Monetary policy is the term used by economists to describe ways of managing the supply of money in an economy. Monetary Policy is the management of money supply and interest rates by central bank to influence prices and employment for achieving the objectives of general economic policy. Monetary policy works through expansion or contraction of investment and consumption expenditure.
According to Paul Einzig
“Monetary policy includes all monetary decisions and measures irrespective of whether their aims are monetary and non-monetary, and all non-monetary decisions and measures that aim it affecting the monetary system.”
According to Harry G. Johnson
“Monetary policy employing the central bank’s control of supply of money as an instrument for achieving the objectives of general economic policy.”
According to G.K. Shaw
“By monetary policy we mean any conscious action undertaken by the monetary authorities, to exchange the quantity, or cost (interest rate) of money.”
From the above discussion monetary policy may be defined as the central bank’s policy pertaining to the control of the availability, cost and use of money and credit with the help of monetary measures in order to achieve specific goals.
The Importance of Monetary Rule
There is a difference in between “pegged” and “fixed” rates, which lies in the adjustment system. A fixed exchange rate is the monetary rule that contains an equilibrating mechanism of the balance of payments. The gold standard was a good example of fixed rates. Countries defined their currencies in terms of weights of gold and exchange rates represented the ratios of the weights. This system got into trouble very rarely, as during war, countries turned to finance deficit etc. Success of gold depends on fiscal prudence. A country fixes the exchange rate between its currency and an important foreign currency. A currency board works automatically to preserve equilibrium in the balance of payments. Some writers now speak of a “currency board” in order to describe a fixed exchange rate system because there is a common confusion between pegged and fixed exchange rate. A fixed exchange rate is a monetary rule that gives the country the monetary policy of the partner country. On the other hand pegged rate is an arrangement whereby the central bank intervenes in the exchange market to peg the exchange rate but still keeps an independent monetary policy. A flexible exchange rate is consistent with any monetary policy at all hyperinflation. Some countries don’t have the option of fixing the exchange rate because some countries are too small but one of the countries is too large to fix, such as United States. This is because there is no currency to fix the US dollar. In this case the only choice is inflation targeting or monetary targeting, which depends on inflation rate. Stability of the inflation rate is an important policy and low inflation rate produce more stable inflation rate. It is very important that monetary aggregates contain important information about the economy. So from all of these discussion we see that how monetary rules affect the economy and its importance infixing the exchange rate.
Objectives of Monetary Policy
Monetary policy aims and methods have changed over time. Both in developed and developing economies, monetary policies seek to maintain price stability by sustained stable output growth in the face of internal and external shocks that are faced from time to time. In developed economies like USA with production factors at or close to full employment, monetary policies are formulated typically with the output gap (difference between the actual and the longer run potential output) in view; the policy stance is eased to provide stimulus at times of slowdown when actual output lags the longer run potential, and the stance is tightened to slow things down when the economy overheats with actual output running ahead of the sustainable longer...