Monetary Policy: Definition, Objectives, Instruments, Types and Indicators

What is meant by monetary policy ( monetary policy )? Understanding monetary policy is a policy issued by the Central Bank to manage a country’s money supply in order to achieve certain goals, for example maintaining the stability of the currency’s value, and increasing employment opportunities.

Another opinion said that the notion of monetary policy is the government’s efforts made through the Central Bank to control the macro economy so that conditions are better by regulating the amount of money in circulation and improving people’s welfare.

In Indonesia, this monetary policy is carried out through Bank Indonesia as a monetary authority to direct the national economy. In its implementation, monetary policy has a relatively shorter time lag compared to fiscal policy because Bank Indonesia does not need permission from the Parliament and cabinet in implementing monetary policy.

Monetary Policy According to Experts

In order to better understand what monetary policy is , then we can refer to the opinions of the following experts:

1. Boediono

According to Boediono, the notion of monetary policy is the action of the government (Central Bank) to influence the macro situation that is implemented, namely by balancing money supply with inventory so that inflation can be controlled, full employment opportunities and fluency in the supply / distribution of goods are achieved.

2. Perry Warjiyo

According to 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 activities carried out by considering the cycle of economic activity, the nature of a country’s economy, and other economic fundamentals.

3. Muana Nanga

According to Muana Nanga, 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 instability in the economy.

4. M. Natsir

According to M. Natsir, the definition of monetary policy is all actions or efforts of the central bank to influence the development of monetary variables (money supply, interest rates, lending rates, and exchange rates) to achieve the desired target.

Monetary Policy Objectives

As mentioned in the initial paragraph, the main objective of this policy is to achieve a more stable macroeconomic. For example increasing economic growth and equity, increasing employment opportunities, maintaining price stability, and maintaining balance of payment stability.

A more detailed explanation of the objectives of monetary policy is as follows:

Circulating the Rupiah as a medium of exchange in economic activities.
Maintaining stability between economic needs and price levels.
Optimizing the distribution of liquidity to enhance economic growth in various sectors.
Maintaining economic stability by controlling the flow of goods and services (productivity).
Maintaining the stability of prices in the market by controlling the level of inflation that occurs.
Help increase employment opportunities by increasing investment so that new jobs open.
Maintaining the stability of the Community Work Trade balance by increasing exports and reducing imports.

Monetary Policy Function

Monetary policy issued by the Central Bank has certain functions for a country’s economy. Following are some of the functions of monetary policy:

Serves to maintain the investment climate in a country.
Serves to create many jobs.
Help improve the stability of a country’s economic growth.
Help improve the balance of payments.
Maintaining the stability of currency exchange rates.
Maintain the balance of the price of goods and guard.
Controlling the inflation rate in a country.

Monetary Policy Instruments

In implementing monetary policy , the Central Bank utilizes various financial instruments. The instruments are as follows:

1. Direct Instruments

Determination of Interest Rates, which includes determining the level of interest rates on deposits or interest rates on Bank loans by Bank Indonesia.
Determination of the Credit Ceiling, which is the stipulation of the maximum amount of credit that can be distributed by banks.
Liquidity Ration, which is the obligation of Commercial Banks to maintain certain currencies in percent, to raise funds for government budget financing.
Direct Credit, which is the obligation of Commercial Banks to provide credit to certain sectors.

2. Indirect Instruments

Open Market Operations (OTP), namely the activity of buying and selling securities by the Central Bank and foreign exchange on the forex market. OMOs are carried out to influence interest rates, rupiah liquidity, inflation, and the exchange rate.
Discount Facility (DF), which is a monetary policy instrument that influences the circulation of money in the community through the determination of the Central Bank loan discount to Commercial Banks. The aim is to reduce the demand for credit from banks and limit the circulation of money.
Reserve Requirement (RR), which is the obligation of commercial banks to save certain mandatory reserves (RR) from third party funds in the Central Bank so that it affects the ability of commercial banks to extend credit.

Monetary Policy Types and Indicators

Monetary policy that applies in Indonesia can be divided into two types, the following explanation;

Contractive Policy, which is a policy that limits the amount of money in circulation due to high inflation.
Expansive policy, which is a policy that increases the money supply in which the aim is to increase people’s purchasing power when the economy is declining.

To determine the success rate of monetary policy, the Central Bank uses 3 indicators, namely;

Money Supply( Monetary Targeting )
Targeting Exchange( Exchange Rate Targeting )
Target Inflation( Inflation Targeting )

The following explanation is in the table:

Indicator	Definition	Advantages	Deficiency
Money Supply ( Monetary Targeting )	Establish growth in the amount of money circulating in the community as an intermediate target	It is possible to implement an independent monetary policy so that the central bank can focus on controlling inflation	> Its application depends on the stability of the relationship between the monetary amount and the final target (inflation). > Difficult to understand by ordinary people.
Targeting Exchange ( Exchange Rate Targeting )	Establish and adjust the value of the domestic currency against the currencies of large countries that have low inflation rates.	> Can reduce inflation. > Simple and easy for people to understand. > Exchange rate targeting is determined by rules that discipline monetary policy	> Prone to speculators. > Turmoil in a country can directly impact the domestic economy
Target Inflation ( Inflation Targeting )	Determination of the medium-term inflation target and commitment to achieve price stability as a long-term goal.	> Simple and very clear achievement targets. > Does not depend on the stability of the relationship between monetary quantities and the final target (inflation). > Improve central bank accountability > Monetary policy can be focused on achieving stability in the domestic economy	Signals to achieving targets are not as fast as previous approaches

Example of Monetary Policy

The following are some examples of monetary policies that have been carried out in Indonesia:

Bank Indonesia (BI) auctioned its certificates, or it could be by buying securities on the capital market
BI can reduce interest rates when economic conditions are in line with expectations. And conversely, BI can raise interest rates when it wants to limit economic activity so that money circulation is reduced.
When the economy goes into a recession, the circulation of money will be increased so that economic activity increases. One example is buying securities.
When inflation occurs, BI can reduce the circulation of money in society by selling securities, thereby reducing excessive economic activity.