Monetary Policy: Definition, Types, Objectives and Instruments

Definition of Monetary Policy – Monetary policy is a policy in an effort to control the country’s economy on a macro basis to achieve a better economy by regulating the amount of money in circulation. A good economy itself can be seen from price stability through a controlled inflation rate, Sinaumed’s. Check out the details below, Sinaumed’s.

Definition of Monetary Policy

Monetary policy is the process of regulating a country’s money supply to achieve certain goals, for example controlling inflation, achieving full employment or more prosperity. Monetary policy can involve setting loan interest standards, ” margin requirements “, capitalization for banks or even acting as last resort borrowers or through negotiated agreements with other governments.

Monetary policy is basically a policy aimed at achieving internal balance (high economic growth, price stability, equitable development) and external balance (balance of payments) and achieving macroeconomic goals, namely maintaining economic stability as measured by employment opportunities, stability prices and a balanced international balance of payments.

If stability in economic activity is disrupted, then monetary policy can be used to recover (stabilization measures). The influence of monetary policy will first be felt by the banking sector, which will then be transferred to the real sector. Monetary policy is an effort to achieve high levels of economic growth in a sustainable manner while maintaining price stability.

To achieve this goal, the Central Bank or the Monetary Authority seeks to regulate the balance between the supply of money and the supply of goods so that inflation can be controlled, achieving full employment and smooth supply or distribution of goods. Monetary policy is carried out, among others, with one but not limited to the following instruments, namely interest rates, minimum reserve requirements, intervention in the foreign exchange market and as the last place for banks to borrow money when experiencing liquidity difficulties.

Understand other popular terms such as economics, monetary, finance, and banking through the Dictionary of Popular Terms: Economics, Monetary, Finance, Banking which is below.

Definition of Monetary Policy According to Expert Opinions

The following is the definition of monetary policy according to experts including:

  • Muana Nanga : The definition of monetary policy is a policy carried out by the monetary authority by controlling the money supply and interest rates to influence the level of aggregate demand and reduce economic instability.
  • Boediono Monetary : What is meant by monetary policy is the action of the government through the Central Bank to influence the macro situation which is carried out by balancing the money supply with the supply of goods so that inflation can be controlled, achieving full employment opportunities and smooth supply or distribution of goods.
  • M. Natsir : What is meant by monetary policy is any action or effort by the central bank to influence the development of monetary variables (money supply, exchange rates, interest rates, and credit interest rates) to achieve the desired goals.
  • Perry Warjiyo : Monetary policy is the policy of the monetary authority or central bank in the form of monetary aggregates to achieve the development of economic activity which is carried out by taking into account the cycle of economic activity, the nature of a country’s economy and other fundamental economic factors.

Types of Monetary Policy

Two types of monetary policies can be taken as steps to influence the money supply. These policies are expansionary monetary policy and contractionary monetary policy, as follows:

1. Expansive Monetary Policy

Expansionary Monetary Policy is often called Loose money policy (easy money policy) is a policy that regulates the amount of money supplied in the economy. This is done by lowering interest rates, buying government securities by the central bank, and lowering reserve requirements for banks. Expansionary policies will also reduce the unemployment rate and stimulate business activity or consumer spending activities.

Overall, in all countries, the objective of expansionary monetary policy is to increase economic growth with the risk that inflation will be even higher. Expansive monetary policy mainly increases the money circulating in society so that the wheels of the economy run faster. This policy is able to increase people’s purchasing power (demand) and reduce the number of unemployed when the economy is experiencing a recession or depression. Expansionary monetary policy also affects the unemployment rate in a country.

For example, expansionary policies are usually implemented to reduce the unemployment rate because the availability of large amounts of money will stimulate business activity so that the labor market gets bigger. With fiscal authority, the central bank controls the exchange rate of the domestic currency (Rupiah) against foreign currencies. A concrete example is that the Indonesian bank increases the money supply by issuing more printed money. Rupiah currency becomes cheaper than other countries’ currencies.

Learn other existing monetary policies in Indonesia through case studies discussed in the book Monetary Economics by Prof. Dr. Haryo Kuncoro, SE, M.SI.

2. Contractive Monetary Policy

Contractive Monetary Policy is a policy in order to reduce the amount of money in circulation. This policy was carried out when the economy experienced inflation. Also known as a tight money policy (tight money policy). Contractive monetary policy (monetary contractive policy) which is called tight money policy (tight money policy) is a policy of reducing the amount of money in circulation.

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The main objective of this policy is to reduce the inflation rate. The goal of contractionary monetary policy is to reduce the money supply in the economy. This goal can be achieved by increasing interest rates, selling government bonds, and increasing reserve requirements for banks.

Examples of Monetary Policy in Indonesia Some examples of monetary policy that have been implemented in Indonesia are as follows: Bank Indonesia (BI ) conducts certificate auctions, or it could also be through purchasing securities in the capital market. UBI may lower interest rates if economic conditions match expectations. Conversely, BI can raise interest rates if it wants to limit economic activity so that the flow of money decreases.

When the economy experiences a recession, the circulation of money will increase so that economic activity increases. An example is buying securities. When there is inflation, BI will reduce the flow of money to the public by selling securities to reduce excessive economic activity.

Prof. Dr. Ali Wardhana as the Governor of the World Bank and International Monetary Fund expressed how hard it was for him to escape from the pressure of developed countries’ policy formulations in the global economic crisis discussed in Prof.’s book. Dr. Ali Wardhana: Monetary and Fiscal Policy Reformer in Indonesia.

Monetary Policy Objectives

Bank Indonesia has the goal of achieving and maintaining stability in the value of the rupiah. This objective as stated in Law no. 3 of 2004 article 7 concerning Bank Indonesia. What is meant by stability in the value of the rupiah includes stability in the prices of goods and services as reflected in inflation.

To achieve this goal, since 2005 Bank Indonesia has implemented a monetary policy framework with inflation as the main target of monetary policy (Inflation Targeting Framework) and adheres to a free floating exchange rate system.

The role of exchange rate stability is very important in achieving price and financial system stability. Therefore, Bank Indonesia also implements an exchange rate policy to reduce excessive exchange rate volatility, not to direct the exchange rate at a certain level.

In practice, Bank Indonesia has the authority to conduct monetary policy by setting monetary targets (such as money supply or interest rates) with the aim of maintaining the inflation rate target set by the Government. Bank Indonesia can also implement monetary control measures based on Sharia Principles. In summary, the objectives of monetary policy include:

1. Economic Stability

Economic stability is a condition in which economic growth takes place in a controlled and sustainable manner. That is, the growth of the flow of goods/services and the flow of money is running in balance.

2. Job Opportunities

Job opportunities will increase if production increases. An increase in production is usually followed by an improvement in the fate of the employees in terms of wages and work safety. Improvements in wages and work safety will increase the standard of living of employees and ultimately prosperity can be achieved.

3. Price Stability

Price stability is characterized by the stability of prices of goods from time to time. Stable prices cause people to believe that buying goods at the current price level is the same as future price levels, or the purchasing power of money over time is the same.

4. International Balance of Payments

The balance of payments can be said to be in a balanced state if the total value of goods exported equals the value of goods imported. To get a balanced balance of payments, the government often implements monetary policy. An example is by devaluing.

5. Maintain stability and economic growth

Maintaining price stability from the large amount of money in circulation, Increasing employment opportunities, Improving the position of the trade balance and balance of payments, if the state devalues ​​the rupiah into foreign currencies.

Monetary Policy Instruments

Monetary policy is an economic policy that regulates the rate of growth and circulation of money within a country. The main macroeconomic variables that are regulated by monetary policy are inflation and unemployment.

The ways that characterize monetary policy are the regulation of interest rates, buying and selling of government securities, and changing the amount of cash circulating in the market. The central bank or state financial regulatory agency such as the Ministry of Finance is responsible for the formulation of monetary policy. The main objectives of this policy are inflation management, unemployment management, and maintenance of currency exchange rates.

Monetary policy can set targets regarding inflation rates, interest rates, and currency values. The Central Bank is the main actor in implementing monetary policy directly and indirectly. Examples of direct monetary policy are printing new money, freezing balances of private/state companies, overhauling the banking system, taking over banking/credit affairs, and many more.

The central bank participates in money circulation and banking credit traffic. Meanwhile, an example of indirect monetary policy is giving influence to the provision of credit by the banking world. The regulation of money supply in society is carried out by increasing or decreasing the amount of money in circulation.

Learn about monetary policy including economic activity cycles, policy targets, to case studies in Indonesia through the book Fiscal & Monetary Policy: Theory & Empirical.

Monetary policy can be carried out by implementing monetary policy instruments, the aim of which is to regulate the amount of money in circulation in order to maintain price stability, both direct and indirect instruments. Some of the main instruments, including:

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1. Discount Facility (Discount Rate)

The Discount Facility is the interest rate set by the government on commercial banks that borrow money from the central bank. When commercial banks experience conditions that require them to borrow money from the central bank, the government can use this opportunity to regulate the amount of money in circulation.

If the government wants to increase the amount of money in circulation, then the government will lower the loan interest rate or discount. When loan interest rates decrease to become cheaper, commercial banks will be more interested in borrowing money from the central bank.

Conversely, when the government wants to reduce the amount of money in circulation, the government will raise interest rates. The increase in interest rates will reduce the intention of commercial banks to make loans at the central bank so that the government can reduce the rate of increase in the money supply.

2. Open Market Operations

Open Market Operations (OMO) are one of the most important indirect monetary policy instruments due to their very flexible nature compared to other instruments. OPT is carried out by the government to control the amount of money in circulation by selling (open market selling) or buying (open market buying) government-owned securities.

a. Open Market Selling is done when the government wants to reduce the amount of money in circulation by selling securities in circulation. When the government sells these letters to the public, the money used by the public to buy these letters will go to the monetary authority. Finally, the money circulating in society is getting less.

b. Open Market Buying is done when the government wants to increase the amount of money in circulation by buying securities in circulation. When the government buys securities from the public, the money circulating in the community will increase.

In Indonesia, monetary policy in the form of OMOs is carried out by selling or buying securities consisting of Bank Indonesia Certificates (SBI, Money Market Securities (SBPU) and Government Securities (SBN) which are divided into Government Securities (SUN) consisting of from State Treasury Bills (SPN) and State Bonds including Zero Coupon Bonds (ZCB) and State Retail Bonds (ORI), State Sharia Securities (SBSN) including Retail SBSN.

When the government wants to reduce the amount of money in circulation, the government will sell various securities, conversely, when the government wants to increase the amount of money in circulation, the government will buy back various securities that have been sold previously.

3. Reserve Requirement Ratio

When the minimum required reserve is reduced, the bank has more money that can be circulated in society through loans. Conversely, if the government wants to reduce the amount of money in circulation, then the government can increase the minimum amount of mandatory bank reserves so that banks have less money to circulate.

When the minimum required reserve is reduced, the bank has more money that can be circulated in society through loans. Conversely, if the government wants to reduce the amount of money in circulation, then the government can increase the minimum amount of bank mandatory reserves so that banks have less money to circulate.

4. Moral Appeal (Moral Persuasion)

Monetary policy instruments in the form of moral appeals can be carried out by the central bank to control the amount of money in circulation through various means. The central bank can urge commercial banks to lower or increase their lending rates.

The central bank can also provide advice to these banks to be careful in providing credit to the public or to limit their desire to borrow money from the central bank through the Discount Facility. In addition to these 4 instruments, Bank Indonesia has several other monetary policy instruments, such as:

  • Direct Credit, namely Bank Indonesia provides credit directly to sectors, programs, projects or activities that are urgent in nature and must be prioritized. This direct credit will increase the amount of money circulating in the community because it is used to finance prioritized programs or activities.
  • Determination of Import Advances whereby importers are required to pay a certain percentage as an advance payment for the purchase of foreign exchange that they need to import goods from abroad. With the establishment of this instrument, the government can regulate the amount of money circulating from the import side and can control the country’s foreign exchange.
  • Overdraft Facility (Overdraft Window) in which Bank Indonesia will provide very short-term loan facilities to banks experiencing short-term liquidity (disbursement) difficulties. The interest rate applied to this facility is higher than other loan sources so that it can control the amount of money in circulation.
  • Rupiah intervention in which Bank Indonesia lends and borrows funds directly at the Interbank Money Market (PUAB) overnight for up to 7 days to assist instruments for Open Market Operations.
  • Bank Indonesia Wadiah Certificates (SWBI) are instruments that were originally created by Bank Indonesia as facilities for Islamic banks, but this does not rule out the possibility that these SWBIs will be used to assist Open Market Operations. The implementation of SWBI is not carried out by auction but instead opens a window so that it is similar to the central bank deposit facility. Furthermore, banks will increase the interest rates they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.