Monetary Policy – Meaning and Instruments

Monetary policy- Introduction

Monetary policy refers to that policy through which Central Bank of the country (Reserve Bank in India) controls i) the supply of money ii) availability of money, to attain a set of objectives focusing on growth and stability of the economy.

Monetary policy focuses on controlling the supply of money as the most patent mean of checking inflation.

Objectives of Monetary Policy –

a) Full Employment

This is the principal objective of monetary policy, particularly in less developed countries. Full employment refers to the situation, wherein all persons who are able to work and willing to work at the prevailing rate of wage get work.

To achieve it, the level of demand and output need to be substantially raised. For this purpose, the government adopts Cheap Money Policy. Under cheap money policy rate of interest is lowered in order to expand the availability of credit.

b) Economic Growth

Economic growth refers to the process of a sustained rise in real income per capita. In underdeveloped countries, income and standard of living of the people are low because of low production activity. Production capacity is low because of the low rate of capital formation. Accordingly, the government adopts the policy as may accelerate the rate of capital formation in the country.

c) Price Stability

Another objective of the monetary policy is to attain price stability in the country. Price stability means control of wide fluctuations in the general price level, in the economy in the form of inflation and deflation.

Monetary policy uses its instruments to stabilize on check upon inflation and deflation period.

d) Reduction in Economic Inequality

In capitalist and mixed economy there is widespread inequality in the distribution of wealth and income. As a result, society is divided into two classes – rich and poor.

Rich class exploits the poor. The monetary policy serves as an instrument of achieving equitable distribution of income and wealth through faster delivery of credit to the weaker section of the society at a lower rate of interest.

Monetary Policy – Meaning and Instruments

Instruments of Monetary Policy-

There are two instruments of monetary policy –

A) Quantitative Policy- Instrument

i) Bank Rate

Bank rate is an important instrument of credit control. Bank Rate is that minimum rate of interest at which Central Bank lends money to commercial banks.

Rise in bank rates – raises rate of interest (as used during inflation) – and contracts money in the economy.

On the other hand, fall in bank rate lowers the rate of interest (as used during deflation) – more money in the economy.

ii) Open Market Operations

When the central bank of a country, buys or sell, securities in open market, it is called ‘Open Market Operation’.

If the credit is to be contracted (during inflation), the central bank begins to sell the security in the open market.

On the contrary, if the central bank wants to expand credit (during the deflation), Central Bank begins to buy the security in the open market.

iii) Change in Minimum Reserve Fund –

Commercial banks are required to keep a given percentage of their total deposit as cash reserve with the central bank.

If the central bank wants to control credit (during inflation), it raises the cash reserve ratio.

On the other, if the central bank wants to expand credit (during deflation), it lowers the cash reserve ratio.

B) Qualitative Policy -Instrument

i) Change in Margin Requirement of Loans

Suppose a person estimates his house worth RS. 1crore with the bank, for a loan of RS. 80lakh. The margin requirement, in this case, would be rupees 20 lakh.

In Case of Inflation –

The margin requirement is raised when the supply of credit needs to be curbed or decrease.

In Case of Deflation –

The margin requirement is lowered when the supply of credit is to be increased.

ii) Rationing of Credit

The central bank is the lender of last resort to commercial banks, hence, if it so chooses, it can introduce rationing of credit in order to control credit.

Rationing of credit may have any of the variants:

a) The central bank can reduce the quantum of loan for all the banks.

b) The central bank can decline the loan to a specified category of the commercial banks.

c) Central Bank and fix quota for different banks.

 As a result of credit rationing, the flow of credit is restricted to combat inflation and deflation

iii) Direct Actions –

Sometimes the central bank may initiate direct action against the commercial bank functioning in order to combat inflation and deflation.

Monetary-Policy-Meaning-and-Instruments
Monetary-Policy-Meaning-and-Instruments

Monetary Policy and Economic Stabilization –

Economic or Internal stabilization implies minimum possible fluctuations in prices in the domestic market.

1) Monetary Policy as an Instrument to Combat Inflation

a) Restraint on New Currency

The central bank of the country as a note-issuing authority will restrain the issuing of new currency.

Lesser the quantity of money in the market, lower the purchasing power of the people, accordingly lower the demand for goods and services.

b) Increase in Rate of Interest

The central bank should raise the bank rate. It will lead to rising in the market rate of interest. Implies lower the demand for credit and, hence it will help in combating inflation.

c) Credit Control

The central bank should adopt quantitative and qualitative methods to control credit flow in the economy.

Minimum Cash Reserve Ratio of the bank is to be increased.

Security is to be sold in the Open Market.

Direct Action may be taken against the commercial bank in the situation of Inflation.

d) Demonetization

Replacement of old currency is known as ‘Demonetization’.

Accordingly, during a short period of time, the flow of credit becomes low, because of demonetization and, it will help in combating Inflation.

2) Monetary Policy as an Instrument to Combat Deflation

a) Liberalizing the Process of Note Issuing

The central bank of the country will liberalize the issuing of new currency.

More, the quantity of money in the market, more the purchasing powers of the people, accordingly, more the demand for goods and services.

b) Reduction in Rate of Interest

Central banks should reduce the bank rate. It will lead to falling in the market rate of interest, implies higher the demand for credit and hence, it will help in combating Deflation.

c) Easy Availability of Money

By adopting quantitative and qualitative methods, Central bank can correct the situation of deflation.

– Buying of Security in Open Market.

– Reduction in Cash Reserve Ratio

– Abolition of Direct Action.

Monetary Policy – Meaning and Instruments

Read here – Meaning of Macroeconomics

 Limitations of Monetary Policy –

 a) Unorganized Money Market

In underdeveloped countries like India, the money market is unorganized. It divides into two parts – One part includes, indigenous bankers like – money lenders, etc. and another part consists of commercial banks and special financial institutions.

Indigenous bankers are out of the jurisdiction of the central bank. These bankers are not under any obligation to implement the monetary policy laid down by the central bank.

By working against the monetary policy of the central bank, the indigenous bankers render that policy ineffective.

b) Non Monetized Sectors

In underdeveloped countries non monetized sector is quite significant.

In this sector, goods are exchanged for goods and, money is not used. Existence of this sector restricts the scope of monetary policy.

c) Black Money

In underdeveloped countries, a large quantity of black money is accumulated on account of political and economic factors.

Black money is used for activities such as hoarding, speculation etc.

It is therefore, becomes difficult to achieve the objective of monetary policy.

d) Illiteracy and Less Development of Banking

Most of the people are illiterate in underdeveloped countries. They, therefore, lack banking habits. Moreover, there, is less development of Banking

Because of the lack of banking habits, monetary policy has very little effect on large sections of society.

e) Non-Banking Financial Institutions

Non-Banking Financial Institutions like LIC, Investment Trust, etc also limit the effect of monetary policy by their activity in the economy.

Monetary Policy – Meaning and Instruments

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