Monetory policy is intended to promote economic growth in a country and maintain stability in the society by making sure the exchange rate of the currency of the country does not drop and reduce the rate of unemployment.
The monetary policy can be further divided into two functional categories which are expansionary and contractionary policy.
The expansionary policy is a situation where the monetary authority puts into place tools which will lead to a boom in the economy. This will imply coming up with strategies that will make money circulate more into the economy in order to reduce unemployment.
On the other hand contractionary policy is a situation that involves the monetary authorities reducing the supply of money into the economy. In a situation of inflation in a country such a monetary policy like will turn to reduce the inflation. The strategies employed here can lead to an increase in unemployment and kill the spirit of excess borrowing for example through loans and therefore reducing the purchasing power.
During inflation the currency of the country turns to be worth less and therefore more money will be needed for the acquisition of the same amount of goods and services. When a country currency losses value its power in the exchange rate market to other currencies is reduced.
Inflation can be controlled in several ways and there are those that work and those that donot work.
One method that can be used to control inflation is the recession method which in most cases does not work. This involves reduction of wages and price control which can impact the population negatively by resulting in loss of jobs.
2. Contractionary monetary policy
The contractionary monetary policy is used to reduce the rate of inflation. This policy achieves its goal by increasing interest rates and decreasing bond prices. Contractionary policy makes less money availability and people turn to save than spend extravagantly. Similarly the high interest rate will scare borrowers. Among the contractionary methods we have:
2.1 Increase in interest rates
The Federal Reserve System which is controlled by the government can be used, for example in the U.S.A the Federal Reserve or simply the Fed serves as the central banking system in the USA. It was created as a consequence of financial panic especially that of 1907. Three major objectives where set in the Federal Reserve Act: making stable prices, moderate long – term interest rate and maximizing employment. Since banks in the country borrow money from the government in what is known as the Federal Reserve rate, if the interest rate increases the banks will be forced to increase their interest rates on customers and it will discourage them from taking much money from the bank and hence reduce the amount of money in circulation.
2.2 Open Market Operations (OMOs)
The Federal Reserve can also conduct transactions with primary dealers on open markets to reduce inflation. An open market is used to define a situation in which the economic system has no barriers to the free market activity. Though the Federal Reserve has in hand a variety of open market operations; the most frequently applied are securities purchases and tri-party. The tri-party are there to allow the introduction of a larger demand for collateral which will improve the potential to address long-drawn-out reserve needs which are anticipated for fourth quarter. In the other hand security purchases will involve the selling and buying of government securities in an open market to be able to contract or expand the available money.
2.3 Increase reserve requirement
This involves increasing the list amount of money the bank is legally allowed to keep at their disposal to cover withdraws. This means that since they have to hold more money they will have less to lend and this will reduce the money in the economy and thereby reduce inflation.
2.4 Reduce Money supply
In this process the government activates policies that seek to reduce the supply of money to the economy. This is because the less people hold money, it will decrease their habit to spend and increase the desire to save money. A direct influence to the market is that it will cause the sellers to reduce their prices. In a situation of inflation, little reduction in the amount of money supplied can reduce inflation.
In a situation that involves the devaluation of the currency of a country, due to high input of black currency of the same kind in the market it results to inflation. One decision to remove the legal value of the currency could be taken and the currency is thereafter removed from circulation.
2.6 Introducing a new currency
The last measure taken in a situation where there is inflation is to replace the existing currency by a new one. An exchange rate is fixed and the old currency changed to the new one. This usually happens in a situation of hyperinflation.