Monetary policy is divided into two categories, contractionary monetary policy and expansionary monetary policy. Contractionary monetary policy is a policy that reduces the money supply and increases interest rate. It aims to slow down economic growth in order to prevent or slow down inflation. Expansionary monetary policy is a policy that lowers interest rate and increases money supply. It aims to stimulate economic growth and to pull the country out of recession. There are different tools of monetary policy such as Open Market Operations, Discount Rate and Reserve Requirements.
The Open Market Operations are one of the major tools in monetary policy. It involves buying and selling bonds to regulate money supply in the country’s economy. In term of expansionary monetary policy, the central bank increases the money supply by buying bonds from commercial banks, and then the funds are increased and the commercial banks can use as loans to public. When there are more cash in the bank, the interest rates will be decreased and this promotes economic growth. In term of contractionary monetary policy, the money supply reduces as the central bank sells bonds to the commercial banks, the short term interest rate of banks increases and therefore it slows down the economic growth.
Discount Rate is the interest rate that commercial banks pay to borrow funds from central bank (U.S. Department of State, n.d.). This works when the public deposit money into commercial banks; commercial banks also deposit money into the central bank. At the same time, the central bank lends money to commercial banks and commercial banks lend money to the public. When there is inflation, the contractionary monetary policy is applied. The central bank charges a high discount rate so commercial banks will charge a higher interest rate so that they earn money from the public. The high interest rate causes less and less people to borrow money from bank. As a result, economic activities are slowed down. On the other hand, when the economy is in a recession period, the central bank lowers the discount rate. This causes commercial banks to decrease their interest rate and more people will start borrowing money and spend money. Therefore, economic activities are stimulated.
‘Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities’ (Board of Governors of the Federal Reserve System, n.d.). When the expansionary policy is applied, the central bank lowers the required reserve ratio. It means that commercial banks are able to keep less money in the central bank and there is more money in the banking system. Therefore, the supply of money increases and the interest rates of commercial banks are decreased. More individuals and businesses will borrow money from commercial banks. Economic activities are stimulated. As a result, it promotes economic growth. When the contractionary policy is...