34 Monetary Policy

Dr. Savita

1. Learning Objectives

After completing this module, the students will be able to understand:

• The concept of Monetary Policy
• Various objectives of Monetary Policy
• Instruments of Monetary Policy
• Role of Monetary Policy in economic development
• Limitations of Monetary Policy

MONETARY POLICY

2. Introduction

Monetary policy plays a significant role in building the economic character of the country because money and credit in a modern economy exercise long lasting influence upon the course, nature and volume of economic activities. Monetary policy plays the significant role in economic development and growth of under-developed countries. It can also help in correcting economic evils of the economy. Monetary policy may be defined as the deliberate and conscious management of money supply for the purpose of attaining a specific objective or a set of objectives. It aims at regulating the flow of currency, credit and other money instruments in an economy. In a broad sense monetary policy refers to the monetary system of a country and deals with all those monetary and non monetary measures and decisions which have monetary effects. However ,in its narrow sense monetary policy includes only those measures and decisions of the state and the monetary authority which aims at controlling the volume of money, affecting the level of interest rates influencing public spending and use of money and credit. Hence monetary policy is identical with central banking operations and as such the instruments of monetary policy are the same thing as the instruments of credit control adopted by the central bank.

In India, monetary policy is watched out by the Reserve Bank of India which aims at managing the growth with price stability in the economy. So in simple words Monetary policy consists of all those decisions of government and RBI with influence the volume and composition of money supply, the size and distribution of credit, the level and structure of interest rates. In India Reserve Bank has sole right to issue currency against minimum security of 200 crores rupees out of which 115 crores should comprise of gold and 75 crores of foreign securities. It is one such important macroeconomic policy through which the central bank influences investment, output, employment and income.

3. Objectives of Monetary Policy

The objectives of monetary policy have been varying from time to time depending upon the nature of problems facing the countries and the general economic policy pursued by them. Earlier, the main objectives of monetary policy were the maintenance of price stability, rigidity of exchange rate, maintenance of full employment. But now more attention has been devoted to the maintenance of full employment.

With the emergence of developing countries monetary authorities have been called upon in promoting the process of economic development. Main objectives of Monetary Policy are:

1.   Stability in foreign exchange rates,

2.   Full employment,

3.   Economic growth,

4.   Price stability,

5.   Stability of financial markets, and

6.   Neutrality of Money.

1. Stability in Foreign Exchange Rates: Exchange rate stability was the traditional methods of monetary policy. To achieve equilibrium in the balance of payments monetary policy controls the flow of credit. Exchange stability means there is not much rise or fall in the rate of interest. If there is deficit in balance of payments the total supply of money is reduced and the domestic rate of interest is lowered it brings down the price level and thereof encourages exports and discourages import however whenever there is surplus in the balance of payments, the supply of money can is increased and rate of interest on foreign loans.

2. Full employment: Full employment can be achieved in an economy by following an expansionary monetary policy. Monetary policy aims to achieve full employment level through infusing the flow of credit by keeping interest rates low in order to boost production activities. By providing concessional to productive sectors monetary policy promotes employment.
3. Economic Growth: Monetary policy is usually regarded as a short term policy measure aims at securing price stability or full employment in an economy. But presently emphasis is being shifted to achieve a higher rate of growth of the economy which is being considered as the objective of monetary policy. This applies to both developed as well as developing economies. So economic growth is defined as a process whereby an economy’s real national income increases over a long period of time. The primary task of monetary authority is to keep the fluctuations in the prices and economic activity at the minimum so that the process of growth is not affected adversely. The flow of money should be properly regulated.
4. Price Stability: Price stability keeps the value of money stable, eliminates business cycles, economic stability and promotes economic welfare. Monetary Policy stabilizes the economy from inflation and deflation by controlling the total flow of quantity of money supply. Money supply is freezed to curb inflation while increasing the supply of money in case of deflation. Mild level is inflation is good for the economy but too much of inflationary pressures is supervised by monetary policy by following methods. Inflation rate between 0 and 3 percent a year is generally seen as being consistent with price.

5.Stability of Financial Markets: An effective monetary policy that accelerates economic development through financial institutions by mobilizing savings of the individuals and by the help of capital formation in the economy by providing long and medium term credit at low rate of interest. In order to avoid wide fluctuations in the economy monetary policy accommodates the interest rates towards the stabilization of financial markets in order to achieve economic development.

6.Neutrality of Money: it is believed that the best monetary system is one in which money is neutral. The monetary authorities should aim at the complete neutrality of money. Money should be a passive factor. So monetary policy has to maintain the quantity of money perfectly stable. The objective of neutrality of money can be attained only when the other objectives are fulfilled.

4.Instruments of Monetary Policy

Monetary Policy used to achieve economic and price stability by influencing aggregate demand or supply in the economy. Monetary policy deals with the expansion and contraction of money. There are two basic instruments of monetary policy through which supply of money can be expanded of contracted

a.Quantitative instruments

b.Qualitative instruments.

Quantitative Instruments or Measures: The important quantitative (systematic expansion and contraction of the volume of credit in accordance with the needs of the economy i.e expansion of credit during depression and contraction of credit during inflation) are as follows:

1) Bank Rate,

2) Open Market Operations,

3) Cash Reserve Requirements, and

4) Statutory Liquidity Ratio

Bank rate: The bank rate is the lending rate of the central bank to commercial banks. When the central bank increases the bank rate, the commercial banks also increase their lending rates and it leads to contraction of credit. This policy is followed to check inflation or during general rise in price-level. Bank rate is lowered during depression when there is need to expand credit creation by the commercial banks, so as to encourage liberal loans to the borrowers for stimulating aggregate demand.

Open Market Operations: Open market operations mean purchase and sale of securities by the central bank to expand or contract the volume of credit of the financial intermediaries (both banks and non-bank financial intermediaries).

Cash Reserve Requirements: The commercial banks in each country are required by law to keep a certain percentage of their deposits as Variable Cash Reserve Ratio with the central bank. The central bank varies Cash Reserve Ratio in accordance with the needs of the economy. To expand the volume of credit VCRR is lowered down, now there will be more cash with the commercial banks to expand the volume of credit and to contract the volume of credit it raises VCRR which means less cash with the commercial banks to lend.

Statutory liquid ratio: All commercial banks required to maintain, under sec 24 of the Banking regulation Act 1949, liquid assets in the form of cash, gold and unencumbered approved securities. This is known as statutory liquid ratio.

These quantitative methods have only a quantitative effect on supply of credit. They are used for either increasing or reducing the volume of credit without regard to the uses to which the credit is to be put by the borrowers.

Qualitative Instruments or Measures: RBI also makes use of certain qualitative or selective instruments to control and regulate the flow of credit into particular industries or sector of the economy (Encouraging productive and socially desirable sectors and discouraging unproductive and socially undesirable sector). The important instruments of qualitative instruments are:

Fixation of Margin,

Regulation of Consumer Credit, Direct Action,

Moral persuasion and publicity Control through Directives

Rationing of Credit

1) Fixation of Margin: The bank gives loan on the basis of tangible security or collateral security. The RBI fixes the minimum marginal requirements on loan for purchasing or carrying securities. Market value of the security and the amount lent by the bank against security is called Margin requirement. If the Central bank fixes a margin of 20% then, on a security of 10,000, the bank will lend rs 8,000 only. If the central bank is to restrict credit to socially undesirable sector, it may raise the margin to25%. In that case bank will be able to lend rs 7,500 only. In case the central bank desires to expand credit to socially desirable channels it may lower margin to 10%.

2) Regulation of Consumer Credit: Regulation of Consumer Credit aims at regulating the demand for consumer durables like Refrigerator, TV set, Laptop, Computer, etc. (Or in order to facilitate their demand-either minimum down payment is raised or maximum period of repayment is lowered in order to curb their demand for these goods, reverse measures are taken.

 3) Direct Action: Direct action refers more or less, a corrective measure against those commercial banks who fails to toe the line of the central bank monetary policy. It may refuse to rediscount their bills of exchange or grant them other financial accommodation, or come to their rescue in their crisis hour. However commercial banks can ill-afford to earn the wealth of the central bank and be its defaulter.

4) Moral Persuasion and Publicity: As a leader of commercial banks, the central bank persuades them to follow a particular monetary policy in the face of prevailing situation of the economy. In view of the vast statutory powers of the central bank, the commercial banks due heard to what the former says. Another way of moral pressure is the use of publicity medium. . It influences the credit policies of the commercial banks to sensitize the people regarding the economic and monetary condition of the country. It publishes weekly or monthly or quarterly statements of the assets and liabilities of the commercial banks as well as reviews of credit and business conditions, reports on its own activities, money market and banking conditions etc for the benefit of general public.

5) Control through Directives: Banks are directed by the central bank to be liberal in granting credit to the priority sectors, like agriculture, power, infrastructure, housing education, etc rather than less priority sectors.

6) Rationing of Credit: Rationing of Credit is practiced to check credit flow to speculative activities by allotting credit quota for diverse business activities. The banks are not allowed to exceed quota limits at the time of granting loans.

These various tools can be used for formulating a proper monetary policy to influence levels of aggregate output, employment and prices in the economy. In times of recession or depression (slow down of business) expansionary monetary policy or what is called easy money policy is adopted ( i.e, by lowering bank rate, purchase of the securities in the open market, lowering the cash reserve ratio, reducing the restrictions on selective instruments) which raises aggregate demand and thus stimulates the economy and helps the recovery of the economy from depression. On the other hand, in times of inflation and over expansion of the economy (during business upswing), contractionary monetary policy or clear monetary policy (i.e, by increasing bank rate, by sale of securities in the open market, raising the cash reserve ratio, increasing the restrictions on selective instruments) is adopted to control inflation and achieve price stability in the economy.

5. Role of Monetary Policy in Economic Development and Growth

Economic development and growth is main objective of the economic policies of developing countries in the world. Monetary policy does not confine to provide solution to boom and depression but also to the development. Economic development is essential for the developing country to face the advance countries in the world. The monetary policy can play an effective role in development and growth of underdeveloped countries.

In an under-developed country there exists vicious circle of poverty. A large part of the population is engaged in the agricultural sector where productivity is very low. People save a small part of their income and even if they save, their savings are not invested in productive sectors. The manufacturing sector has not developed in such an underdeveloped economy. Development programmes in such an economy should aim at increasing the productivity of labour force either within the sector in which labour is already employed or if necessary , by an inter-sectoral transfer of labour force from the agricultural sector where productivity is lower to the manufacturing sector where the productivity is higher .

The monetary policy of the central bank can assist greatly such transfer of resources from the low productive to high productive sectors. In fact, by a judicious use of selective instruments of credit control it is often possible for the central banks to discourage investments in socially unproductive or undesirable sectors and encourage investments in socially productive or desirable necessary sectors. The central bank can also help the process of expansion by a suitable expansion of the currency and credit supply which is necessary for the maintenance of price stability.

In under-developed economy central bank has to play the part of regulator of the currency and credit supply side by side with the role of provider of the necessary amount of liquidity for financing and expanding volume of production and trade. The regulator of the currency and credit supply is necessary because of extreme sensitivity of such an economy to the forces of inflation. In fact, unlike in the developed economies in the under-developed economies, inflation may co-exist with unemployment. Role of monetary policy in under-developed countries is very crucial as compared to developed countries due to lack of existence of organized and developed money market, lack of organized banking system, scarcity of financial institutions and unequal interest rate prevailing in different sectors of economy. In nutshell, the role of monetary policy in economic development and growth may be stated below:

Price stability: Maintenance of stability in the domestic price level is an important condition for economic condition for economic development and growth. In under-developed countries inflation is most susceptible. It generally occurs when there is an abnormal increase in the effective demand due to government expenditure. . The monetary authority should keep a constant watch on the movement of prices by regulating the supply of money and credit so that inflation can be controlled.

Appropriate Adjustment between Demand for and Supply of money: In the under-developed countries economic fluctuation occurs because of lack of proper adjustment between demand for and supply of money. Economic development results in rising demand for money because of the increase in the volume of production and transaction. The regularly rising demand for money makes it imperative for the monetary authority to increase the supply of money at a rate that is roughly equal to the rate of increase in real income.

Strengthen Financial Institutions: Monetary policy can speed up the process of economic development by improving the currency and credit system of the country. To achieve the purpose more banks and financial institutions need to be established for larger credit facilities and to mobilize savings for productive purposes. The expansion of banks and other non banking financial institutions can help both in generating banking habits among the public and transform savings into capital formation. In under-developed countries there is existence of vast non-monetized sector which is not affected by the changes in the quantity of money and interest rates and such this sector remains outside the effective control of the central bank. So all efforts must be made by the monetary author to extend the sphere of the monetized sector to make monetary policy a success.

Suitable Interest Rate Structure: Monetary policy can help in developing countries to adopt most appropriate interest rate structure which can stop fluctuations in the money market as well as investment activities. If economy wants to establish equilibrium between saving and investment then appropriate interest structure should be followed.

Monetary Policy and Investment: Monetary policy has an important role to play in boosting up the level of investment by making available saving or resources mobilized by banks for the purpose of investment and production. The banks fulfill this task by offering bank credit for investment to business and industry.

Promotion Role: In under-developed countries the monetary authorities have a promotional role which will improve the efficiency of the banking system as a whole.

So monetary plays an important role in under-developed or developing countries. Economic development in developing economy needs economic planning and monetary policy is a tool for economic planning. Monetary policy can promote capital formation by encouraging saving in the economy. Monetary policy by adopting suitable rate of interest and expanding banking facilities can attract the private investors to invest funds. So, monetary policy can play a crucial role in the economic development and growth in the developing countries.

6. Limitation of Monetary Policies

The importance of monetary policy is realized in the fact it tries to promote economic development by supervising inflationary and deflationary gaps, disequilibrium in balance of Payments, stability in exchange rate, infusion of capital formation yet monetary policy faces certain barriers which are highlighted as under:

Money market is not organized– There is a huge size of money market in our country which is unorganized such as indigenous bankers like money lenders etc. they do not come under the control of the RBI. Thus any tool of the Monetary Policy does not affect the unorganized money market making Monetary Policy less effective.

Large Non-monetized Sector: Large non-monetized sector which hinders the success of monetary policy since all the transactions conducted therein are mere barter exchanges. People do not deposit money with banks rather than use them for conspicuous consumption, etc. Such activities encourage inflationary pressures because they lie outside the control of the monetary authority.

Large Number of NBFLs: Coverage area of Monetary Policy is limited since Monetary Policy covers only commercial banking sector. Other non-banking institutions remain untouched. NBFI which do not come under the purview of monetary policy greatly hampers to achieve the objectives of monetary policy in the less developed country.

Existence of Parallel Economy: The existence of parallel economy limits the working of the monetary policy. The black money is not recorded since the borrowers and lenders keep their transactions secret and hidden. Consequently the supply and demand of money gap arises and also doesn’t remain as desired by the monetary policy.

Deficit Financing: A monitory authority wants to check the supply of money while deficit financing helps to increase the supply. In today’s scenario deficit financing is the main source of financing development activities and thereof with deficit financing objectives of monetary policy becomes inoperative.

Only a Persuasive Policy: In underdeveloped economies monetary policy is soft, persuasive and lenient which sometimes leave a scope of tax evasion, antisocial elements, black money etc. in the economy which limits the effectiveness of monetary policy

Time lag: Monetary Policy works judiously only after series of time lags. The time gap between the formulation of the plan and implementation of it is known as time lag. These lags can be further divided into two phases:

Inside lag	Outside lag
The inside lag is the amount of time taken to enforce a policy and its effect in the economic activities. There are of further divided into two types.	Outside lag is a Lag which needed by the consumers, firms, government and the outside stakeholders to have an impact in their economic activities due to change in monetary policy. Outside lag is the

Poor banking Habits: Lack of awareness and poor banking habits of individuals such as preference to use cash rather than cheque leads to circulation of money in the economy only without coming back to banks for deposits which ultimately leads to reduction in credit creation in the economy.

Summary: Monetary policy is concerned with changing the supply of money stock and rate of interest for the purpose of stabilizing the economy at full employment or potential output level by influencing the level of aggregate demand. There are two types of monetary policy i.e. expansionary and contractionary. There are two monetary instruments through which RBI control the money supply in the economy that is quantitative and qualitative instruments. . In developing economy, monetary policy plays a significant role in accelerating economic development by influencing the supply and uses of credit, controlling inflation, and maintaining balance of payments. Once development gains momentum, effective monetary policy can help in meeting the requirements of expanding trade and industry by providing elastic supply of credit.