Answer:
Monetary policy is a set of tools used by a nation’s Central bank to control the overall money supply
and promote economic growth. It employs strategies such as revising interest rates and changing
bank reserve requirements.
Objectives of monetary policy:
• Inflation targeting: The main aim of monetary policy is to regulate the supply of money in the
economy through inflation targeting. It helps in controlling the inflation and interest rates in an
economy.
• Check on unemployment: An expansionary monetary policy decreases unemployment, as
higher money supply and attractive interest rates stimulate business activities and expansion of
the job market.
• Financial stability and growth: Monetary policy acts as a counter-cyclical tool for smoothing
the business cycle. When the economy grows too slowly, an expansionary monetary policy can
boost economic growth, and on the other hand, when the economy is overheated, a
contractionary monetary policy can dampen economic activity.
• Management of exchange rates: The exchange rates between domestic and foreign currencies
can be affected by monetary policy. With an increase in the money supply, the domestic currency
becomes cheaper than its foreign counterpart.
• Favourable balance of trade: Increasing the money supply tends to devalue the local currency,
which can serve to boost exports as these products are effectively less expensive for foreigners
to purchase. Decreasing the money supply tends to revalue the local currency, making the imports
costly.
Limitations of monetary policy:
• Time lag: Businesses and consumers may not immediately respond to changes in interest rates
or credit availability, and it can take several months or even years for these changes to filter
through the economy.
• Technical limitations: Interest rates can only be lowered nominally to zero, which limits the
bank’s use of this policy tool when interest rates are already low. Keeping rates very low for
prolonged periods of time can lead to a liquidity trap. This tends to make monetary policy tools
less effective during economic recessions.
• Generic in effect: Monetary policy tools have an economy-wide impact and do not account for
the fact that some areas in the country might not need the stimulus.
• Dependence on the government: In countries like India, the higher weight of food items in the
consumer price index (CPI), makes inflation less amenable to control through monetary policy
tools. The central bank, then, is forced to rely more on “supply-side” measures by the government.
Despite its weaknesses, monetary policy is generally viewed as the first line of defence in stabilizing
the economy. In the long run, monetary and fiscal policy tools are used in concert to help keep
economic growth stable.