Monetary policy is a macroeconomic policy to influence the money supply and credit in the economy. The central bank or monetary authority is responsible for implementing it.
Purpose of monetary policy
Monetary policy aims to influence aggregate demand in the economy. Changes in aggregate demand ultimately affect output, price stability, and unemployment.
Extreme fluctuations in the business cycle result in some undesirable effects such as recession and hyperinflation. All that happens when the economy operates far from its potential level. When it is far below the potential level, it triggers recession and deflation. Conversely, when the economy runs above its potential level, it triggers hyperinflation.
The role of the central bank
Most central banks have a mandate to maintain price stability. Through several instruments, they try to control inflation, so it does not lead to hyperinflation, while also avoiding deflation.
Price stability is outstanding because it has indirect effects on other macroeconomic targets, such as employment and output.
Monetary policy tools
The central bank uses three main types of instruments to influence the economy, namely:
- Open market operations, namely buying or selling government securities. When done massively, it is known as quantitative easing.
- Policy rates
- Reserve requirements for commercial banks, namely the portion of deposits that must be held by banks and not used to make loans.
Monetary policy types
In general, types of monetary policy are expansionary and contractionary. Both are trying to influence the money supply and aggregate demand.
Expansionary monetary policy (or a loose monetary policy) increases the money supply, thereby stimulating economic growth and avoiding deflation. That was done by lowering policy rates, buying government securities, and reducing the reserve requirement ratio.
An increase in the money supply pushes aggregate demand upwards, stimulating economic growth. Output production increases, and businesses create more jobs.
The opposite is a contractionary monetary policy (also known as a tight monetary policy). This policy is to moderate economic growth and avoid hyperinflation by reducing the money supply. Options are raising policy rates, selling government securities, and increasing the ratio of reserve requirements.
A decrease in the money supply reduces aggregate demand. Business reduces the level of production as demand weakens. As a result, economic growth lowers, and inflationary pressures falls.
Changes in interest rates
Reducing the interest rate policy makes borrowing costs cheaper. In theory, it will encourage consumers and companies to borrow and spend more. Rising demand stimulates businesses to produce more output and recruit more workers. As a result, real GDP grows, and unemployment falls.
Inflation will also tend to rise. When the economy operates above its potential level, upward pressure on prices will increase.
When interest rates fall, investors see the stock market more attractive. Increased production and demand leads to a more positive outlook for corporate profits. This situation leads to an increase in stock prices.
Rising stock prices encourage a general feeling of increasing household wealth. This sense of growing wealth should help consumers to spend more and save less. Thus, it increasingly stimulates the economy.
Conversely, an increase in interest rates can slow down the economy. Borrowing costs are more expensive, making consumers reduce the consumption of several items, especially items financed through loans such as durable goods.
Reserve requirements ratio
The central bank requires commercial banks to hold a certain proportion of their deposits in the form of reserves. They cannot use it to make loans. This proportion is known as the reserve requirement ratio.
A decrease in the reserve requirement ratio increases the money supply. For example, the central bank lowered the reserve ratio from 10% to 5%. That way, from every Rp100 deposit, banks have more money to lend than before, from Rp90 to Rp95.
As more money in the economy, liquidity increases and pushes lending rates down. When interest rates fall, aggregate demand increases, and stimulates economic growth.
Through the process of creating money, every Rp1 will result in an increase in the money supply to Rp20 when the reserve requirement ratio is 5%. So, when banks have Rp95 in cash to lend, it will increase the money supply by Rp1,900.
Money multiplier = 1 / Reserve requirements ratio
Now, let’s briefly discuss the process of money creation.
Say, a bank lends Rp95 to a debtor. Debtors use it to buy products from the seller ABC. Then, the seller saves the money to bank XYZ.
Bank XYZ set aside Rp4,75 (95 x 5%) as a mandatory reserve. The bank uses the remaining Rp90.25 for loans. This process continues so that the money of Rp95 circulates in the economy many times to Rp1,900 (Rp95/5%).
Open market operations
Open market operations involve the sale and purchase of government securities. This policy affects the money supply directly.
When selling securities, money moves from commercial banks to central banks. Now, the commercial banks have less money to make loans. As a result, the money supply has shrunk.
Conversely, if the central bank buys government securities through open market operations, money moves from the central bank to the buyer’s bank account. That increases the capacity of banks to provide loans, causing increased money supply growth through a money multiplier mechanism.