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Monetary policy refers to the deliberate actions of the monetary authorities of a country to manipulate monetary
instruments to achieve macroeconomic objectives. The Government uses it to indirectly influence the level of
aggregate demand in the economy. The main target variables of monetary policy are the rate of interest (price of
money) and the supply of money.
Open market operations These operations are the sale and purchase of securities on the money market by
the government. Government, through the Central Bank, uses open market operations to influence the money
supply of an economy.
o If the government thinks the money supply is too low, Central Bank purchases securities from the
public; money enters the circular flow of income and then the commercial banking system. The
money supply is therefore expanded and causes interest rates to fall and aggregate demand to rise.
o If the government wants to decrease the money supply, Central Bank sells securities to the public;
money leaves the circular flow of income and then the commercial banking system. The money
supply contracts and causes interest rates to rise and aggregate demand to fall.
Maintaining a legal reserve requirement The reserve requirement is that proportion of deposits that
commercial banks must keep on hand in the form of cash to facilitate the daily transactions of their
customers. These deposits must not be used for lending or investing. The money multiplier (1/reserve
requirement) changes when the reserve requirement changes. As such he legal reserve requirement may be
changed to influence the money supply.
o When the government wants to increase money supply, the Central Bank can decrease the legal
reserve requirement, thereby increasing the money multiplier. A larger proportion of the deposits of
the commercial banks are now available for lending and the credit creation process is more easily
facilitated. As such the money supply increases.
o When the government wants to decrease the money supply, the Central Bank can increase the legal
reserve requirement, thereby decreasing the money multiplier. The commercial banks now have fewer
deposits available for lending and the credit creation process is stifled. As such, the money supply
increases. In addition, the Central Bank can institute the use of special reserve deposits onto
commercial banks and other financial institutions. This may be done in addition to the increasing of
Moral suasion The Central Bank may attempt to persuade institutions of the financial sector to take a
particular line of action by simply communicating its wishes to them. The Central Bank may use letters and
verbal statements in its encouragement. However, the commercial banks are not obligated to follow the
Tight or contractionary monetary policy This course of action is taken to restrict the amount of spending
in an economy. To achieve this, the money supply is decreased and/or interest rates are increased.
Deflationary monetary policy is used to counter inflation, by reducing the attractiveness of borrowing, and
Elasticity of the demand for investment This refers to the responsiveness of demand for investment as a
result of a change in interest rates. If this demand is inelastic, a change in the interest rates would have little
effect on the level of investment, and therefore aggregate expenditure. This occurs in the case of interestinsensitive investments investments undertaken for reasons such as business expectations and government
still hold the excess (which theoretically should have been lent out).
Liquidity trap When the demand for money is perfectly interest, the interest rate remains unchanged even
when the money supply increases. This tends to occur at very low rates of interest. No capital gain is
expected from holding financial assets at such low interest rates and all wealth is held in terms of money. If,
then, the Central Bank increases the money supply, the whole increase would be added to speculative
investments take time; a fall in the rate of interest works with a time lag.
Fiscal indiscipline If the governments fiscal policy strategies do not have the same objective as monetary
policy, the monetary policy will not be effective. For example, monetary policy could be implemented to curb
inflation by increasing interest rates. However, its effects are negated if the government increases spending,
thereby promoting economic activity.
BIBLIOGRAPHY
Bahaw, E. (2011). CAPE Economics: Comprehensive Economics For Caribbean Students Unit II. Caribbean
Educational Publishers.
Caribbean Examinations Council. (2012). CAPE Economics for self-study and distance learning. Nelson
Thornes Ltd.
Monetary Policy. (n.d.). Retrieved January 28, 2015, from Encyclonomic Webpedia:
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=monetary+policy