Meaning 

The use of interest rate and other instruments by the Central bank to influence money supply to achieve certain macroeconomic goals is known as monetary policy.

Objectives

• Monetary Policy provides guidance to policy makers.
• Accelerating growth of economy
• Price stability
• Exchange rate stabilization
• Balancing savings and investment

Monetary policy is the policy related to money supply in the economy.

RBI manages money supply. While managing money supply, the RBI keeps primarily two factors in mind (i) economic growth and (ii) inflation.

Relation between Economic Growth and Inflation

• Economic growth is desirable, whereas increase in inflation is undesirable.
• Decrease in Economic growth is undesirable whereas decrease in inflation is desirable.
• Usually both inflation and growth move in the same direction.
• With increase in money supply, people demand more products because they have more funds in hand. Greater demand for products leads to inflation (increase in price).
• At the same time, on account of an increase in money supply, people invest more money, leading to higher economic growth.
• In times of increase in money supply, inflation rate as well as economic growth increases. (One is undesirable, and the other is desirable).
• On the contrary, if there is a decrease in money supply, the rate of inflation as well as the growth rate decreases.

Working of Monetary Policy

• When inflation rates are high in the economy, the main focus of the RBI is to target inflation and, thus, the growth objective is side lined.
• Decreasing inflation is given priority over economic growth because inflation affects both rich and poor, whereas economic growth mainly benefits the rich.
• To counter inflation, demand needs to be reduced, so the RBI reduces the money supply in the economy by making credit dearer (costlier). Thus, in times of high inflation, the RBI adopts dear/tight money policy.
• On the contrary, when inflation rate is low or moderate, the main focus of the RBI is on increasing growth in the economy.
• Therefore, the RBI increases money supply by making credit cheaper. Thus, in times of low or moderate inflation, the RBI adopts cheap/easy money policy.

(See more about this in Types of Monetary Policy)