What is Tight Monetary Policy?
Tight Monetary Policy also known as contractionary monetary policy is focused on contracting (decreasing) the money supply in an economy.
A contractionary monetary policy is implemented by increasing key interest rates thus reducing market liquidity (money supply). Low market liquidity usually negatively affects production and consumption. This may also have a negative effect on economic growth.
When interest rates are increased, people tend to borrow less. Besides increasing interest rates, the central bank can also engage in open market operations, and sell assets in the market. Tight monetary policy and a tight fiscal policy, in spite of being different from one another, can be brought in sync by government authorities. This involves increasing tax rates or reducing government expenditure.
Difference Between Fiscal Policy And Monetary Policy
When RBI adopts a contractionary policy, the central bank
- increase Policy Rates (Interest Rates) like Repo, Reverse Repo, MSF, Bank Rate etc.
- increase Reserve Ratios like Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
- sells government securities from the market as part of Open Market Operations (OMO) – taking out liquidity from the market
Now, let’s also try to understand some advanced concepts associated with a contractionary monetary policy.
- A decrease in Bond prices: Contractionary monetary policy results in an increase in bank interest rates. When the rate of interest provided by banks keeps increasing, bonds which provide an interest rate fixed earlier may become less attractive. This may result in a fall in the demand for bonds and thus may result in a decrease in bond prices.
- A decrease in Foreign bond prices: Even though the demands for bonds as such may fall, the higher interest rates offered in India may make foreign bonds less attractive. So the demand for foreign bonds may fall and the demand for domestic bonds may rise.
- An increase in the exchange rate: Higher interest rates tend to be attractive for foreign investment. This may increase the currency’s relative value. An increase in interest rate may result in more foreign investment and thus more foreign currency. As the demand for domestic currency increases and the demand for foreign currency falls, an increase in the exchange rate may happen.
- A decrease in exports and BoP: A higher exchange rate may cause exports to decrease, imports to increase and the balance of trade to fall.
- Lower Capital Investment: Higher interest rates may lead to lower levels of capital investment.
Implications of a Tight Monetary Policy
- Tight, or contractionary, monetary policy seeks to slow economic growth to head off inflation.
- The Federal Reserve might increase reserve requirements, the amount of money banks must hold to cover deposits and increase the discount rate, the rate charged to banks which borrow money to cover reserve requirements.
- Due to an increase in the cost of borrowing money for banks, banks tend to hold money to avoid having to borrow.
- Actions such as these will result in reduced money supply and restrictions on credit availability for small businesses and consumers alike.
- Reduced credit and funds availability have an impact on the ability of businesses to expand and hire additional workers.
Top 4 Important Curves In Economics
What is an Expansionary (Loose) Monetary Policy?
Loose monetary policy also known as expansionary monetary policy is focused on expanding (increasing) the money supply in an economy. This is also known as Easy Monetary Policy.
An expansionary monetary policy is implemented by lowering key interest rates thus increasing market liquidity (money supply). High market liquidity usually encourages more economic activity.
When RBI adopts Expansionary Monetary Policy, the central bank
- decrease Policy Rates (Interest Rates) like Repo, Reverse Repo, MSF, Bank Rate, etc.
- decrease Reserve Ratios like Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
- buys government securities from the market as part of Open Market Operations (OMO) – providing liquidity in the market
Now, let’s also try to understand some advanced concepts associated with an expansionary monetary policy.
- Increase in Bond prices: Expansionary monetary policy results in a reduction in the bank interest rates. When the rate of interest provided by banks keeps falling, bonds which provide a fixed interest rate for a longer duration will become more attractive. This may drive up the demand for bonds and thus may result in an increase in bond prices.
- Increase in Foreign bond prices: Even though the demands for bonds as such may increase, the lower interest rates may make domestic bonds less attractive. So the demand for domestic bonds may fall and the demand for foreign bonds may rise.
- A decrease in the exchange rate: Lower interest rates tend to be unattractive for foreign investment. This may decrease the currency’s relative value. A reduction in interest rate may result in less foreign investment and thus less foreign currency. As the demand for domestic currency falls and the demand for the foreign currency rises, a decrease in the exchange rate may happen.
- Increase in exports and BoP: A lower exchange rate may cause exports to increase, imports to decrease and the balance of trade to increase.
- Higher Capital Investment: Lower interest rates lead to higher levels of capital investment.
Implications of a Loose Monetary Policy
- Loose, or expansionary, monetary policy seeks to stimulate production and employment through an increase in the availability of money and credit in the marketplace.
- Reducing the discount rate or reserve requirements provides banks with an incentive to loan money and make credit available.
- With the implementation of loose monetary policy, small businesses benefit from expanded credit opportunities, leading to increased investment, production and employment options.
Distinguishing Between Tight and Loose Monetary Policies
Look at current interest rates to determine if current monetary policy is tight or loose. Increasing interest rates on loans and credit opportunities represent a period of tightening monetary policy, while decreasing interest rates represent a period of loosening monetary policy. Small businesses looking to expand and invest are better served by taking advantage of the lower interest rates which mark the implementation of expansionary monetary policy.
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