Monetary policy is the process to manage the supply of money in such a way, that specific goals such as price stability, employment, etc., are achieved. A central bank's measures to influence short-term interest rates and the supply of money and credit, to promote national economic goals are another way to define this policy.
In general, central banks serve the role of supervising the smooth operation of the financial system as well as monetary policy. They are generally given liberty to avoid interference from the ruling government.
This policy is said to be easy, loose or expansionary, when the quantity of money in circulation is being rapidly increased and short-term interest rates are thus being pushed down. On the other hand, it is called tight or contraction when the quantity of money available is being reduced, and short-term interest rates are thus being pushed to higher levels.
Its primary instrument is typically a short-term interest rate. Interest rates on loan contracts or debt appliances such as treasury bills, bank certificates of deposit, or commercial paper having maturities less than one year, often called money market rates, are short-term interest rates. In the future, the amount of goods and services the economy produces, and the number of jobs it generates, both will depend on the factors other than monetary policy. These include technology and people's preferences for saving, risk, and work effort.
Currently all central banks in industrialized countries adopt monetary policy through market-oriented instruments geared to influencing short-term interest rates as operating targets. They do so mainly by determining the conditions that stabilize supply and demand in the market for bank reserves
Factors to be considered
It is the total money available in a particular economy at a particular point in time. Also various sorts of things may be serving as money at the same time in any particular economy. Exact definition and measurement of the money stock presents some serious practical problems for the policy maker, who needs to use manipulation of the growth of the money stock as a tool of economic policy.
Open Market Operations
Nations central bank, (in the U.S., the Federal Reserve) sells or purchases government debt devices such as treasury bonds, treasury bills, treasury notes on the open financial markets, as part of its efforts to control the size of the money supply, and the levels of interest rates. Central bank verdict to buy government debt instruments make for an expansionary monetary policy, while sales of government debt instruments by the central bank represent a contractionary monetary policy.
Also a well-functioning good labor market form an important factor of competitiveness within the single monetary policy. Fiscal policy, also plays as an instrument of growth policy, through its effect on national saving, by means of the structural budget deficit, through incentive effects on work, saving and investment via tax rates and tax structure, and through public investment in human capital and physical infrastructure.
Price stability is the unique objective for monetary policy for long term. The upsetting effects of price instability in the economy are felt in the form of Business Cycles. When there are rapid changes in the price level there are fluctuations in the level of economic activities also. Price stability means that the average price as found by the wholesale or Consumer Price index fluctuate within a narrow range.
Both rise in price level and drop in price level cause disturbances and have bad effects on the economy. A monetary policy may reduce short-term interest rates by flooding the banks and financial markets with funds by providing loans, and yet at the same time may in fact raise longer-term interest rates by prompting fears among lenders that inflation will soon speed up.
Sadly, medium and long-term interest rates have much more pressure on the rate of growth of the economy and on levels of unemployment, than short-term interest rates do. It is because major new investment spending like research and development for new products or the construction of whole new factories are long-term projects that require financing, and they are less likely to be undertaken. It should therefore be very carefully planned and efficiently worked out, since it decides the economic growth of a country.