Scribble and Scrawl: Monetary Policy and Inflation

The announcement of monetary policy is awaited by businesses and investors alike, who are eager to know the impact of the change in policy on their savings or on their business. Here we look at how monetary policy impacts the economy.The objective of Monetary policy is to control the supply of money to boost economic growth while keeping inflation within acceptable limit.

Some tools of monetary policy that are used by the central banks are:

1. Lowering of short-term Interest Rates:
This is the first tool used by the central banks around the world. When interest rates are lowered, it becomes cheaper to borrow money and less lucrative to save. This brings about a decline in savings; individuals and corporations are encouraged to spend, more money is borrowed, and more money is spent, thus increasing the overall economic activity.

2. Open Market Operations: Under OMO, the central bank buys bonds (from banks or general public) in the open market. By exchanging bonds for cash, the central bank increases money supply in the economy. Due to increase in the supply of money relative to demand, money can be borrowed at lower interest rates. This means that the short term interest rate for borrowing decreases. Conversely, if the central bank sells bonds, it decreases the money supply, drains liquidity and increases short term rates. Different countries have different ways of conducting OMOs. In India, effective instruments for OMOs are Liquidity Adjustment Facility (LAF) and Market Stabilization Scheme (MSS). Repo and Reverse Repo rate constitute the LAF system. Securities purchased and sold in OMOs are dated securities, T bills.

3. Reserve Requirement: The central bank has the ability to adjust banks' reserve requirements, which determines the level of reserves a bank must hold in comparison to specified deposit liabilities. By adjusting the reserve ratios, the central bank can increase or decrease the amount of money that banks can lend.

4. Quantitative Easing: When interest rates are near zero but still the economy remains stalled, then central banks start supplying money from their reserves to the financial institutions by purchasing assets. The central bank purchases assets (government securities or other securities from the market) by spending the money it has created. Through QE, the central bank increases the quantity of money supply and that results in increased spending and in increased consumption, which increases the demand for goods and services, fosters job creation and, ultimately, creates economic vitality. Quantitative easing is generally used a last resort by policy makers. Though both QE and OMO involve purchase of assets, but QE involves purchase of longer duration assets, and mortgage backed securities.

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Other effects of monetary easing:

Since it takes time for productivity to increase (due to policy bottlenecks, lack of infrastructure, technology constraints etc), till the time productivity increases, supply of goods and services remains more or less the same. So with more money available to buy a finite set of products, prices go up, resulting in inflation. For this very reason, central banks tend to hold back rate cuts or even hike interest rates when inflation data is high.
When the interest rates on bank deposits go down, investors move to the stock market and buy shares in hope of higher returns. As a result markets tend to react positively to the news of a interest rate cut or to QE. But, when continued for a long time expansive monetary policy has led to creation of bubbles in stock markets and real estate markets, as had happened in Japan in the early 1990s. Withdrawal of QE, takes cash out of circulation and tightens the money supply. That is the reason why markets react negatively to the news of reduction in QE.