general or advances against particular commodities or unsecured advances. Regular meetings and discussions are also held by the Reserve Bank with commercial banks to impress upon them the need for their cooperation in the effective implementation of the economic policy.

Essay # 3. Evaluation of the Monetary Policy:

The twin objectives of the monetary policy of the Reserve Bank had been to (1) accelerate the process of economic growth and to (2) control the inflationary pressures in the economy. Though, the Reserve Bank has been extensively using various credit control methods, but it has not been able to bring stability to the economy of the country.

Major failures and limitations of the monetary policy of the Reserve Bank are as discussed below:

1. Minor and Restricted Role in Economic Development:

The monetary policy has not been given an active and crucial role in the economic development of the country. Rather, it has been assigned only a minor role in the expansion and development of the Economy. The Reserve Bank has been assigned a very minor and restricted role that is to see that the economic development of the country is not hampered because of the non-availability or inadequacy of funds.

2. Lack of Coordination between Monetary and Fiscal Policies:

There is lack of coordination between the monetary policy of the Reserve Bank and the fiscal policy of the government of India. The five year plans emphasised that there should be proper coordination between the fiscal policy particularly relating to deficit financing and the Reserve Bank Credit Policy relating to commercial banks. To maintain a reasonable balance between aggregate demand and aggregate supply, it was necessary to limit the deficit financing to a reasonable level and to have a bank credit policy which cooperates with the policy of deficit financing. In reality, the Reserve Bank has been monetising the increasing budgetary deficit which in turn leads to a less effective monetary policy. As the proper integration between the monetary and fiscal policies could not be achieved due to lack of serious efforts, our basic objectives of growth and price stability could also not be achieved.

3. Imbalance in Credit Allocation:

Another limitation of our monetary policy has been imbalance in the allocation of credit. Even though agriculture and small scale industries are given priority in the five year plans, still relatively less credit is diverted towards these sectors. After the nationalisation of the banks, some efforts have been made by the commercial banks to provide credit to these priority sectors; but the efforts are not sufficient. These sectors remain dependent mainly upon private resources for their financial needs.

4. Unsatisfactory Role of Capital Market:

Another drawback of our monetary policy lies in the unsatisfactory and limited role of the capital market. The distribution of credit in the market is not based on the efficiency and profitability of the enterprises demanding funds. The present scenario is that the public financial institutions are raising the resources at lower than the market price to finance investments in private industries. Now there is a strong need to enlarge the Capital Market. This can be done by encouraging both the public and private enterprises to seek much larger support from the capital market. Funds should be provided to the enterprises on the basis of their capacity and credit worthiness.

5. Excessive Budgetary Deficit and Government Borrowings:

Another reason for the failure of monetary policy in India has been the impact of excessively growing budgetary deficit and large scale government borrowings. The main reason for developing excessive budgetary deficit was to maintain high level of plan outlays and to promote investment in the economy. But the results have been contrary. The high level of deficit financing has created excessive monetary demands which have further led to inflationary pressures in the economy of the country.

6. Excessive Increase in Bank Credit to the Commercial Sector:

The Reserve Bank has provided excessive credit to the Commercial banks, which is another cause of the failure of the monetary policy. This excessive credit was provided to promote growth and investment in the country, to provide liberal and concessional credit to the priority sector and to give preferential treatment to the government agencies and the private sector. All this has led to a large expansion of money supply in the economy.

7. Limited Role in Curbing the Inflationary Pressures:

The monetary policy of the Reserve Bank has played only a limited role in curbing the inflationary pressures in the economy. It has not succeeded in achieving the objectives of economic growth with stability.

The general and selective measures adopted by the Reserve Bank are effective only if the inflation is caused due to expansion of bank credit. If inflation is caused due to deficit financing or shortage of goods, these measures will not prove to be effective. The average rate of money supply during the plans has been 15% p. a. whereas the average rate of growth of domestic product is just 4%. This disproportionate increase is a major factor in the inflationary pressures of the economy.

8. Increased Liquidity of Commercial Banks:

After the nationalisation of the banks, their liquidity position has improved. As a result of nationalisation, there has a rapid growth of banking industry. The commercial banks have increased mobilisation of savings as well as increased growth of deposits. Now they do not have to depend upon the Reserve Bank for their financial needs. The Reserve Bank may increase the CRR or the SLR but the commercial banks do not get affected much. They can grant as much loans as are required without resorting to the Reserve Bank. This has also reduced the effectiveness of the monetary policy.

9. Existence of Black Money:

Another limitation of monetary policy in India is the existence of black money which limits the working of the monetary policy. The black money is not recorded since the borrowers and lenders keep their transactions secret. As a result, the supply and demand of money do not remain as desired by the monetary policy.

10. Underdeveloped Money Market:

The underdeveloped money market of our country limits the coverage as well as the efficient working of the monetary policy. The Indian money market consists of organised as well as unorganised money market. The monetary policy cannot reach the unorganised money market thus the desired results cannot be achieved.

In short, the monetary policy of the Reserve Bank suffers from many limitations. It requires improvements in many directions.

Essay # 4. Suggestions/Recommendations of the Chakravarty Committee on Monetary Policy:

The Committee to review the working of the monetary system was appointed by the Reserve Bank of India in 1982 with Prof. Sukhmoy Chakravarty as the chairman. The Committee submitted its report in 1985.

The following were the terms of reference of this committee:

(i) To critically review the structure and operation of the Monetary System, in the context of the basic objectives of planned development.

(ii) To assess the interaction between monetary policy and Public debt Management in so far as they have a bearing on the effectiveness of monetary policy.

(iii) To evaluate the various instruments of monetary and credit policies.

(iv) To recommend suitable measures for improving the effectiveness of monetary policy.

The following were the main recommendations of the committee:

1. Price Stability :

The committee had strongly emphasised that price stability, in the broadest sense, should be the objective of the monetary policy. The committee suggested that average annual increase in the wholesale price index should not be more than 4%. To achieve this objective measures had to be adopted to control both the aggregate demand and aggregate supply of money. For achieving this target the government should aim at improving the output level and the Reserve Bank should control the reserve money and money supply.

2. Non-Inflationary Financing of Plans :

The committee expressed its concern over the increase in government deficits, despite the rise in savings rate. In this context it stressed that deficit financing measured in terms of governments’ recourse to credit from Reserve Bank, should not exceed safe limits.

The plans should be financed in non-inflationary manner with the help of the following measures:

(i) Tapping the Savings of the public in greater measure.

(ii) Realising higher savings from public sector enterprises.

(iii) Improving efficiency in revenue gathering and expenditure functions.

3. Monetary Targeting :

The committee observed that the major cause of substantial increase in the money supply since 1970 has been the rise in the Reserve Bank credit to the government, as reflected in the high degree of monetisation of the debt. In this regard the committee recommended that the target for the growth of money supply in a year should be set within a range. It should be reviewed in the course of the year to accommodate revisions, if any keeping in view growth in output and the price situation. Monetary targeting is an aggregative concept which lends clear direction to the monetary policy instruments.

4. Co-Ordination of Monetary and Fiscal Policies :

The committee suggested that to coordinate monetary and fiscal policies, the concept of “Budgetary deficit” should be redefined.

The present policy does not provide a clear picture of the monetary impact of the fiscal operations because:

(i) It does not cover the rise in Reserve Bank’s holding of dated securities which has a monetary impact.

(ii) The deficit is related to only the changes in the level of Treasury bills outstanding.

(iii) It does not distinguish between an increase in the Reserve Bank’s holding of treasury bills which has a monetary impact and the absorption of the Treasury bills by the public which does not have a direct monetary impact.

Hence, there should be suitable modification in the definition of the budgetary deficit.

5. Interest Rate Policy :

The committee made the following recommendations regarding the policy of rate of interest:

(i) The banks should have greater freedom in the determination of their rates of interest. This would prevent unnecessary use of credit which presently is possible due to low rate of interest.

(ii) Concessional rates should be used in a very selective manner that to as a distributive device.

(iii) The interest rates on bank rates should be positive after adjusting the inflation. This will encourage small savers.

(iv) The interest rates should reflect the real cost of long term loans for industrial projects. This will discourage those projects which are basically not viable.

6. Credit Planning :

The committee recommended the need for Credit-Budgeting to achieve desired sectorial credit allocation in line with plan priorities. It suggested the need to support quantitative credit controls with a price rationing mechanism in the context of excess demand for credit. The committee also suggested a reduction in the importance of cash credit in bank lending and greater resort to financing through loans and bills.

7. Restructured Money Market :

The committee suggested that the money market in India should be restructured to make it more efficient. The monetary system of the economy should be restructured in such a way that the Treasury bill market, the call money market, the commercial bill market are able to play an important role in the allocation of short term resources with minimum transaction cost and minimum delay. The committees stressed that improvement in productivity in all aspects of banking operations was to be pursued by banks as an important management objective. As regards the traditional non-banking financial intermediaries, the committees suggested that beyond a suitable cut off point, these should also be under a legal obligation to obtain license.

8. Priority Sector Lending :

To make the priority sector lending more effective, the committee suggested the need for organisational reorientation and effective communication and monitoring. In this area, credit delivery system should be strengthened, so that sufficient and timely credit is made available to this sector.

9. Role of Reserve Bank for the Conduct of Monetary Policy :

The committee was of the view that the Reserve Bank should have adequate powers and authority to match its responsibility to supervise and control functioning of the Monetary System.

The committee gave the following suggestions in this regard:

(i) The Reserve Bank should not depend too much on any single instrument of monetary policy.

(ii) The regulatory measures should be adopted early and slowly so that effects of these measures are not too drastic and create hardship to the specific sectors.

(iii) The creation of reserve money should be kept within limits.

(iv) The developmental institutions should get their working funds from sources other than the Reserve Bank and the Bank should provide only a secondary support to these institutions.

The government has accepted the recommendations of the Chakravarty committee and these are now being implemented.

Related Articles:

  • Monetary Policy of Reserve Bank of India (RBI)
  • Monetary Policy and Fiscal Policy of India
  • Instruments of Monetary Policy
  • Monetary-Fiscal Policy Link (With Diagram) | Economics
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Democratic Donors’ Big Question: What’s Plan B?

An unsteady debate performance by President Biden has scrambled the thinking among some donors about whether the party needs to find an alternative.

By Andrew Ross Sorkin ,  Ravi Mattu ,  Bernhard Warner ,  Sarah Kessler ,  Michael J. de la Merced ,  Lauren Hirsch and Ephrat Livni

President Biden, standing at a podium in a dark suit, looks to his right as the words “CNN” and “debate” appear on a screen behind him.

Post-debate panic

After a bruising 90-minute debate that underscored President Biden’s single-biggest weakness — concern about his age — Democratic donors exchanged panicked texts and emails with one question: What’s Plan B?

The 81-year-old Biden’s halting, shaky performance against a confident (if sometimes misleading) showing by Donald Trump has set off alarm among Democrats with just seven weeks before the Democratic National Convention and four months before the November election.

Some party faithful who were suppressing their doubts about Biden are now privately lobbying Democratic leaders and scouring rule books to figure out how to change the presidential ticket.

“Disaster,” one unnamed Democratic donor told CNBC after the debate, reflecting the mood among the party’s moneyed class. Other reactions included “absolute train wreck” and “game over.” “Do we have time to put somebody else in there?” Mark Buell, a well-known Democratic donor, told The Times.

Biden himself brushed off the concerns . But even Vice President Kamala Harris conceded that he’d had a “ slow start ” to the debate.

Biden skeptics said the performance justified their concerns. Many business leaders, including Elon Musk and the financier Bill Ackman, have bemoaned having to choose between Biden and Trump. After the debate, Ackman, who backed Dean Phillips in his Democratic presidential bid, posted to X that Trump was “going to win in a landslide . The country should rally around Trump and help him succeed.”

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IMAGES

  1. Monetary Policy Essay

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  2. Monetary Policy Essay.pdf

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  3. HSC Economics: Monetary Policy Essay

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  4. Monetary Policy Essay Example

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  5. Monetary Policy Essay

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  6. Monetary Policy Essay (Topic 5: Financial Markets)

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VIDEO

  1. @1Dimee Rates Countries and Explains Why Andrew Tate is a Marxist

  2. Monetary Policy UK Themes

  3. Monetary Policy Report Press Conference, May 2021

  4. Honesty is the Best Policy Speech in English|| Honesty is the Best Policy essay||

  5. Macbeth: One FULL Essay Plan Which Fits EVERY GCSE Question

  6. How to Read and Interpret a Monetary Policy Statement Quickly

COMMENTS

  1. Monetary Policy: What Are Its Goals? How Does It Work?

    The federal funds rate The FOMC's primary means of adjusting the stance of monetary policy is by changing its target for the federal funds rate. 5 To explain how such changes affect the economy, it is first necessary to describe the federal funds rate and explain how it helps determine the cost of short-term credit.. On average, each day, U.S. consumers and businesses make noncash payments ...

  2. 2021

    Assess the RBA's use of monetary policy to manage price stability and economic growth in the Australian gro wth. Intro: - Define price stability and economic growth - RBA use monetary to achieve EG and PS goals (above 3% and 2-3% respectively) - Essay follows significant time period over the past two decades

  3. Monetary Policy with theory essay

    The Rudd governments contractionary fiscal policy of a deficit of 4% in 2011 to 1% in 2012/13 acted in assisting monetary policy to constrict growth. Consequently, in tightening monetary policy in response to a positive shock, the Australian economy was able to manage price levels and growth at the cost of a major appreciation in the AUD.

  4. Evaluating Monetary Policy (Online Lesson)

    an essay-based activity, in which 2 example essays on monetary policy are provided (along with some examiner commentary) and students need to consider the strong features of these essays; extension reading; We anticipate that the "core" of the lesson would take around one hour, with an extra 90 minutes for the written tasks. For the data ...

  5. Role of Monetary Policy in the Economy

    Fundamentally, monetary policy can influence the price level—the rate of inflation, the aggregate price level in an economy. And it is appropriate to provide a more expansionary monetary policy when there's evidence that inflation is falling or will fall below the desirable level. In the Fed's case, we target a 2% rate of inflation.

  6. Monetary Policy: Stabilizing Prices and Output

    Changing monetary policy has important effects on aggregate demand, and thus on both output and prices. There are a number of ways in which policy actions get transmitted to the real economy (Ireland, 2008). The one people traditionally focus on is the interest rate channel. If the central bank tightens, for example, borrowing costs rise ...

  7. Keynes's Theory of Monetary Policy: An Essay In Historical

    I. INTRODUCTION. Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management (Keynes, 1936, p.206).The purpose of this paper is to reconstruct Keynes's theory of monetary policy, as ...

  8. HIGH BAND 6 // MONETARY POLICY ESSAY PLAN

    3 pages. Free sample. This monetary policy essay plan provides a structured and comprehensive approach to writing a top-notch essay on this critical topic in economics. The plan covers all the essential elements of a strong essay, including an introduction to monetary policy, a discussion of its objectives, a review of the various monetary ...

  9. Monetary policy

    Monetary policy is the domain of a nation's central bank.The Federal Reserve System (commonly called the Fed) in the United States and the Bank of England of Great Britain are two of the largest such "banks" in the world. Although there are some differences between them, the fundamentals of their operations are almost identical and are useful for highlighting the various measures that ...

  10. Essay on Monetary Policy

    Monetary and fiscal policy Introduction Fiscal policy is defined as the power that the federal government poses that enables it to impose taxes and also spend to achieve its goals in the economy. On the other hand, the monetary policy is maintaining the programs that try to increase the nation's level of business through regulation the supply ...

  11. Policy Has Tightened a Lot. How Tight Is It?

    On May 6, 2022, I first published an essay explaining why I focus on long-term real rates to evaluate the overall stance of monetary policy, which includes effects from both the setting of the federal funds rate and changes to the Federal Reserve's balance sheet. Please see that essay for a discussion of why long-term real rates drive economic activity rather than short rates or nominal rates.

  12. Economic Effects of Higher Interest Rates (Revision Essay Plan)

    Here is an essay plan to this question: "To what extent can a policy of higher interest rates lead to an improvement in macroeconomic performance. ... The decision by central banks such as the Federal Reserve and the Bank of England to start tightening monetary policy by raising interest rates are often finely balanced. In the UK for example ...

  13. Monetary Policy

    What is Monetary Policy? Monetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment.. These policies are implemented through different tools, including the adjustment of the interest rates, purchase or sale of government securities, and changing the ...

  14. PDF Essays in Monetary Policy

    Essays in Monetary Policy Abstract This dissertation presents three chapters addressing issues pertaining to monetary policy, in-formation, and central bank communication. The -rst chapter studies optimal monetary policy in an environment where policy actions provide a signal of economic fundamentals to imperfectly informed agents.

  15. The Fed

    The Federal Reserve conducts the nation's monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. This section reviews U.S. monetary policy and economic developments in 2020, with excerpts and select figures from the Monetary Policy Report published in February 2021 and June 2020 ...

  16. Federal Reserve Board

    Monetary Policy. Monetary policy in the United States comprises the Federal Reserve's actions and communications to promote maximum employment, stable prices, and moderate long-term interest rates--the economic goals the Congress has instructed the Federal Reserve to pursue.

  17. Monetary Policy: Introduction

    centralized financial institution responsible for the monetary policy of a country (or group of countries with the same currency, such as the eurozone). a good, typically a raw materials or agricultural products, that can be bought and sold. what happens when prices continue to rise, meaning a country's currency is worth less than it was ...

  18. What Is Monetary Policy? How Does It Work?

    Central banks use monetary policy to manage the supply of money in a country's economy. With monetary policy, a central bank increases or decreases the amount of currency and credit in ...

  19. PDF FRBNY The Story of Monetary Policy Lesson Plans High School

    The Story of Monetary Policy High School Lesson Plan. Standards. New York. • 12.G5b. On various issues, certain governmental branches and agencies are responsible for determining policy. Those who create public policies attempt to balance regional and national needs, existing political positions and loyalties, and sources of political power.

  20. 25 Mark Essay Technique

    Here is a video recording of a revision webinar looking at shaping an answer to this 25 mark question. "Monetary policy is as important as supply-side polici...

  21. Monetary Policy Essay

    Monetary Policy Essay. "These are the times that try men's souls" is a quote attributed to political writer Thomas. Paine. In 1776 Paine used this phrase as the opening line in his pamphlet titled The American. Crisis, referring the start of the American Revolutionary War. Not to take anything a;0way from.

  22. PDF Fiscal and Monetary Policy Infographic Classroom Activity

    This activity connects fiscal and monetary policy actions to the real economy. Students will interpret the following headlines and scan the corresponding articles or op-eds to identify whether the topic relates to fiscal or monetary policy actions, then will fill in the corresponding tables. 1. Headline: "Fed's Kaplan Says Monetary Policy ...

  23. Essay on the Monetary Policy

    Here is an essay on the 'Monetary Policy' for class 11 and 12. Find paragraphs, long and short essays on the 'Monetary Policy' especially written for school and college students. Essay on the Monetary Policy Essay # 1. Introduction to the Monetary Policy: Monetary policy refers to the steps taken by the Reserve Bank of India to regulate the cost and supply of money and credit in order ...

  24. PDF R Chard K. (R L Ons

    in Central Banking, Monetary Theory and Practice: Essays in Honor of Charles Goodhart, edited by P. Mizen, Edward Elgar, 2003, 160-179. "The Future of the Foreign Exchange Market," Brookings-Wharton Papers on Financial Services, Robert Litan and Richard Herring (eds.), Brookings Institution Press: Washington, DC, 2002, 253-280.

  25. Milei Shifts Policy in Second Phase of Argentina Plan

    Argentine President Javier Milei's administration embarked on what it called the second phase of its economic plan Friday by announcing that it will swap out notes held at the central bank for ...

  26. Fed officials are talking down the chance of rate cut this year

    At the beginning of the year, Federal Reserve officials projected they would cut interest rates three times this year. By June, they had lowered that projection to just one cut.

  27. Rich countries plan to buy more gold despite record price

    Of the emerging market respondents, nearly 40 per cent plan to raise their holding. The main reasons cited by central banks for holding gold are its long-term value, performance during a crisis ...

  28. IMF Staff Completes 2024 Article IV Mission to Vietnam

    A recovery began in late 2023, fueled by a rebound in exports, tourism, and appropriately expansionary fiscal and monetary policy support. Inflation picked up in the first quarter of 2024, driven partly by rising food prices, though core inflation remained relatively low and stable. The external current account posted a large surplus in 2023, 5 ...

  29. Democratic Donors' Big Question: What's Plan B?

    An unsteady debate performance by President Biden has scrambled the thinking among some donors about whether the party needs to find an alternative. By Andrew Ross Sorkin, Ravi Mattu, Bernhard ...

  30. Argentina Officials Move to Shore Up Bank Support for Debt Plan

    Economy Minister Luis Caputo and Central Bank Chief Santiago Bausili sought to shore up support Monday in a meeting with executives from private banks for a monetary policy pivot announced late ...