What is the Monetary Policy?

The monetary policy has been defined as the policy that is used by the Federal Reserve (the central bank of the US) or the central bank (the central bank of India is RBI) along with the use of the supply of money to accomplish certain macroeconomic policies. Monetary policy is a supply-side macroeconomic policy that supervises the growth rate and money supply in the economy.

Types of Monetary Policy

There are two types of monetary policies which are as follows:

1. Contractionary monetary policy: Reduction of the supply of money in the economy is the aim of this monetary policy. Raising the reserve requirement for banks, selling off government bonds, and increment interest rates can be accomplished through this contractionary monetary policy. The government brings into play this contractionary monetary policy to control the level of inflation in the economy. 
2. Expansionary monetary policy: Increment of the supply of money in the economy is the aim of this monetary policy.  Decreasing the reserve requirements for banks, reducing the interest rates, and buying government securities by central banks are done in this policy.  Restoration of spending by the consumers and the business activities and unemployment can be lowered by the expansionary monetary policy. Stimulation of economic growth is also the objective of the expansionary policy. Moreover, higher levels of inflation can be the possible consequence of expansionary policy. 

Objectives of Monetary Policy

The objectives of monetary policy are as follows:

• Business cycle stabilization: Nominal and Actual GDP is controlled by monetary policy. The level of unemployment has an impact on monetary policy. For example, a reduction in the level of unemployment is due to expansionary monetary policy. Moreover, more job opportunities will come up, and restoring of business activities will happen due to increment in the supply of money. 
• Inflation: To keep a healthy important economy, it is important to keep levels of inflation lower. Using monetary policy, price stability can be achieved. 
• Stabilizing exchange rates: The exchange rate system is also an integral part of a monetary policy. Regulation of fiscal rates between the domestic and foreign currency can be done by commercial banks by utilizing its fiscal policy.

Tools of Monetary Policy

There are three tools of monetary policy which are as follows:

1. Open market operations (OMO): Purchasing and selling of government securities by the central bank to the public or to the banks are known as Open Market Operations (OMO) which affects monetary policy. Increment in money supply and lending consequently leads to obtaining more money by the banks.
2. Adjustment of interest rate: Discount rates can be changed when the interest rates were influenced by the central bank. In short-term loans, the interest rate which is charged by the central bank is known as the discount rate.
3. Requirements of reserve: The small amount of money that has to be kept in reserve by the commercial bank is usually set up by the central bank. The supply of money can be influenced by the central bank by changing the required amount of money to be kept by a commercial bank. Supply of money falls if the monetary authorities increase the small amount of money as a reserve then less amount is left with a commercial bank to lend to the borrowers.

The Equation of Exchange

In the classical model of macroeconomics, the quantity theory of money is the equation of exchange which states that the supply of money, when multiplied by the velocity of money, equals to price level when multiplied by real GDP. To understand the equation of exchange, at first, it is important to understand what the quantity theory of money is.

The Quantity Theory of Money

The quantity theory of money is the equation that shows the velocity of money is proportional to the price level in an economy.

Money supply x Velocity of money = Price level x Real GDP

i.e., M x V = P x Y

or, MV = PY

Where, M = Money supply

Y = Real GDP

P = Price level

V = Velocity of money

Total demand of money must be equal to the total supply of money

The relationship between the level of price and the supply of money in the economy also indicates the reason for the demand for money in the economy. The two versions of Quantity Theory of Money are as follows:

1. Cash balance version
2. Cash transaction version

Cash Balance Version

The cash balance version is the Cambridge version of the quantity theory of money. In this version, it is assumed that out of total money income, people keep a small amount of money. Let this small amount of money be (k). If the price level is P and the total output in the economy is Y, then PY is the total income in the country and M^d is the demand for money in the economy. Then,

M^d = kPY

Where, M^d = Demand for money in the economy

             k = Small amount of money which is kept by hands

             P = Price level 

             Y = Total output in the economy   

if M = the total supply of money is, then total demand is equal to the total supply of money i.e., M = M^d = kPY

or, M = kPY

Hence, this equation M = kPY is the Cambridge version of the equation. The price level and the money demand in the economy will go in the same proportion and direction. Moreover, k and the total output will be constant if there exists full employment in the economy.

Cash Transaction Version

The article, “The Purchasing Power of Money (1911)” written by American economist professor Irving Fisher has explained the cash transaction version of the quantity theory of money. The money demand and money supply determine the price level in the economy. Any changes in the value of money take place due to the changes in the quantity of money. An increment in the supply of money will take place if the level of price rises lead then the value of money i.e., purchasing power will fall and vice versa. Then,

Money supply x Velocity of money = Price level x Real GDP

M x V = P x T 

or, MV = PT 

Total demand for money = Total supply of money 

Total demand of money must be equal to the total supply of money

where, M = The money supply by the government

V = The velocity of money

P = Price level

T = Goods and services that are being bought and sold.

After solving the above equation for V, we get:

V = $\frac{\text{PT}}{\text{M}}$

The variable (T) also includes the new financial transactions along with the goods and services which are being produced in the economy and the transaction velocity of money will stay constant. Price level and money supply are directly proportional to each other.

Assumptions of cash transaction version

• The only medium of exchange is money and it is accepted for selling and buying goods and services. The need for money for making the transaction which also determines the demand for money.
• Full employment of all the factors of production and the total transaction of goods in an economy
• Aggregate demand for these goods is equal to the aggregate supply of these goods.
• There is the constant velocity of money in the economy. 

There lies a small difference between the Cambridge version and Fisher version of the quantity theory of money. There is a slight difference between the Cambridge version and Fisher version of the quantity theory of money. The total output in the year may not be equal to the total transactions which are taking place in the market in the year in other words, the goods produced in a year may not be equal to the goods which are being sold in a year in the market which indicates the presence of unsold goods.  

Now, we assume that (T = Y), we are neglecting the slight difference between T and Y and making the comparisons of both the equations of Fisher’s version (MV = PT) and Cambridge’s version (M^d = kPY) of quantity theory of money, we get:

k = $\frac{1}{\text{V}}$ or V = $\frac{1}{k}$

The velocity of money is decreasing 

⇒M = kPY

⇒M = $\frac{1}{V}$ PY

⇒MV = PY (Since k = $\frac{1}{V}$ )

Hence, it can be inferred from the above equation that Fisher’s version (MV = PT) and Cambridge’s version (M^d = kPY) of the quantity theory of money are complementary to each other where V is the velocity of the transactions and 1k is known as the velocity of the income of the money. 

Context and Applications 

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for

• Bachelor of Arts in Economics  
• Master of Arts in Economics