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Monetary policy and interest rates

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Monetary policy is a procedure which helps the government to manage the circulation of money in the economy. Monetary policy is worked out by the government, central banks or the monetary authorities. The monetary policy along with the fiscal policy governs the money management in an economy (wikepedia2007 [online]). This policy is formulated to attain the economic goals of an economy. Monetary policy saw its independent existence in the 19th century. Earlier, the monetary policy was a part of fiscal policy in most of the nations. But keeping the changing trends of the market, the monetary policy was given its own entity .A monetary policy is formulated keeping in mind the current circulation of money in the economy, short term and long term interest rates, exchange rates, capital inflow of the foreign currency within the nation and etc. (Walsh nd).



Tools of Monetary Policy (wikepedia2007 [online]):

l        Monetary base: monetary policy can be used to change the amount of money that is circulating with in the economy

l        Discount window lending: the central bank that formulates the monetary policy can change the size of the money that is lent by it in the country

l        Reserve requirements: the monetary policy can regulate the minimum assets that various banks must hold. This changes the amount of cash that the banks can lend in the market

l        Interest rates: the monetary policy increases or decreases the interest rates to tackle the overheated economy or to reduce the state of unemployment with in the nation.


Monetary Policy and the Interest rates

The monetary policy is dependent upon the interest rates in an economy. This is the rate at which the money is actually borrowed (wikepedia2007 [online]). Basically, there are two types of monetary policies. The first type is called the expansionary policy. In this type of monetary policy the total circulation of money is increased in the market. This is done by lowering the interest rates (Reddy 2006). Lowered interest rates encourage people to borrow money to start new business. With the reduction of interest rates the capital investments are thereby increased. The expansionary type of monetary policy is thereby applied to combat the problem of unemployment. The lowering of interest rates in a monetary policy lowers the attraction towards the domestic bonds, whereas the foreign bonds become more popular. This in turn lowers the value of the domestic currency. The second type of monetary policy is the contraction monetary policy. In this type of monetary policy, the government hikes the interest rates to reduce the circulation of money in the market. This type is applied when the economy is facing the acute problem of inflation. It is seen that when the interest rates are high, people abstain from borrowing money and thereby the circulation of money in the market can be controlled. Hence, the capital investments are highly reduced. In contrast to the expansionary monetary policy, the domestic bonds gain popularity in comparison to the foreign bonds. This type of monetary policy in turn strengthens the domestic currency. Hence, the interest rates serve as a tool to manage an economy. Depending upon the state of the economy, the policy making authority that are generally referred to as the central bank decide the type of monetary policy that should be applicable for the nation.






Monetary Theory and Policy by Carl E Walsh


Macroeconomics and Monetary Policy by Y. V. Reddy


Wikipedia. (2007). Available: Last accessed 25 October 2007.


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