The Central Bank (Reserve Bank of India) will change the Monetary Policy based on the economic situation in the country either by increasing or decreasing the supply of money in the economy. The types of monetary policies are expansionary monetary policy and contractionary monetary policy which increase and decrease the money supply in the economy respectively. “Types of Monetary Policy” is one of the important concepts in the UPSC/IAS 2023 Economy syllabus which is discussed in this article in detail.

What is Monetary Policy?

• Monetary policy refers to a collection of activities that a country's central bank can take to control the entire money supply and achieve long-term economic growth.
• Monetary Policy can be broadly categorised into Expansionary and contractionary monetary policy.
• Interest rates can be raised or lowered, cash can be directly lent to banks, and bank reserve requirements can be changed.

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Types of Monetary Policy

Expansionary Monetary Policy

• The goal of an expansionary monetary policy is to increase the money supply in a given economy.
• Lowering key interest rates and enhancing market liquidity are used to implement an expansionary monetary policy.
• This is generally used when the economy is undergoing recession to boost the money supply and increase consumption and generate demand.
• It is also called as Dovish Monetary Policy.
• For Instance, due to the COVID-19 situation present in the country in March 2020, the RBI took an accommodative stance and reduced Repo Rate by 75 basis points from 5.15% to 4.40%.
• It also reduced the reverse repo rate from 4.9% to 4.00% and the Marginal Standing Facility rate from 5.40% to 4.65% to boost consumption.

Contractionary Monetary Policy

• The goal of contractionary monetary policy is to reduce (decrease) the money supply in an economy.
• Increases in key interest rates, which reduce market liquidity, are used to achieve a contractionary monetary policy.
• This is generally used when the economy is undergoing inflation to reduce the money supply and decrease consumption and reduce demand.
• It is also called as Hawkish Monetary Policy.
• For Instance, in August 2018 due to inflationary concerns (inflation was estimated around 4.8%) and falling rupee, the RBI maintained a neutral stance and increased Repo Rate by 25 basis points from 6.25% to 6.50%.
• It also reduced the reverse repo rate from 6.00% to 6.25% and the Marginal Standing Facility rate from 6.50% to 6.75% to reduce household demand.

Conclusion

To maintain the goal of the monetary policy framework and keep the inflation in the band of 2% above and below the 4% inflation target the RBI has used the monetary policy instruments to increase or decrease the supply of money in the economy.

GS Mains Questions and Model Answers

Q1: Discuss the objectives and significance of monetary policy in managing the economy.

Answer: The primary objectives of monetary policy are to maintain price stability, control inflation, manage the money supply, stabilize the currency, and foster economic growth. It plays a crucial role in regulating the cost and availability of money in the economy, which influences consumption, investment, and overall economic activity. By adjusting interest rates and using tools like the repo rate, cash reserve ratio, and open market operations, central banks can stimulate growth or curb inflationary pressures. Effective monetary policy ensures economic stability, promotes investor confidence, and supports sustainable development.

Q2: Compare and contrast expansionary and contractionary monetary policies with examples of their application.

Answer: Expansionary monetary policy aims to increase the money supply and stimulate economic growth. It typically involves lowering interest rates, reducing reserve requirements, or purchasing government securities. For example, during an economic downturn, a central bank may lower interest rates to encourage borrowing and spending. In contrast, contractionary monetary policy seeks to reduce the money supply to control inflation. This involves raising interest rates, increasing reserve requirements, or selling government securities. An example would be tightening monetary policy when inflation rates rise to prevent the economy from overheating. Both policies are used to maintain economic balance, depending on prevailing conditions.

Q3: Explain the tools used by the Reserve Bank of India (RBI) to implement monetary policy.

Answer: The Reserve Bank of India (RBI) uses various tools to implement monetary policy, including the repo rate (rate at which banks borrow from the RBI), reverse repo rate (rate at which banks deposit excess funds with the RBI), cash reserve ratio (CRR) (portion of deposits banks must hold as reserves), and statutory liquidity ratio (SLR) (percentage of deposits banks must maintain in cash or near-cash assets). Open market operations (OMOs), which involve buying or selling government securities, are another key tool. By adjusting these instruments, the RBI controls liquidity, influences interest rates, and manages inflation to ensure economic stability.

Previous Year Questions on Types of Monetary Policy

1. UPSC CSE 2020

Question: Evaluate the impact of expansionary monetary policy on economic growth and inflation.

Answer: Expansionary monetary policy, by increasing the money supply and lowering interest rates, stimulates economic growth by encouraging borrowing, investment, and consumer spending. This can lead to higher demand for goods and services, boosting production and employment. However, if not managed carefully, it may also lead to inflationary pressures as increased demand pushes prices higher. Balancing the positive effects on growth with the risk of inflation is a key challenge for policymakers. Effective use of expansionary measures requires monitoring economic indicators to avoid overheating the economy.

2. UPSC CSE 2019

Question: Discuss the role of contractionary monetary policy in controlling inflation and its potential side effects.

Answer: Contractionary monetary policy aims to reduce inflation by decreasing the money supply, raising interest rates, and discouraging borrowing and spending. By tightening liquidity, it curtails demand, helping stabilize prices. However, the side effects may include reduced consumer spending, lower investment, slower economic growth, and potential increases in unemployment. Policymakers must carefully balance these measures to ensure price stability without excessively stifling economic activity. Proper timing and calibration are essential to minimize negative impacts on growth while achieving the desired control over inflation.