Any economy in the world tries to achieve certain goals which are called macroeconomic variables/goals. These goals are interrelated and they try maintaining good balance between those goals. Macroeconomic goals are
01. Achieving economic growth
02. Maintaining low inflation
03. Low unemployment
04. Avoid negative balance of payments
05. Avoiding heavy fluctuations in exchange rates
These goals are contradicting with each other and economy has to maintain a healthy balance between these variable for their survival.
Monetary policy can be explained as government using interest rate to adjust/control the level of aggregate demand, money supply and the inflation level of an economy. Government exercises monitory policy through activities of central bank by influencing interest rates, open market operations, adjusting reserve requirements and etc. By doing so, government influences the aggregate demand, money supply, inflation, unemployment, exchange rates and balance of payment.
Central bank is the banker to the government and in charge of controlling monetary policy of an economy. Central bank interferes in deciding lending rates and they control the money supply of the market by conducting open market operations and imposing certain reserve requirements for commercial bank. And also they act as the advisor for the government in designing and adopting the monetary policy.
The central bank can influence macroeconomic goals in many ways. Ways in which that the central bank exercise their influences are called monetary policy tools. There are many monetary policy tools such as:
Open market operations are the transactions performed by Central Bank to buy or sell securities such as treasury bills and treasury bonds in order to control the money supply of the economy. This means central bank issues securities in order to reduce the money supply in the market and thereby reduce aggregate demand, price levels and inflation. Reduction in inflation makes exports cheaper and imports expensive which will help to maintain balance of payment equilibrium as imports will be less than the exports. On the other hand reducing aggregate demand and inflation can lead to increase in unemployment levels. If the government buys back the issued security it will have opposite consequences to what is mentioned above.
If the interest rates are set high it will lead to increase in the savings and thereby reducing the consumption and reduce the aggregate demand. This will reduce the money supply and inflation, reduce economic growth due to fewer investments in the economy and increase unemployment. When interest rates on deposits are made relatively higher than the other countries, foreign investors will be attracted to invest their money in local banks. This will create demand for domestic currency and as a result value of the domestic currency will appreciate. And also when foreign investments are attracted there will be capital inflow and this will lead to a favorable balance of payment. If the interest rates were set low it will have opposite consequences to what is mentioned above.
Reserve requirement is the amount of money/deposit that a commercial bank has to deposit at Central bank which is calculated based on the deposits held by the commercial bank. This means the central bank order commercial banks to keep a certain percentage of their deposits by customers with Central bank. When the reserve percentage is increased it reduces the bank’s ability to lend and this will reduce the consumption and thereby reduce the aggregate demand, inflation and economic growth. This will also result increase in unemployment. If the bank reduces the reserve percentages it will lead have opposite have opposite consequences to what is mentioned above.
Commercial banks hold certain amount of deposits with central bank and central banks pays an interest/return for the deposits made. From time to central bank changes the interest rate paid on these deposits to alter the money supply. When the interest rate on deposits are made higher than the normal lending rates of commercial banks, commercial banks would prefer to deposit money with central bank rather than lending money to general public. This would reduce the amount of landings and thereby reduce the consumption, aggregate demand and inflation. But this can increase the unemployment level and the economic growth. If the interest rates on deposits are set low it will have opposite consequences to what is mentioned above