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MONETARY POLICY

Meaning of Monetary Policy
Monetary Policy of India is formulated and executed by Reserve Bank
of India to achieve specific objectives
...
It refers to the policy measures
undertaken by the government or the central bank to influence the
availability, cost and use of money and credit with the help of monetary
techniques to achieve specific objectives
...
e
...

The techniques of monetary policy are the same as the techniques of
credit control at the disposal of the central bank
...
R
...
Kent defines
monetary policy as the management of the expansion and contraction of the
volume of money in circulation for the explicit purpose of attaining a specific
objective such as full employment
...
J
...
”

▪

In the words of D
...
Rowan, “The monetary policy is defined as
discretionary action undertaken by the authorities designed to
influence (a) the supply of money, (b) cost of money or rate of interest
and (c) the availability of money
...
It involves
the management of money and credit for the furtherance of the general
economic policy of the government to achieve the predetermined objectives
...
Different objectives

clash with each other and there is a problem of selecting a right objective for
the monetary policy of a country
...

Types of Monetary Policy
There are three common types of monetary policy
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Expansionary Monetary Policy
2
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Unconventional Monetary Policy
1
...
It involves
increasing the money supply and lowering the interest rates
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The increased economic activity leads to more employment
opportunities

thus

decreasing

unemployment
...
It is also
known as Easy Money Policy or Loose Money Policy as central banks seeks
to increase the money supply by lowering the interest rates
...
Contractionary Monetary Policy
Contraction monetary policy is the monetary policy which is used to
fight the inflation in economy
...
As reduction in money supply increases the
interest rates, the borrowers will be reluctant to borrow the money due to
higher borrowing cost which ultimately reduces the economic activity
...

It is also known as tight money policy as central banks seeks to reduce the
money supply by restricting credit by increasing interest rates
...
Unconventional Monetary Policy
Unconventional monetary policy is pursued by central banks when
their traditional instruments of monetary policy cease to achieve their goals
...

Objectives of Monetary Policy
According to RBI Governor Dr
...
Subba Rao, “The objectives of monetary
policy in India are price stability and growth
...
” Following are the main objectives of monetary
policy:
i
...
Monetary policy is farmed to regulate the money
supply in the economy by credit expansion or credit contraction
...
By credit contraction (giving less loans) money supply can

ii
...


be decreased
...
In other words, monetary policy
aimed at expanding and contracting money supply according to the
needs of the economy
To Attain Price Stability:
Another major objective of monetary policy in India is to maintain
price stability in the country
...
Price
level, is affected by money supply
...

To promote Economic Growth:
An important objective of monetary policy is to make available
necessary supply of money and credit for the economic growth of the
country
...
iv
...
Higher rates of interest promote saving and investment
...


To Control Business Cycles:
Boom and depression are the main phases of business cycle
...
In period of
boom, credit is contracted, so as to reduce money supply and thus
check inflation
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v
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To Manage Aggregate Demand:
Monetary authority tries to keep the aggregate demand in balance
with aggregate supply of goods and services
...
Because of low interest rate, more people take loan to
buy goods and services and hence aggregate demand increases and

vi
...

vii
...
Priority sector includes
agriculture, small- scale industry, weaker sections of society, etc
...
To Promote Employment:
By providing concessional loans to productive sectors, small and
medium entrepreneurs, special loan schemes for unemployed youth,
monetary policy promotes employment
...

To Develop Infrastructure:

x
...
It provides
concessional funds for developing infrastructure
...
RBI has
expanded banking to all parts of the country
...
Besides it, government
has also set up cooperative banks and regional rural banks
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Quantitative, general or indirect (CRR, SLR, Open Market
Operations, Bank Rate, Repo Rate, Reverse Repo Rate)
...
Qualitative, selective or direct (change in the margin money, direct
action, moral suasion)
These both methods affect the level of aggregate demand through the
supply of money, cost of money and availability of credit
...
Policy instruments are meant to regulate the overall level of
credit in the economy through commercial banks
...
They include changing margin
requirements and regulation of consumer credit
...
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
...
There is contraction of credit and prices are
checked from rising further
...

It is cheap to borrow from the central bank on the part of
commercial banks
...

Businessmen are encouraged to borrow more
...

government = money supply ^ = sell bonds = reduction in money supply = (buy bonds) = money supply

b
...
If government wants to reduce money supply, it issues these
bonds
...
Similarly, to increase the money supply,
the government sells these bonds thereby increasing the monetary base
of the economy
...

Open market operations refer to sale and purchase of securities
in the money market by the central bank of the country
...
The reserves of commercial banks are reduced and they are
not in a position to lend more to the business community or general
public
...
Contrariwise, when recessionary forces start in the economy,
the central bank buys securities
...
It
further raises Investment, output, employment, income and demand in
the economy hence the fall in price is checked
...
Cash Reserve Ratio (CRR)
It refers to the cash which banks have to maintain with the
Reserve Bank of India as percentage of Net Demand and Time Liabilities
(NDTL)
...
Therefore it reduces their deposit
available for credit and they lend less which affect their profitability and
also reduces the money supply in economy
...
Statutory Liquidity Ratio (SLR)
Apart from CRR, the banks in India are required to maintain
liquid assets in the form of gold, cash and approved securities
...


e
...

•

Repo Rate: It is the interest rate at which the Reserve Bank provides
overnight liquidity to banks against the collateral of government and
other approved securities under the liquidity adjustment facility
(LAF)

•

Reverse Repo Rate: The (fixed) interest rate at which the Reserve
Bank absorbs liquidity, on an overnight basis, from banks against
the collateral of eligible government securities under the LAF

f
...
This provides a safety valve against
unanticipated liquidity shocks to the banking system
g
...

h
...
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
...

Banks are required to keep more with the central bank
...
The volume of investment, output and
employment are adversely affected
...

They lend more and the economic activity is favourably affected

2
...
They usually take the form of changing margin
requirements to control speculative activities within the economy
...

a
...
For instance, raising the margin
requirement to 70% means that the pledger of securities of the value of
Rs 10,000 will be given 30% of their value, i
...
Rs 3,000 as loan
...

b
...

Monetary Policy during Depression:
Depression is characterised by falling prices, incomes, output and
employment
...
The objectives of monetary policy during depression are to offset
the decline in velocity of money, to satisfy through additional money supply
demands for precautionary and speculative motives; to strengthen the cash
position of banks and non-bank groups
...
The cheap money policy is followed with a
view to increasing aggregate demand, using excessive saving for development,
stimulating the prices of securities to increase confidence in tire security
market
...

It has been argued that monetary policy during depression has little
scope, for it encounters practical difficulties
...

Injections of cash and other liquid securities into the economy are
absorbed by firms, banks and individuals in strengthening their liquidity
position
...

In these circumstances, businessmen are scared away by the rapidly
depleting profit margins
...
Businessmen borrow only when
business is expanding
...

One can take a horse to water but cannot make it drink
...
Thus, monetary
policy, if pursued during depression, is rendered ineffective
...
Monetary
policy is a necessary adjunct to other measures for maintaining full
employment
...
K
...
”
Even in industrially advanced countries there is scope for effective antidepression credit (monetary) policy as long as real estate credit, consumer
instalment credit and other particular types of credit remain restricted by high
interest rates
...

Monetary Policy during Inflation:
Inflation is characterised by rising prices, income output and
employment
...
In response, more cash is released by
banks making additions to consumers’ income and outlay
...
The improved prospects of business and the high values
of securities in the stock exchanges make the banking authorities willing to
expand credit which is used in making additions to plant and machinery
...
Unfortunately, this does not
happen
...

Under inflation the aims of monetary policy are to slow down the rate
of expansion of money, to reduce the volume of liquid assets, to reduce
consumption by means of high interest rates
...
The idea is to check inflation and to level off the boom conditions
...
It is easier to raise interest rates than to lower them, and the
can be raised as high as the monetary authorities wish
...

Moreover, margin requirements and consumer credit conditions may
also be tightened
...
Thus, some believed that monetary policy can be fairly effective,
if applied quickly and continuously, in preventing booms from developing into
inflation
...

The effectiveness of monetary policy during inflation would depend
upon changes in the velocity of circulation of money, because these changes
may sometimes completely neutralise the restrictions imposed by the central
bank on the supply and cost of money
...
These financial
institutions include insurance companies, housing societies, savings and loan
associations, financial houses which mobilise savings from the public and
advance loans
...
It is impossible for
the policy makers to ignore the differential effects of a tight money policy on
different sectors of the economy
...

Increasing the Effectiveness of Monetary Policy:
In order to make monetary policy more effective, no time should be lost
between the need for action and the action taken
...
But in actual practice the actions of monetary authorities
are not so prompt and sometime elapses between the need for action, its
recognition and the actual action taken
...
Even if the need for a change in policy is recognised, sometime must

elapse before suitable action is taken
...

The sum of recognition lag and action lag is called the inside lag
...

Once the policy is changed, sometime must elapse before the changes
in the policy work their way through the system to become effective in
changing aggregate output or employment
...

Why monetary policy is ineffective in India?
There are many reasons for monetary policy not able to achieve its intended
objectives
...
This large segment is not
affected by monetary policy instrument
...
have influence on overall liquidity in the economy
...


•

High currency-deposit ratio: The rural economy in India has more
inclination towards the usage of cash
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The monetary policy only touches the deposit section
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Conclusion:
So, it can be concluded that the implementation of the monetary policy
plays a very prominent role in the development of a country
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