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MONETARY POLICY

Definition: Monetary policy is the macroeconomic policy laid down by the central bank. It
involves management of money supply and interest rate and is the demand side economic
policy used by the government of a country to achieve macroeconomic objectives like
inflation, consumption, growth and liquidity.
Description: In India, monetary policy of the Reserve Bank of India is aimed at managing the
quantity of money in order to meet the requirements of different sectors of the economy and
to increase the pace of economic growth.

The RBI implements the monetary policy through open market operations, bank rate policy,
reserve system, credit control policy, moral persuasion and through many other instruments.
Using any of these instruments will lead to changes in the interest rate, or the money supply
in the economy. Monetary policy can be expansionary and contractionary in nature.
Increasing money supply and reducing interest rates indicate an expansionary policy. The
reverse of this is a contractionary monetary policy.

For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the
RBI is dependent on the monetary policy. By purchasing bonds through open market
operations, the RBI introduces money in the system and reduces the interest rate.

MONETARISM is a macroeconomic school of thought that emphasizes (1) long-run

monetary neutrality, (2) short-run monetary nonneutrality, (3) the distinction between real and
nominal INTEREST RATES, and (4) the role of monetary aggregates in policy analysis. It is
particularly associated with the writings of MILTON FRIEDMAN, Anna Schwartz, Karl
Brunner, and Allan Meltzer, with early contributors outside the United States including David
Laidler, Michael Parkin, and Alan Walters. Some journalists—especially in the United
Kingdom—have used the term to refer to doctrinal support of free-market positions more
generally, but that usage is inappropriate; many free-market advocates would not dream of
describing themselves as monetarists.

An economy possesses basic long-run monetary neutrality if an exogenous increase of Z

percent in its stock of money would ultimately be followed, after all adjustments have taken
place, by a Z percent increase in the general price level, with no effects on real variables (e.g.,
consumption, output, relative prices of individual commodities). While most economists
believe that long-run neutrality is a feature of actual market economies, at least approximately,
no other group of macroeconomists emphasizes this proposition as strongly as do monetarists.
Also, some would object that, in practice, actual central banks almost never conduct policy so
as to involve exogenous changes in the MONEY SUPPLY. This objection is correct factually
but irrelevant: the crucial matter is whether the supply and demand choices of households and
businesses reflect concern only for the underlying quantities of goods and services that are
consumed and produced. If they do, then the economy will have the property of longrun
neutrality, and thus the above-described reaction to a hypothetical change in the money
supply would occur.1 Other neutrality concepts, including the natural-rate hypothesis, are
mentioned below.

Short-run monetary nonneutrality obtains, in an economy with long-run monetary neutrality,

if the price adjustments to a change in money take place only gradually, so that there are
temporary effects on real output (GDP) and employment. Most economists consider this
property realistic, but an important school of macroeconomists, the so-called real business
cycle proponents, denies it.

Table 1 Selected Statistics, 1960–1999, percentages (average or changes)

Year or Fed M1
CPI Inflation “Real” Adjusted Unemployment
Average Funds Growth
Dec.–Dec. Funds Rate M1B Growth Rate
Over Rate Rate

1960–64 1.2 2.9 1.7 2.8 — 5.7

1965–69 3.9 5.4 1.5 5.0 — 3.8

1970–74 6.7 7.1 0.4 6.1 — 5.4

1975 6.9 5.8 −1.1 4.7 — 8.5

1976 4.9 5.0 0.1 6.7 5.8 7.7

1977 6.7 5.5 −1.2 8.0 7.9 7.1

1978 9.0 7.9 −1.1 8.0 7.2 6.1

1979 13.3 11.2 −2.1 6.9 6.8 5.8

1980 12.5 13.4 0.9 7.0 6.9 7.1

1981 8.9 16.4 7.5 6.9 2.4 7.6

1982 3.8 12.3 8.5 8.7 9.0 9.7

1983 3.8 9.1 5.3 9.8 10.3 9.6

1984 3.9 10.2 6.3 5.8 5.2 7.5

1985–89 3.7 7.8 4.1 7.7 — 6.2

1990–94 3.5 4.9 1.4 7.8 — 6.6

 1995–99 2.4 5.4 3.0 −0.4 — 4.9

Sources: Economic Report of the President, 2003, except: Adjusted M1B Growth: Alfred
Broaddus and Marvin Goodfriend, “Base Drift and the Longer Run M1 Growth Rate:
Experience from a Decade of Monetary Targeting,” Federal Reserve Bank of Richmond
Economic Review 70 (November–December 1984), pp. 3–14.

 £1 used to equal $2. Now £1 is only

equal to $1.75

What does this Depreciation in the value of the

Pound mean?

 Buying goods from America becomes

more expensive. If a meal cost $10 it used to
require £5 (10/2) for a British tourist. But, now
after the depreciation the $10 meal will cost
effectively £5.71 (10/1.75)
 The depreciation in the pound may
discourage British tourists to travel to the US.
 It makes US imports into the UK more
EXCHANGE RATE expensive so it may reduce UK imports
 UK Exports will become relatively
more competitive. It is cheaper for Americans to
buy UK goods, so the quantity of exports should
Currency exchange rates represent the
increase.
value of one country's money in terms of
 UK inflation will increase. Imported
another's. The value of different goods are more expensive (cost push inflation).
currencies is affected by the strength of Also, British goods are more attractive causing a
the countries' economies as measured by rise in demand (demand pull inflation)
various factors, including inflation,
confidence in the government and Summary of depreciation
interest rates in the country. For example,
if one country is suffering from high  A depreciation in exchange rate makes
inflation or has an unstable government, exports more competitive and imports more
the value of its currency is likely to expensive
decrease.  A depreciation helps UK exporters and
improves UK growth prospects.
 Depreciation – fall in value of
exchange rate – exchange rate becomes weaker Effects of appreciation
(see also: definition of devaluation and
The effects of an appreciation in Sterling will
depreciation)
lead to the opposite.
 Appreciation – increase in value of
exchange rate – exchange rate becomes stronger.
 A higher value of sterling makes US
imports cheaper for British consumers, but, UK
Example of Pound Sterling depreciating
exports become more expensive.
against the Dollar.
 An appreciation in the exchange rate
will tend to reduce aggregate demand (assuming
 demand is relatively elastic) Because exports will
fall and imports increase.
 An appreciation is likely to worsen the
current account (assuming Marshall Lerner
condition and demand is relatively elastic)

An appreciation is likely to reduce inflation

because:

 Import prices are cheaper

 Fall in aggregate Demand
 Firms have more incentives to cut
costs.