Monetary policy is the macroeconomic policy set up by the Reserve Bank or the central bank of a country. Monetary policy can be simply explained as a manipulation of the demand side of money through tools such as an interest rate. This is done to help the government solving macroeconomic problems and to achieve macroeconomic goals

There are two types of monetary policy, contractionary monetary policy and expansionary monetary policy.

Lets talk about contractionary monetary policy. Reserve bank uses contractionary monetary policy to cut off inflation. The tool which Reserve bank use for cutting down the infation is Intrest rate. Reserve bank will increase the intrest rate, as a result of which the money supply is reduced and facilitate the central bank as well as the governmnet to curtail inflaion.

Now about Expansionary monetary policy, its just the opposite of what we said in the contractionary monetary policy. Reserve bank uses
Expansionary monetary policy to avoid recession. The tool which Reserve bank use for avoid recession is Intrest rate. Reserve bank will decrease the interest rate, as a result of which the money supply is increased and facilitate the central bank as well as the government to avoid recession, unemployment etc.

Tools of monetary policy

Open Market Operations

The first tool of monetary policy is Open market operations. Here reserve bank will buy or sell securities from/with commercial banks. When the central bank buys securities, it pumps cash to the banks, from there to people, and to the economy. When the central bank sells the securities, the cash holdings with banks reduces. The bank now has less to lend.

So to be precise Reserve bank buys securities when it wants to pump money into the economy ie during the expansionary monetary policy. It sells them when it wants to reduce the money supply ie during contractionary monetary policy.

Cash Reserve Ratio(CRR)

Central banks usually set up the minimum amount of reserves that must be held by a commercial bank. So the reserve bank will change this required amount based on economic condition. In case to increase the money supply in the economy the CRR will be reduced, which enables the banks to lend more money; and vice-versa

Bank rate

This is the re-discounting rate that RBI extends to banks against securities such as bills of exchange, commercial papers and any other approved securities. In recent years, it has been the repo rather than the bank rate that has acted as a guideline for banks to set their interest rates.

Statutory liquidity ratio

SLR denotes the percentage of investment that commercial banks should have in government approved securities. So in order to increase the supply of money or during expansionary policy Reserve bank will reduce SLR;and vice versa

Repo rates and reverse repo

Repo rates are the rates at which overnight lending are done by RBI or Central Banks to Commercial Banks. So in order to increse the supply of money or during the expansionary policy, the repo rates would be reduced; and vice versa.

The reverse is the reverse repo rate, its the rate at which the commercial banks give overnight loans to RBI.


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