What is monetary policy?

Governments intervene in the economy by rewriting basic rules of investment, commerce and trade, by changing tax rates, or by playing with the amount of money available. Economists label changes in tax rates — broadly defined to include taxes, tariffs, transfers, rebates and surcharges — fiscal policy. Monetary policy relates to how the government controls aggregate supply of money, which in the short-term can affect relative prices of goods within the economy and over a longer term, alter the relative price of domestic currency to foreign currencies. Monetary policy also affects interest rates and has powerful influences on investment and employment in the short-run. In developed economies, changes in investment policies are rarer than changes in tax rates, and monetary policy is the commonest form of intervention. How does the government affect the amount of money in the economy? Since only the government — or typically central banks like the RBI — can print money, the easiest way to affect the stock of money is to print it or to withdraw some from circulation. Increasing the supply of money causes inflation as more banknotes chase the same amount of goods and services. Squeezing the supply of money has the opposite impact, a fall in prices, or more realistically, a slowdown in the rate of inflation. The role of determining monetary policy is typically left to the central banks, the RBI for instance in the Indian context. How does monetary policy affect the real economy? Till as recently as 60 years ago, economists' knowledge about money, prices and its links with the real economy was rudimentary. For example, it was assumed that inflation made the prices of everything rise and fall in the same proportion at the same time. If so, then the effect of monetary policy on employment, say, would be zero for the change in the price of labour (wages) would be cancelled out by a similar change in the price of output (things produced by labour). In the 1930s, John Maynard Keynes pointed out that this was wrong, at least in the short run. In the short run, there are leads and lags in the economy and the prices of everything do not change at the same speed. Wages for example, could change once a year, while the prices of potatoes could change several times in the same time. Given that, changes in the overall money supply would affect relative prices rather than cancel out for the economy as a whole. Keynes also linked interest rates to the supply of money. When money is plentiful, borrowing is cheap, interest rates are low. When money is scarce, people pay higher rates to borrow. This is why today most central banks use interest rates as levers to control money supply. Raising rates induce people to save, withdrawing money from circulation and drawing it out of markets into savings. The opposite is true when rates are lowered. With interest rates linked to money supply in the short run, it is easy to see that investments too are influenced by monetary policy. That's because, other things being equal, investments pick up when it is cheaper to borrow and slacken when funds become cheaper. Since investments influence long-term prospects, it might seem to be a good idea to have low rates and high liquidity all the time. Why does monetary policy keep changing? There are good reasons to be careful about excessive liquidity. Easy money promotes inflation, which is a tax on people like the old and the poor whose incomes do not adjust in proportion to price hikes. Runaway inflation can have high economic and political costs. High inflation and low interest rates can be deadly to economies that are open to trade and investment flows, because the comparative rates of inflation across different countries determine how their currencies are valued. Since capital flows on expectations of future gains, rapid depreciation driven by inflation can signal trouble, leading to capital flight and making the crisis real. Trade flows too, are affected by exchange rate movements which change the relative prices of local and overseas goods. So governments and central banks tread carefully on monetary policy. They can't tighten money supply too much for fear of choking off domestic investment and exports through high interest costs and an appreciating currency. Nor can they afford easy money for long for fear of kicking off inflation, depreciation and capital flight. Monetary policy treads the thin line in between, adjusting continuously to global movements.

What is monetary policy?

Governments intervene in the economy by rewriting basic rules of investment, commerce and trade, by changing tax rates, or by playing with the amount of money available. Economists label changes in tax rates — broadly defined to include taxes, tar...

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