Q. Describe about Monetary policy?
By monetary policy we mean policy directed at controlling the money supply and interest rates. In most nations, central bank is responsible for monetary policy. It generally has complete or nearly complete control over:
- Overnight interest rates
- the monetary base
It also has some control over:
- Interest rates with longer maturity. Because loans with longer maturities are substitutes for overnight loans, central bank also has some control over longer interest rates. Control is larger for shorter rates.
- Money supply. Monetary base is only a small part of total money supply however the multiplier effect, central bank's control over the money supply is magnified.
- Inflation. For many central banks, it is the variable they are typically interested in controlling. For all central banks, it's a significant variable. Exactly how the central bank affects inflation by controlling overnight interest rate and monetary base is one of the most significant issues in macroeconomic theory.
As we shall see in the subsequent section, it's not possible to choose overnight interest rate and monetary base independently of each other. In most nations, main focus of central bank is on controlling the overnight interest rate instead of the monetary base. The subsequent section demonstrates that Central bank should increase the monetary base if it wants to lower the overnight interest rate. When it increases the monetary base, money supply will increase and we would observe a negative correlation between overnight rate and money supply.
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When the overnight interest rate decreases, the money supply increases
When the overnight interest rate increases, the money supply decreases
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