To maintain a strong and stable economy, the government administers several policies, known as the economic policies. These policies include decision making regarding taxation, redistribution of income and supply of money.
Monetary policy is one such economic policy aimed at managing the money supply. Central banks use these policies to manage the money supply in a country’s economy. The two types of monetary policies are contractionary and expansionary.
Meaning of Monetary Measures
Monetary measures are also called Federal measures. The monetary authority of a country adopts these measures to stabilise the country’s economy by reducing inflation. The main objective of these measures is to promote maximum employment and support long-term economic growth.
Monetary Measures to Control Inflation
A certain rate of inflation is preferable for the country’s economy, but it becomes a problem when it crosses the desirable limit. When the inflation rate increases, certain monetary measures are applied to bring the situation under control.
The monetary measures to control inflation are as follows.
- Discount rate policy by banks: It is also known as the Central Bank Rediscount rate and it is an important monetary measure to control inflation. The central bank acts as a lender where it buys commercial documents or exchanges bills from commercial banks to build its reserves. It functions in the following two ways.
(i) During inflation, the central bank increases its interest rate leading to a decrease in the borrowing by the commercial banks. As a result, the money flow from these banks to the public also decreases, and the bank credit controls the inflation rate to a certain extent.
(ii) When the central bank raises its rate of interest, the commercial banks also follow the same and raise the rates for the public. Hence, with declining borrowing rates money flow to the public is reduced and inflation is controlled.
2.Reserve Ratio: It is also known as Cash Reserve Ratio (CRR). The reserve ratio is a portion of the deposits maintained by commercial banks. The central bank implements CRR to control the money supply. When the CRR increases, the lending capacity of commercial banks decreases. As a result, the money flow from these banks to the public also decreases. This helps control inflation.
3.Open Market Operations: It refers to the central bank’s purchase and sale of Government securities. These government securities are sold to the public via commercial banks, resulting in a decline in the flow of money from the banks to the public. Thus, inflation is controlled.
Monetary Policy and Inflation
Inflation is the persistent rise in prices of daily commodities resulting in a higher cost of living. It occurs when the production cost increases, that is, the cost of raw materials and wages. To sum up, inflation is the monetary phenomenon in which the production level is lower than that of the growth of the money stock.
In recent times, the central banks use inflation as a target to maintain stable prices and steady economic growth. With an inflation target of 2-3%, there’s a deviation in the prices. In such situations, the central bank can implement monetary measures to restore that target.
In situations where the rate of inflation increases dramatically, contractionary monetary measures such as increasing the rate of interest or restricting the supply of money are put into action to decrease the inflation rate.
Conclusion
Monetary measures play a key role in controlling inflation and stabilising the economy of a country. With the help of price controls, the government can control the inflation rate but this will lead to recession and unemployment. By implementing a contractionary monetary policy, which involves reducing the supply of money or decreasing the rate of interest, the government can fight against inflation. Reserve requirements also work towards this purpose. Hence, the goal of contractionary monetary policies is to decrease prices and increase interest rates which ultimately helps in less spending.
There are three tools of monetary measures. The first is open market operations, which means the purchasing and selling of government securities. The second is the discount rate, which refers to short-term loans charged by the central banks. Third is reserve requirements, which refer to the deposit portions maintained by the bank.
