Monetary policy can be expansionary and contractionary in nature. Monetary policy is also concerned with maintaining a sustainable rate of economic growth and keeping unemployment low. Liquidity Trap Defined: A Keynesian Economics Concept, Expansionary vs. This theory states that the governments of nations can play a major role in influencing the productivity levels of the economy of the nation by changing (increasing or decreasing) the tax levels for the public and thus by modifying public spending. The Central Bank or the monetary authority of any country is generally mandated with the responsibility of conducting the national monetary policy, which essentially represents the delicate act of finding some balance between the demand for and supply of money, often … Monetary policy is concerned with changing the supply of money stock and rate of interest for the purpose of stabilising the economy at full-employment or potential output level by influencing the level of aggregate demand. Such adjustments can be made quickly, and monetary authorities devote considerable resources to monitoring and analyzing the economy. That is, the sum of consumption expenditure, private investment spending and Government expenditure exceeds the full-employment level of output by E1H. Therefore, modern Keynesians equally advocate for the adoption of discretionary monetary policy as for the discretionary fiscal policy to get rid of recession. According to Statutory Liquidity Ratio, in addition to the Cash Reserve Ratio (CRR) banks have to keep a certain minimum proportion of their deposits in the form of some specified liquid assets such as Government securities. A glance at Fig. Fiscal and monetary policies go hand in hand in the federal legislature, where annual budgets dictate government spending in certain economy-stimulating areas as well as the creation of jobs through social welfare initiatives. 29.3 that at a low rate of interest r0 demand curve for money Md is absolutely elastic showing people demand or hold on to all the increases in money supply beyond MS1 for speculative purposes and not invest in bonds. The price stability goal is attained when the general price level in the domestic economy remains as low and stable as possible in order to foster sustainable economic growth. As the Federal Reserve conducts monetary policy, it influences employment and inflation primarily through using its policy tools to influence the availability and cost of credit in the economy. He teaches at the Richard Ivey School of Business and serves as a research fellow at the Lawrence National Centre for Policy and Management. This influence exerted by the policy helps in curbing inflation, increasing employment and most importantly it helps in maintaining a healthy value of the currency. The government needs adequate revenue to fulfill responsibilities.The state cannot fulfill its duties in case of a shortage of money but excessive taxes cannot be imposed for increasing revenue. Similar to the Cash Reserve Ratio (CRR), in India there is another monetary instrument, namely, Statutory Liquidity Ratio (SLR) used by the Reserve Bank to change the lending capacity and therefore credit availability in the economy. Further, the effect of increase in investment on output and employment depends on the size of multiplier. It is generally agreed that a high degree of transparency and an effective communication of policy are necessary for the successful performance of central bank tasks. According to the monetary rule suggested by Friedman, money supply should be allowed to grow at the rate equal to the rate of growth of output. However, in some countries such as the USA the Central Bank (i.e., Federal Reserve Bank System) enjoys an independent status and pursues its independent policy. The empirical studies show that demand for money (liquidity preference) never becomes flat and instead it falls throughout. In times of recession or depression, expansionary monetary policy or what is also called easy money policy is adopted which raises aggregate demand and thus stimulates the economy. Monetary Rule: Monetary Policy Prescription: From the above analysis it follows that monetarists are not in favour of stabilising the interest rate, they advocate for the adoption of a rule rather than pursuing discretionary monetary policy to stabilise the economy. Monetary policy is important in decisions the United States government makes about economic practices and regulations, but equally important are the fiscal policies, which government spending and tax reform are geared toward in stimulating the economy. The liquidity provided by a constantly growing money supply will cause the aggregate demand to expand. Image Guidelines 5. Thus, according to moneterists, it is not the presence of certain inherent destabilising factors in a free-market economy but the monetary mismanagement by the discretionary monetary policies which is the root cause of economic instability that has been existing in the free market economies. In the Keynes’ theory, rate of interest is determined by the demand for and supply of money. Report a Violation, Monetary Policy: Meaning, Objectives and Instruments of Monetary Policy, Monetary Policy of India: Main Elements and Objectives, Public Expenditure: Meaning, Importance, Classification and Other Details. As explained above, tight monetary policy seeks to reduce the money supply through contraction of credit in the economy and also raising the cost of credit, that is, lending rates of interest. With greater reserves, commercial banks can issue more credit to the investors and businessmen for undertaking more investment. Contractionary Monetary Policy, Greed Is Good or Is It? Monetary policy is another important instrument with which objectives of macroeconomic policy can be achieved. 29.2.Now, if due to a large budget deficit and excessive creation of money supply, aggregate demand curve shifts to C + I2 + G2; inflationary gap of E1H comes to exist at full-employment level. But it is worth mentioning that there are several weak links in the full chain of increase in money supply achieving a significant expansion in economic activity. In its monetary policy strategy the Eurosystem has adopted a medium-term orientation. It is worth noting that it is the Central Bank of a country which formulates and implements the monetary policy in a country. For example, if expansionary monetary policy is adopted because the various economic indicators show the situation of mild recession then, due to the time lags involved, say six to eight months, for the policy to yield results, the economic situation might change and becomes reverse during that period and becomes one of mild inflationary situation. They therefore emphasized the role of fiscal policy for fighting severe recession. It should be further remembered that in our analysis of the successful working of the tight monetary policy it is assumed that demand for money curve (i.e., liquidity preference curve) is fairly steep so as to push up the rate of interest from r1 to r2 and further that investment demand curve II in panel (b) of Fig. 29.4 shows that with the rate of interest remaining unchanged at r0, the level of investment does not rise. Whereas transactions demand for money is determined by the level of national income, the speculative demand for money depends on the expectations regarding future rates of interest.During depression, current rate of interest may fall so low that most of the people expect the interest rate to rise in future and therefore they hold on to their money for the present. But the tight money policy to check the rate of interest from rising will lower the aggregate demand when the economy is recovering from recession, and will again cause the recessionary situation.