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importance of monetary policy

More specifically, at times of recession monetary policy involves the adoption of some monetary tools which tend the increase the money supply and lower interest rates so as to stimulate aggregate demand in the economy, on the other hand, at times of inflation, monetary policy seeks to contract the aggregate spending by tightening the money supply or raising the rate of interest. Thus, in the context of developing countries the following three are the important goals or objectives of monetary policy: (1) To ensure economic stability at full-employment or potential level of output; (2) To achieve price stability by controlling inflation and deflation; and. Monetary policy is often in the hands of bankers, and refers to interest rates, access to credit and inflation rates. 29.3 reveals that expansion in money supply from MS1 to MS2 does not lower the rate of interest as the economy is operating in the range of liquidity trap. How, according to Keynesian view, expansion in money supply can help to cure recession is illustrated in Fig. With lower reserve requirements, a large amount of funds is released for providing loans to businessmen and in­vestors. The Central Bank sells the Government securities to the banks, other depository insti­tutions and the general public through open market operations. In fact, Keynes himself was of the view that in times of depres­sion, monetary policy will be ineffective in reviving the economy and therefore he laid stress on the adoption of fiscal policy to overcome depression. How tight money policy helps in checking inflation is graphically shown in Fig. Monetary policy, by construction, lowers interest rates when it seeks to stimulate the economy and raises them when it seeks to cool the economy down. In line with the above goals of monetary policy it has often been asserted by Governors of Reserve Bank of India that growth with price stability is the goal of monetary policy of the Reserve Bank of India. Therefore, modern Keynesians and other economists now believe that monetary policy can play a useful role in stabilising the economy at full employment level. Monetary policy is an important instrument for achieving price stability k brings a proper adjustment between the demand for and supply of money. Monetary policy is concerned with changing the supply of money stock and rate of interest for the purpose of stabilising the economy at full-employment or potential output level by influencing the level of aggregate demand. Therefore, for all these reasons (especially because of the liquidity trap in the demand for money curve at lower rates of interest), Keynes was of the view that monetary policy is not an effective instrument in bringing about revival of the economy from the depressed state. Low inflation. The most important anti-inflationary measure is the raising of statutory Cash Reserve Ratio (CRR). The bank rate may also be raised which will discourage the banks to take loans from the central bank. To maintain liquidity, the RBI is dependent on the monetary policy. It takes about six months for the effects to trickle through the economy. The monetary policy manages the supply of money in the country through the Central Bank. This makes the demand for money absolutely elastic at a low rate of interest as is shown in Fig. Let us assume that full-employment level of national income is YF as depicted in panel (c) of fig. Role and importance of monetary policy transparency and communication . Monetary rule has been criticised by the Keynesian economists. They contend that demand curve for money is quite steep and the investment demand curve is quite elastic so that when there is a change in money supply, it significantly affects the investment demand and therefore the equilibrium level of nominal income. As rate of interest falls, it becomes profitable to invest more in producing or buying capital goods. Importance of Monetary Policy for Economic Stabilization! In truth, without either fiscal or monetary policy in United States federal—and indeed local and state—government, the delicate balance of our economy might slip back into another Great Depression. Under these circumstances the economy is said to have fallen in a liquidity trap. The supply of money includes cash, checks, credit, as well as money market mutual funds. Fourthly, an important anti-inflationary measure is the use of qualitative credit con­trol, namely, raising of minimum margins for obtaining loans from banks against the stocks of sensitive commodities such as food-grains, oilseeds, cotton, sugar, vegetable oil. How these three tools of monetary policy work to influence aggregate spending and eco­nomic activity. With less reserve with the banks, their lending capacity will be reduced. Monetary policy is important in decisions the United States government makes about economic practices and regulations, but equally important are the fiscal policies, which government spending and tax reform are geared toward in stimulating the economy. II. Its other goals are said to include maintaining balance in exchange rates, addressing unemployment problems and most importantly stabilizing the economy. Now, in panel (c), it is shown how the increase in investment expenditure from I1, to I2 shifts the aggregate demand curve (C + I1 + G) upward so that the new aggregate demand curve C + I2 + G intersects the 45° line at point E2 and thus establishes equilibrium at full-employment output level YF. The government needs adequate revenue to fulfill responsibilities.The state cannot fulfill its duties in case of a shortage of money but excessive taxes cannot be imposed for increasing revenue. They therefore emphasized the role of fiscal policy for fighting severe recession. Professor of Business, Economics, and Public Policy, Fighting Inflation Versus Fighting Unemployment. The Chakravarty committee has emphasized that price stability, growth, equity, social justice, promoting and nurturing the new monetary and … However, as shall be discussed below, it is the monetarists led by Friedman who do not favour discretionary monetary policy to check cyclical instability. To prevent this fall in interest rate, if money supply is increased, it will generate inflationary pressures in the economy. Monetary policy refers to the actions of a central bank to influence a nation's money supply and economy. A strong currency is considered to be one that is valuable, and this manifests itself when comparing its value to another currency. Thus, under these circumstances Keynes and his early followers thought that monetary policy as a remedy for depression was quite ineffective and did not help the economy in staging a recovery from recession.It may, however, he noted that the concept of liquidity trap is not supported by empirical studies. Now, Fig. They have argued that monetary rule will have a destabilising effect. It may be noted that the use of all the above tools of monetary policy leads to an increase in reserves or liquid resources with the banks. Thus, money supply increase may sometimes exceed the growth of output and sometimes fall short of it and as result may cause sometimes demand-pull inflation and sometimes recessionary conditions. ... For currency traders it is of great importance to track the policy cycle of central banks because that is crucial for their forex speculations.The European Central Bank is one recent case in point with regard to expansionary measures. There are additional decision-makers and tools for such tasks. Monetary policy can offset a downturn because lower interest rates reduce consumers’ cost of borrowing to buy big-ticket items … The central bank undertakes open market operations and buys securities in the open market. The Federal Reserve annually dictates interest rates, liquidity, and currency circulation, which in turn also stimulate the market. In our figure it has been assumed that contraction of money supply from M2 to M1 and as a result rise in rate of interest from r1 to r2 is sufficient to reduce investment expenditure equal to I2 – I1 which is equal to inflationary gap and in this way macroeconomic equilibrium without any inflationary pressure is established at output level YF. 29.2 is fairly elastic so that rise in rate of interest from r1 to r2 is sufficient to reduce investment by I2 – I1 or ∆I. The role of monetary policy in achieving economic stability at a higher level of output and employment will be discussed below and its role in promoting economic growth in a developing country with special reference to India will be explained. Privacy Policy 8. In fact, according to the monetarists, in view of the uncertainty about the exact duration of time lags involved, the use of discretionary monetary policy to stabilise the economy may backfire and further intensify the cyclical instability. 4. By controlling the interest rate it has actually destabilised the economy. The strength of a currency depends on a number of factors such as its inflation rate. More private investment will cause aggregate demand curve to shift upward. Undertaking selective credit controls. Monetary policy can be expansionary and contractionary in nature. (3) To promote and encourage economic growth in the economy. Banks can misread economic data as the Fed did in 2006. This will not only make credit cheaper but also increase the availability of credit or money supply in the economy. Monetary policy has great importance. The reverse of this is a contractionary monetary policy. This selective credit control has been extensively used in India to control inflationary pressures. 29.2.Now, if due to a large budget deficit and excessive creation of money supply, aggregate demand curve shifts to C + I2 + G2; inflationary gap of E1H comes to exist at full-employment level. Increasing money supply and reducing interest rates indicate an expansionary policy. The growth of output of an economy will absorb the extra money supply created as per this rule, without generating inflationary or recessionary conditions, and will thus ensure stability in the economy. Given that the velocity of money (V) is unstable or variable, increase in money supply (M), according to this rule, may not ensure growth of aggregate demand (which, according to monetarist theory, is equal to MV) equal to the rate of growth of output in a year which is difficult to predict. We examine below both these sources of monetary mismanagement: First, there is a problem of variable long time lags that occur for changes in money supply to bring about desirable effects on nominal income. Thus, according to moneterists, it is not the presence of certain inherent destabilising factors in a free-market economy but the monetary mismanage­ment by the discretionary monetary policies which is the root cause of economic instability that has been existing in the free market economies. sector in the transmission of monetary policy. It is generally agreed that a high degree of transparency and an effective communication of policy are necessary for the successful performance of central bank tasks. This will lead to the reduction in investment spending and help in reducing inflationary pressures. The research is part of what might be called "new normative macro- economic research." According to the monetary rule suggested by Friedman, money supply should be allowed to grow at the rate equal to the rate of growth of output. Demand deposits by refraining from giving new loans as old loans are back! 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