Monetary Policy

Monetary Policy: Meaning, Objectives and Instruments of Monetary Policy

Meaning of Monetary Policy:
Monetary policy refers to the credit control measures adopted by the central bank of a
country.
Monetary policy is concerned with the measures taken to regulate the supply of money, the
cost and availability of credit in the economy. Further, it also deals with the distribution of
credit between uses and users and also with both the lending and borrowing rates of
interest of the banks. In developed countries the monetary policy has been usefully used for
overcoming depression and inflation as an anti-cyclical policy.
However, in developing countries it has to play a significant role in promoting economic
growth. As Prof. R. Prebisch writes, “The time has come to formulate a monetary policy
which meets the requirements of economic development, which fits into its framework
perfectly.” Further, along with encouraging economic growth, the monetary policy has also
to ensure price stability, because the excessive inflation not only has adverse distribution
effect but hinders economic development also.
Objectives or Goals of Monetary Policy:
The following are the principal objectives of monetary policy:
1. Full Employment:
Full employment has been ranked among the foremost objectives of monetary policy. It is
an important goal not only because unemployment leads to wastage of potential output,
but also because of the loss of social standing and self-respect.
2. Price Stability:
One of the policy objectives of monetary policy is to stabilise the price level. It may however
be noted that price stability does not mean absolutely no change in price at all. In a
developing economy like ours where structural changes take place during the process of
economic growth some changes in relative prices do occur that generally put upward
pressure on prices. Therefore, some changes in price level or, in other words, a certain rate
of inflation is inevitable in a developing economy.
Thus, price stability means reasonable rate of inflation. A high degree of inflation has
adverse effects on the economy.
First, inflation raises the cost of living of the people and hurts the poor most. Therefore,
inflation has been described as enemy No. 1 of the poor. Inflation sends many people below
the poverty line.
Secondly, inflation makes exports costlier and, therefore, discourages them. On the other
hand, due to higher prices at home people are induced to import goods to a large extent.
Thus, inflation has an adverse effect on the balance of payments.
Thirdly, when due to a higher rate of inflation value of money is rapidly falling, people do
not have much incentive to save. This lowers the rate of saving on which investment and
economic growth depend. Fourthly, a high rate of inflation encourages businessmen to
invest in the productive assets such as gold, jewellery, real estate etc.
3. Economic Growth:
One of the most important objectives of monetary policy in recent years has been the rapid
economic growth of an economy. Economic growth is defined as “the process whereby the
real per capita income of a country increases over a long period of time.”
4. Balance of Payments:
Another objective of monetary policy since the 1950s has been to maintain equilibrium in
the balance of payments.
Meaning of some monetary policy terms
Cash Reserve Ratio
Cash reserve ratio as the ratio which banks maintain between their holdings of cash and
their deposit liabilities, and sometimes referred to as the Cash Ratio.
Banks have to keep a certain proportion of their total assets in the form of cash, partly to
meet the statutory reserve requirement and partly to meet their own day-to-day needs for
making cash payments. Cash is held partly in the form of “cash on hand” and partly in the
form of “balances with the RBI”.
Higher the CRR with the RBI lower will be the liquidity in the system and vice-versa. RBI is
empowered to vary CRR between 15 percent and 3 percent. But as per the suggestion by
the Narshimam committee Report the CRR was reduced from 15% in the 1990 to 5 percent
in 2002. As of October 2012, the CRR is 4.5 percent. Current CRR is 4%.
Statutory Liquidity Ratio
Every bank is required to maintain a minimum percentage of their net demand and time
liabilities as liquid assets in the form of cash, gold and unencumbered approved securities.
This ratio of liquid assets to demand and time liabilities is known as statutory Liquidity Ratio
(SLR).
The difference between CRR and SLR is that cash Reserves are to be kept with the Central
Bank whereas statutory ratio is maintained by the commercial banks concerned. The SLR
operates as an instrument of monetary control in two distinct ways. One is by affecting the
borrowings of the government from the RBI and the other is by affecting the freedom of
banks to sell government securities or borrow against them from the RBI. In both the ways
the creation of High powered money is affected and thereby variations in the supply of
money. There was a reduction from 38.5% to 25% because of the suggestion by Narshimam
Committee. The current SLR is 19.50%.
Bank rate
The dictionary meaning of Bank Rate is the discount rate of a central bank. Now it is known
as the base rate and it is also called as the Minimum Lending Rate (MLR). It is the rate at
which the central bank lent to the other banks.
The Reserve Bank of India Act defines Bank Rate as ―the standard rate on which it is
prepared to buy or rediscounts bills of exchange or other commercial papers eligible for
purchase under this Act‖. That is why Bank Rate is known as the “Rediscount Rate”.
Generally, Bank rate policy aims at influencing the level of economic activity, the cost and
availability of credit to the commercial banks, and the interest rates and money supply in
the economy. There is a direct relationship between the bank rate and the market interest
rates. Changes in the bank rate influence the entire interest rate structure, i.e. short-term as
well as long term interest rates. A rise in the bank rate leads to a rise in the other market
interest rates, which implies a clear money policy increasing the cost of borrowing. Similarly,
a fall in the bank rate results in a fall in the other market rates, which implies a cheap money
policy reducing the cost of borrowing.
Repo rate
Repo is a money market instrument, which enables collateralized short-term borrowing and
lending through sale or purchase operations in debt instruments. Under a repo transaction,
a holder of securities sells them to an investor with an agreement to repurchase at a pre-
determined date and rate.
In short, Repo rate is the rate at which the RBI lends short term money to banks. When the
repo rate increases, borrowing from RBI becomes more expensive.
Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and
increase in Repo rate discourages the commercial banks to get money as the rate increases
and becomes expensive. As the rates are high the availability of credit and demand
decreases resulting to decrease in inflation.
Reverse Repo rate
Reverse repo rate is the rate at which banks park their short-term excess liquidity with the
RBI. The RBI uses this tool when it feels that there is too much money floating in the banking
system. An increase in the reverse repo rate means that the RBI will borrow money from the
banks at a higher rate of interest. As a result, banks would prefer to keep their money with
the RBI.
Marginal Standing Facility (MSF)
Marginal standing facility rate refers to the rate at which the scheduled banks can borrow
funds overnight from RBI against government securities. MSF is a very short term borrowing
scheme for scheduled commercial banks.
Instruments of Monetary Policy:
The instruments of monetary policy are of two types: first, quantitative, general or indirect;
and second, qualitative, selective or direct. They affect the level of aggregate demand
through the supply of money, cost of money and availability of credit. Of the two types of
instruments, the first category includes bank rate variations, open market operations and
changing reserve requirements. They are meant to regulate the overall level of credit in the
economy through commercial banks. The selective credit controls aim at controlling specific
types of credit. They include changing margin requirements and regulation of consumer
credit. We discuss them as under:
Bank Rate Policy:
The bank rate is the minimum lending rate of the central bank at which it rediscounts first
class bills of exchange and government securities held by the commercial banks. When the
central bank finds that inflationary pressures have started emerging within the economy, it
raises the bank rate. Borrowing from the central bank becomes costly and commercial banks
borrow less from it.
The commercial banks, in turn, raise their lending rates to the business community and
borrowers borrow less from the commercial banks. There is contraction of credit and prices
are checked from rising further. On the contrary, when prices are depressed, the central
bank lowers the bank rate.
It is cheap to borrow from the central bank on the part of commercial banks. The latter also
lower their lending rates. Businessmen are encouraged to borrow more. Investment is
encouraged. Output, employment, income and demand start rising and the downward
movement of prices is checked.
Open Market Operations:
Open market operations refer to sale and purchase of securities in the money market by the
central bank. When prices are rising and there is need to control them, the central bank sells
securities. The reserves of commercial banks are reduced and they are not in a position to
lend more to the business community.
Further investment is discouraged and the rise in prices is checked. Contrariwise, when
recessionary forces start in the economy, the central bank buys securities. The reserves of
commercial banks are raised. They lend more. Investment, output, employment, income
and demand rise and fall in price is checked.
Changes in Reserve Ratios:
This weapon was suggested by Keynes in his Treatise on Money and the USA was the first to
adopt it as a monetary device. Every bank is required by law to keep a certain percentage of
its total deposits in the form of a reserve fund in its vaults and also a certain percentage
with the central bank.
When prices are rising, the central bank raises the reserve ratio. Banks are required to keep
more with the central bank. Their reserves are reduced and they lend less. The volume of
investment, output and employment are adversely affected. In the opposite case, when the
reserve ratio is lowered, the reserves of commercial banks are raised. They lend more and
the economic activity is favourably affected.
Selective Credit Controls:
Selective credit controls are used to influence specific types of credit for particular
purposes. They usually take the form of changing margin requirements to control
speculative activities within the economy. When there is brisk speculative activity in the
economy or in particular sectors in certain commodities and prices start rising, the central
bank raises the margin requirement on them.
The result is that the borrowers are given less money in loans against specified securities.
For instance, raising the margin requirement to 60% means that the pledger of securities of
the value of Rs 10,000 will be given 40% of their value, i.e. Rs 4,000 as loan. In case of
recession in a particular sector, the central bank encourages borrowing by lowering margin
requirements.
Conclusion:
For an effective anti-cyclical monetary policy, bank rate, open market operations, reserve
ratio and selective control measures are required to be adopted simultaneously. But it has
been accepted by all monetary theorists that (i) the success of monetary policy is nil in a
depression when business confidence is at its lowest ebb; and (ii) it is successful against
inflation. The monetarists contend that as against fiscal policy, monetary policy possesses
greater flexibility and it can be implemented rapidly.