What the central bank controls
Monetary policy is administered by the central bank and deals with money supply, inflation and interest rates, with two purposes: promoting economic growth and managing price stability, that is inflation. Like fiscal policy it is described by its stance.
| Expansionary | Contractionary | |
|---|---|---|
| Aim | Push the economy up | Cool down an overheated economy |
| Money supply | Increased steeply | Reduced, or its increase slowed |
| Interest rates | Reduced | Increased |
The tools
The central bank steers money supply and rates with a small set of instruments. The exam wants each one defined exactly.
Direction decides the first pair: the central bank lending is repo, the central bank borrowing is reverse repo. Location decides the second: CRR is cash parked with the central bank, SLR is assets the bank itself holds (gold, government securities). Bank rate is the odd one out because it needs no collateral and runs longer.
The central bank raises the repo rate and the CRR. Banks now pay more to borrow short-term liquidity and must park a larger slice of deposits as idle cash. Both reduce the money banks can lend and raise the price of what they do lend: a contractionary move aimed at inflation. A cut in both would be the expansionary mirror image.
Why the formula never works the same twice
There is no sure-shot recipe for slowing growth, inflation or exchange rate problems. Because economies differ in the composition of GDP, in growth rates and in demographics, the same policy action can produce different outcomes in different places. And an action taken to fix one problem can have unintended consequences and cause a fresh one. Stimulating a stagnant economy by expanding money supply, raising spending or cutting taxes risks pushing inflation up. Cooling an overheated economy with fiscal measures, raising taxes to pull money out of circulation or cutting spending, risks a slow-moving economy and high unemployment in the long run.
- Monetary policy, run by the central bank, deals with money supply, inflation and interest rates to promote growth and manage price stability.
- Expansionary policy pushes the economy up with a steep rise in money supply and lower rates; contractionary policy cools it by cutting money supply or slowing its growth and raising rates.
- Tools: repo rate (central bank lends to institutions against approved securities it promises to resell, very short term), reverse repo (central bank borrows against securities), bank rate (uncollateralised lending to commercial banks for medium to long term or emergencies), CRR (minimum share of deposits banks hold as cash with the central bank), SLR (minimum share held in cash equivalents such as gold and government of India securities).
- No sure-shot formula: the same action has different outcomes across economies, and fixing one problem can create another. Stimulus risks inflation; cooling measures risk a slow economy and high unemployment.