Objectives of Monetary Policy
The objectives of monetary policy may be different at different times and in different economic conditions.
During the pre-Keynesian times, the monetary policy was the only macroeconomic policy and the objective was only price stability. But after the 1930s the role of monetary policy was drastically changed. Broadly speaking, the objectives of monetary policy are as follows:
- Neutrality of money
- Exchange rate stability
- To correct disequilibrilium
- Price stability
- Full employment
- Economic growth with stability
Understanding these objectives individually,
Neutrality of Money
Classical economists believed that one of the main objectives of monetary policy was to maintain complete neutrality money. Money should not play an active role.
According to this objective, money is a passive factor. It functions only as a medium of exchange. Therefore the aim of money should be only to facilitate the barter exchange. It should not affect the functioning of economic forces like demand and supply.
With the neutral money supply, there will be disturbances in the economic system. But it is wrong to assume that a neutral money policy can check the business fluctuations in the economy. So, the neutral money policy has no practical use and abandoned from use.
Exchange Rate Stability
The maintenance of a stable exchange rate is an essential condition for the development of international trade. It creates international confidence and promotes smoothly the international trade on the largest scale. The importers and exporters know in advance how much they will have to pay and how much they will receive in terms of domestic currencies.
Any change in the equilibrium rate of exchange will have great repercussions on the balance of payments of a country. It is, therefore, essential to maintain stability in the exchange rates.
To Correct Disequilibrium
The objective of exchange stability could easily achieve an equilibrium balance of payments (BOP) of a country. Monetary policy plays an important role in bringing the BOP equilibrium without disturbing the stable exchange rate.
A country with a deficit in BOP, for example, adopts a restrictive monetary policy. Contraction of currency and credit as a result of the restrictive monetary policy brings down the price level within the country. This will encourage exports and discourage imports, which, in turn, will correct the disequilibrium in the BOP position.
The fourth of the objectives of monetary policy is price stability. It refers to the policy of keeping the value of money stable, which eliminates cyclical fluctuations and achieves economic stability. Price stability does not mean fixed or frozen price level.
In other words, price level does not mean that each and every price should be kept fixed. It simply means that the average of prices, i.e. general price level should not fluctuate beyond a certain limit. Generally, a 2-4 percent annual rise in prices is considered a stable price level.
The fluctuations in the price level bring uncertainty and instability to the economy. The rise or fall in the price level causes disturbances in economic relationships within a country as well as among countries. Therefore, the policy of price stability eliminating business fluctuation and promoting economic activity. It also leads to equitable distribution of and wealth in the society.
To achieve price stability, the central bank adopts contractionary monetary policy during inflation and expansionary monetary policy during deflation or economic depression. Therefore, the aim of this policy is to remove sharp fluctuation in the price level by monetary measures.
The fifth of the objectives of monetary policy is full employment. Keynes emphasized the role of monetary policy promoting full employment of human and natural resources in the country.
According to Keynes, unemployment is caused due to the deficiency of investment and the level of employment can be increased by increasing investment to the level that exceeds saving. So long as there are unemployed resources in the economy, an excess of investment over saving will lead to an increase in income and employment. Once full employment level is attained by the economy, investment and saving should be kept equal.
Thus, to achieve full employment, the monetary policy has to expand the money supply and reduce the rate of interest, which raises investment demand makes it equal to the full employment saving.
If investment exceeds saving at full employment level, inflationary forces will appear. If investment falls below saving at full employment level deflation will appear. Thus, monetary policy must maintain saving-investment equality at full employment.
The monetary policy which helps in increasing investment and achieving full employment is commonly called the cheap money policy.
Economic Growth with Stability
The objective of monetary policy has been shifted from price stability and full employment to economic growth and a direction of establishing a welfare state, which is a long-term policy.
Economic growth refers to a process whereby an economy’s real national income increases over a long period of time. Thus, economic growth means the transformation of the society of a country from a state of underdevelopment to a high level of economic achievement. Economic growth is measured by the increase in the number of goods and services produced in a country. In its wider aspect, economic growth implies raising the standard of living for the people and reducing inequalities of income distribution.
The monetary policy promotes sustained economic growth in the economy mainly in two ways:
Firstly, the monetary authority has the responsibility of maintaining equilibrium between the total money demand and the economy’s total productive capacity. To fulfill this responsibility the monetary policy must be flexible. There must be equilibrium between aggregate demand for money and aggregate supply of foods and services.
A restricted money policy will have to be applied when the aggregate demand for money exceeds the aggregate supply of goods and services that threaten to raise prices. On the contrary, when the aggregate supply of goods and services exceeds the total monetary demand, which causes the prices and employment in the economy to fall, the expansionary money policy should be adopted.
Secondly, monetary policy can promote growth by creating a favorable environment for saving and investment in the country. How can this favorable environment be created? Rising prices, on the one hand, discourage saving. On the other hand, price stability encourages saving. Saving is the principal source of supply of investable funds, i.e. capital.
In conclusion, sustained economic growth is not possible without capital formation. Capital formation is not possible without saving, which, obviously, would not be encouraged if prices are not stable. Thus, the aim of monetary policy should be the stability of prices in the economy.