Expansionary vs Contractionary Monetary Policy

Understand the difference between Expansionary and Contractionary Monetary Policy.

Monetary policy refers to the actions undertaken by a nation’s central bank to control the money supply. Control of money supply helps to manage inflation or deflation.

In India, the Reserve Bank of India (RBI) is in charge of the Monetary Policy.

The monetary policy can be expansionary or contractionary.

What is an Expansionary Monetary Policy?

An 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 adopt 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 advance 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. 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.

What is a Contractionary Monetary Policy?

A contractionary monetary policy is focused on contracting (decreasing) the money supply in an economy.

This is also known as Tight Monetary Policy.

A contractionary monetary policy is implemented by increasing key interest rates thus reducing market liquidity (money supply). Low market liquidity usually negatively affect production and consumption. This may also have a negative effect on economic growth.

When RBI adopt a contractionary monetary 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 advance 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. 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.

UPSC Question from the topic Expansionary/Contractionary Monetary Policy

UPSC CSE 2020) If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?

1. Cut and optimize the Statutory Liquidity Ratio
2. Increase the Marginal Standing Facility Rate
3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below :

a) 1 and 2 only
b) 2 only
c) 1 and 3 only
d) 1, 2 and 3

Correct Answer: b) 2 only