What is monetary policy?

Monetary policy is how central bank manage the money supply to guide healthy economic growth. The money supply is credit, cash, checks, and money market mutual funds. The most important of these is credit, which includes loans, bonds, mortgages, and other agreements to repay.

The major objective of central banks is to manage inflation. The second objective is to reduce unemployment, once inflation has been controlled.

Central banks reduce inflation by raising the lending rate to banks, selling securities through its open market operations or other measures to reduce liquidity.

Ideally, monetary policy should work hand in glove with the Central government's fiscal policy. However, it rarely works this way. That's because elected representatives prefer to spend revenue, cut taxes and reward voters.
As a result, fiscal policy is usually expansionary. To avoid inflation, monetary policy must be a little contractionary. Increasing money supply and reducing interest rates is expansionary policy and vice versa is contractionary policy.

All central banks use at least three tools of monetary policy, but most have many more. They all work by directly impacting the amount of liquidity in an economy. This is done by managing banks' reserves.

Open market operations, bank rate policy, reserve system, credit control, moral persuasion are major instruments resorted to by central banks to effect desirable changes in interest rates or the money supply in the overall economy. RBI lends (no collateral required for long term lendings) to the commercial banks through its discount window to help the banks meet depositors' demands and reserve requirements for long term. The interest rate the RBI charges the banks for this purpose is called bank rate. Every commercial bank has to keep money equivalent to certain proportion of its total liabilities with the RBI. Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and approved securities. Higher liquidity ratio forces commercial banks to maintain a larger proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances, thus it is an anti-inflationary impact.