Monetary Policy is another important part of economics which is used by the Government or the central bank to maintain the liquidity in the market and keep long term interest rate stable. It also provides the favorable monetary platform for economic growth and stability with the aim of stable prices and low unemployment.
The central bank of the country which is also known as the Government bank is the main entity to define the monetary policies with the help of Government finance department. Central bank is expected to use the monetary policies properly to provide the best possible platform for stable prices and economic growths.
The roles of Central bank regarding the monetary policies are as follows:
Keep the long term interest rate favorable to support the economic growth.
Control the inflation and keep it within the target limit.
Control the liquidity in the market. Excess liquidity pushes the inflation and lower liquidity hampers the economic and industrial activities. Central Bank’s job is to maintain the liquidity level to support the economic activities without boosting inflation.
Boost the economic activity and expansion by the private companies to keep the unemployment rate low.
Control the long term interest rate as well.
Control the domestic currency exchange rate. Should reduce the adverse movement of the exchange rate and volatility to support the export and inport industries.
Keep the exchange rate fixed for some countries if needed.
Reserve the forex for any money market operations required in future to control the exchange rate movement.
Central bank’s main three monetary policy tools
Interest Rate: Central bank uses different interest rate like Bank rate, Repo rate and Reverse Repo rate to maintain the liquidity in the system. Different banks rely upon these rates to lend and deposit money with the central bank. Central banks can control the money supply and the lending rate on different types of loan in the market by using these policy rates.
Bank reserve: Central banks uses two main policy tools Cash Reserve Requirements or Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio to maintain the liquidity in the market. Higher value of bank reserve ratio means, higher amount of money should be kept with the bank.
Money Market Operations: This is the most commonly used monetary policy tool which is used to maintain the liquidity in the market. This operation involves buying and selling of government bonds and treasury securities in the open market.
All these tools will be explained in detail manner to make them understandable.