20 Monetary Policy
Deven Mahajan
1. Learning Outcome:
After completing this module the students will be able to:
Understand the concept of Monetary Policy Describe the objectives of Monetary Policy .Learn the instruments of Monetary Policy Interpret the terminology related to Monetary Policy
2. Introduction
The macroeconomic policy determined by the central bank to accomplish the macroeconomic objectives of the government of a country like growth, liquidity, inflation and consumption is known as monetary policy. It involves money supply and interest rate management. In India monetary policy is decided by Reserve Bank of India (RBI).Many instruments are used to execute the monetary policy like bank rate policy, credit control, moral influence and many other mechanisms are also applied.
The purpose of monetary policy of Reserve Bank of India to achieve certain macroeconomic objectives like liquidity, economic growth, to establish stability in the prices so as to control inflation or interest rate and build a general interest in the economy.
In India, to speed up the pace of economic expansion and to accomplish the requirements of diverse sectors of economy Reserve Bank of India manages the money supply. Through monetary policy there can be contraction or expansion of money suppy in the economy. During the days of recession interest rates can be lowered and money supply can be expanded in the economy .The belief is that trouble-free credit will be accessible to the people and it will be helpful for expansion of businesses and work as a means to combat unemployment. Whereas to shrink the money supply in the economy and to conquer the motive to slow down the impact of inflation the interest rates are increased.
3. Monetary Policy during Pre Reform Period and Post Reform Period
3.1 Pre Reform period and monetary policy (1972-1991):
A good coordination is required between monetary policy and fiscal policy. Basically monetary policy is the reaction of fiscal policy in India .Fiscal deficit was created during seventies and eighties by fiscal policy. Money was created at that time by borrowing from Reserve Bank of India against issue of treasury bills by government. Money supply was increased due to credit by Reserve Bank of India to the government. Due to growing budget deficit the objective of monetary policy during seventies and eighties was to neutralize the impact of inflation
3.2 Post Reforms period and monetary policy (1991-1996):
In the post reform period the objectives of monetary policy were economic growth and price stability. To tackle the economic crisis economic reforms were executed. To accelerate the economic growth and to encourage competition deregulation and industrial liberalization policy was followed. The objective was to reduce fiscal deficit and to attain price stability. Quantitative restrictions on imports reduced and Indian economy was opened and trade was liberalized in the external sector.
4. Definition of Monetary Policy
Some definitions of monetary policy are as follows:
4.1 In the words of Johnson “Monetary policy is the policy employing central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy.”
4.2 As per G.K. Shaw “Any conscious action undertaken by the monetary authorities to change the quantity, availability or cost of money is monetary policy.”
4.3 R.P. 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.”
4.4 According to A J. Shapiro, “Monetary Policy is the exercise of the central bank’s control over the money supply as an instrument for achieving the objectives of economic policy.”
4.5 In the words of D.C. 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.”
5. Objectives of monetary policy
Economic growth, exchange rate stability and price stability are the objectives of monetary policy and to achieve these objectives there are certain targets such as interest rates, supply of money or bank credit which are vital to be altered through instruments of monetary policy to realize these objectives. Reserve requirements variation, bank rates and interest rates change, currency supply adjustment, selective credit control and open market operations are certain instruments of monetary policy to achieve these targets.
The monetary policy must move in parity with economic policy because it is one instrument of overall economic policy. The objectives of monetary policy are: maintenance economic growth, rupee exchange rate stability with foreign currencies, inflation control or stability in prices, full employment and balance of payments.
5.1 Economic Growth
Monetary policy has another important objective i.e. economic growth. The economic growth can be achieved by making credit availability to be adequate and lowering cost of credit. Economic growth quickens when credit is available at low interest rate which ultimately stimulates investment.
5.2 Exchange Rate Stability
Fixed exchange rate system is followed by India till 1991 and with permission of IMF, India devalued the rupee rarely. Since 1991 there is volatility in the exchange rate of rupee due to globalization and floating exchange rate. Fluctuations in rupee exchange rate are due to capital outflows and inflows and alterations in foreign exchange demand and supply which crop up due to imports and exports. So as to ensure stability in the foreign exchange rate Reserve Bank have to take suitable monetary measures to prevent large appreciation and depreciation of foreign exchange rate.
5.3 Inflation control or price stability
Monetary policy has the major objective to control inflation or maintenance of price stability. However price stability does not mean totally no changes in the prices. In a developing country like India certain price level changes or inflation is quiet expected. Although there may be an adverse effect of the high degree of inflation on the economy. Firstly the cost of living of the people is raised by inflation. Secondly, exports are discouraged because inflation makes them costly and people are forced to import goods because of high prices in domestic markets. Hence there is an adverse effect on balance of payments due to inflation. Thirdly due to high inflation money value quickly falls and people have less motivation to save .Ultimately investments are reduced which leads to lower economic growth. Fourthly people are encouraged to invest in other assets like real estate, jewellery and gold etc.
6. Instruments of monetary policy
Recent monetary policies have focused upon credit availability changes than cost of credit i.e. rate of interest which is a good instrument to regulate aggregate demand. The credit availability is reduced by various methods. The availability of credit in the economy can be reduced by open market operations. Government securities are being sold by Reserve Bank of India through open market operations. Payment for them, especially by banks to buy securities is in terms of cash reserves. Capacity to lend money will be reduced when cash reserves are less with banks. Hence loanable funds supply by banks will be reduced and hence lead to reduction in business firm’s investment demand.
Numerous instruments are used by RBI to put into practice the monetary policy which leads to make over the money supply and interest rate. With the help of monetary policy RBI maintains liquidity in the economy.
There are two types of instruments of monetary policy .First is quantitative, general or indirect and second is qualitative, selective or direct. With the help of availability of credit, cost of money and supply of money aggregate demand is affected. Alterations in reserve requirements, bank rate variations and open market operations are included in the first type of instruments. Commercial banks are important media to regulate the overall level of credit in the economy.
The control of specific type of credit is covered under selective credit controls. Regulation of consumer credit and changing margin requirements are included in that.
6.1 Bank Rate Policy Bank Rate
Bank Rate is the rate at which the central bank lends money to the commercial banks and is also called discount rate .The government securities and first class bills of exchange held by commercial banks are rediscounted at the minimum lending rate of central bank, this minimum lending rate is called bank rate. During the periods of inflation the bank rate is increased to increase interest rate on borrowings. Hence commercial banks will borrow less from central bank, because cost of borrowing from central bank is increased due to rise in bank rate.
As a result the lending rates by the commercial banks are increased due to which borrowers and business community can borrow from commercial banks at high cost. This leads to credit contraction and price rise is also checked. It will have an undesirable impact on borrowers.
When the prices are declining bank rate is reduced and the borrowers can avail funds at low interest rates. The bank rate is reduced when there is depression in the prices. Central bank lowers the lending rates and the commercial banks can borrow at cheap rates. Ultimately borrowers and businessmen are motivated to borrow more. This leads to increase in investment .As a result output, income, demand and employment sources are generated and price movement in downside is checked.
6.2 Open Market Operations
The purchase and sale of securities by the central bank in the money market is known as open market operations. The securities are sold by the central bank, when there is an increase in the prices and a control is required. The commercial banks are not in a position to lend more to borrowers and business community because their reserves are reduced. As a result price rise is checked due to discouraged investment.
In the same way when recession starts in the economy, the securities are purchased by the central bank and there is a rise in the reserves of commercial banks. Price fall is checked, because commercial banks lend more, which leads to increase in investments, output, employment, income and demand rise.
6.3 Reserve Ratios changes
As per law banks are required to keep in the form of reserve fund a certain percentage of total deposits in its vaults and a certain percentage with the central bank. This is known as reserve ratio. The reserve ratio is increased by the central bank when prices are rising. It means banks are required to park more funds with the central bank and they lend less. As a result investments are reduced and it affects adversely the employment and output. In the same way on lowering the reserve ratio the commercial bank’s reserves are increased and they are in a position to lend more and which leads to more positive economic activity.
6.4 Selective Credit Controls:
To influence the specific type of credit for particular purposes selective controls are used. Within the economy to control speculative activities they may take place in the form of changing margin requirements. The central bank increases the margin requirements on them when there is rapid speculative activity in the economy or in particular sectors or commodities and prices are rising. As a result against specified securities the borrowers are given less money in the form of loans. For example when the margin requirement is increased to 55% means for the value of Rs. 10,000 the pledger of securities will be given 45% of their value i.e. Rs.4,500 as loan. In the time of recession the margin requirements are lowered when borrowings are encouraged by the central bank.
6.5 Credit tightening through Monetary Policy
A suitable policy framed for availability of credit and interest rate is monetary policy. Monetary policy is an important tool to control inflation which reduces aggregate demand. Monetary policy can affect cost of credit and credit availability for business firms. When there is high rate of interest then borrowing of business firms will be costly. To encourage savings and discourage borrowings the rate of interest is kept high and it is very effective anti inflation measure.
There are arguments that private investment is discouraged and economic growth is less when there are higher interest rates. Hence it is said that there may be sacrifice of certain growth when interest rates are raised although it will reduce inflation. Which means there exists a trade off between growth and inflation.
7. Some Monetary Policy terms
7.1 Cash Reserve Ratio (CRR)
CRR is the minimum cash reserve amount which the commercial banks have to park with RBI and is certain minimum part of total deposit of customers. There will be lesser availability of funds for bank credit when CRR is increased and when CRR is reduced then more funds will be available for bank credit. As CRR controls money supply in the economy hence it is also known as liquidity ratio.
The purpose of CRR is that depositors can get the payments on demand and banks are not out of cash to meet their demands and this is maintained in the form of cash equivalents and cash with RBI or in the vaults of bank. For the money supply in the economy CRR works as brakes.
Hence, when the cash reserve ratio is 7% and deposit of the bank increased by Rs.1,000 then bank will be able to use only Rs. 930 for credit and investment purpose and have to park additional Rs. 70 with RBI as Cash Reserve Ratio. The bank will be able to use lower amount for lending and investment when CRR is higher.CRR is an effective tool in the hands of RBI to reduce lendable amount of the bank and effective in controlling liquidity in the banking system.CRR can be varied between 3% and 15% by RBI.
7.2 Statutory Liquidity Ratio (SLR)
In a developing country like India expansion of money supply is needed to accelerate the pace of economic growth. To increase the supply of money in the economy, RBI issues currency, government borrows from foreign countries and make new provisions in the budget.
Excessive money supply in the economy may lead to hyper-inflation. Hence Reserve Bank has the responsibility to manage the money supply so that inflation may not adversely affect the various sections of the society. A variety of credit control procedures are followed by RBI to accomplish this purpose. These control actions may be quantitative controls or qualitative controls.
7.3 Repo Rate (Repurchase Rate)
Repo Rate is the rate at which the commercial banks can borrow from RBI. When the banks are in need of funds they can borrow from RBI. When the repo rate is reduced then the banks can borrow the funds from RBI at cheaper rates. Similarly by the increase of repo rate the borrowing funds are available to the banks from RBI at higher cost. Generally RBI lends to the banks against government securities. Liquidity is generated in the banking system by RBI with help of Repo Rate Due to increase in repo rate bank pay more money to central bank i.e. Reserve Bank of India. Hence bank charges higher rate of interest on the loan and industries will be reluctant to take loan from the banks. As a result excess liquidity will be withdrawn from the market. Due to inflation this type of situation arises in the economy.
7.4 Reverse Repo Rate
Reverse Repo Rate is the rate at which central bank may lend money from commercial banks. Reverse repo rate is an instrument to control money supply in the economy. To reduce the money supply the Reverse repo rate is increased, which means the banks are given more incentives when funds are provided to RBI and it may lead to reduced supply of money in the market. The reverse action is taken by RBI when money supply is to be increased in the economy i.e. reverse repo rate is reduced.
When the apex bank is under shortage of money then commercial banks are asked to provide loans. The rate at which the banks are said to provide loan funds is called reverse repo rate. Always reverse repo rate is higher than repo rate. Between Repo Rate and reverse Repo Rate a difference of 1% is maintained. It means if the banks provide loans to RBI then their money will not be under risk if comparatively loans are provided to common consumers. Hence excess money with the banks is lent to RBI. The rate at which liquidity is absorbed by RBI from the banks is known as Reverse Repo Rate.
8. LIMITATIONS OF MONETARY POLICY
8.1 Huge Budgetary Deficits
To control inflation and balance the money supply in the market best efforts are made by Reserve Bank of India but monetary policy has been unproductive due to budgetary deficits Of the central government.
8.2 Only Commercial Banks are covered
RBI can control the inflationary pressure caused by banking finance only because it has control on commercial banks and have no control on other factors which can cause inflation like goods scarcity and deficit financing.
8.3 Problems in management of Financial Institutions and Banks
Inflation can be controlled by monetary policy and overall development can be achieved only when there is dedicated and efficient management of banks and financial institutions.
8.4 Money Market is unorganised
There is an unorganized money market present in the Indian financial system over which RBI has no control .Hence monetary policy turn out to be less effectual
8.5 Black Money
- Black money generation is a bigger problem of the Indian economy which is not controllable by RBI.
- Hence total money supply in the economy is beyond the sphere of RBI and monetary policy.
- Making credit availability to be adequate and lowering cost of credit. Economic growth quickens when credit is available at low interest rate which ultimately stimulates investment.
8.6 Exchange Rate Stability
Fixed exchange rate system is followed by India till 1991 and with permission of IMF, India devalued the rupee rarely. Since 1991 there is volatility in the exchange rate of rupee due to globalization and floating exchange rate. Fluctuations in rupee exchange rate are due to capital outflows and inflows and alterations in foreign exchange demand and supply which crop up due to imports and exports. So as to ensure stability in the foreign exchange rate Reserve Bank have to take suitable monetary measures to prevent large appreciation and depreciation of foreign exchange rate.
8.7 Inflation control or price stability
Monetary policy has the major objective to control inflation or maintenance of price stability. However price stability does not mean totally no changes in the prices. In a developing country like India certain price level changes or inflation is quiet expected. Although there may be an adverse effect of the high degree of inflation on the economy. Firstly the cost of living of the people is raised by inflation. Secondly, exports are discouraged because inflation makes them costly and people are forced to import goods because of high prices in domestic markets. Hence there is an adverse effect on balance of payments due to inflation. Thirdly due to high inflation money value quickly falls and people have less motivation to save .Ultimately investments are reduced which leads to lower economic growth. Fourthly people are encouraged to invest in other assets like real estate, jewellery and gold etc.
- Summary
The practice to control money supply by the monetary authority in a country is called monetary policy. In other words the act of a central bank, other regulatory working group to settle on the economic growth through money supply which has an effect on the interest rates is called monetary policy. Economic growth, exchange rate stability and price stability are the objectives of monetary policy. Numerous instruments are used by RBI to put into practice the monetary policy which leads to make over the money supply and interest rate. There are certain limitations of monetary policy like black money is generated by it, Only Commercial Banks are covered, etc.The monetary policy must move in parity with fiscal policy to accelerate on the path of growth and achieve other objectives of the economy.
Few important sources to learn more about Monetary Policy:
1. Datt, Gaurav, Ashwani Mahajan (2014), Datt and Sundharam Indian Economy, New Delhi: S Chand and Co. Pvt. Ltd.
2. Ahuja,H.L. (2014),Macroeconomic Theory and Policy New Delhi: S Chand and Co. Pvt. Ltd.
3. Ahuja,H.L. (2013),Modern Economics,17th ed.,New Delhi: S Chand and Co. Pvt. Ltd.
4. Fernando,A,C., (2013),Business Environment, 3rd ed.,New Delhi: Pearson.
5. Puri,V.K.,S.K. Misra (2013), Indian Economy, 31st ed., Mumbai: Himalaya Publishing House.
6. Cherunilam Francis (2012),Business Environment,Text and Cases ,21st ed.,Mumbai: Himalaya Publishing House.
7.Ashwathapa,K. (2011),Essentials of Business Environment,Text,Cases and Exercises , 11th ed.,Mumbai: Himalaya Publishing House.
8. Dwivedi,D.N. (2010), Macroeconomics Theory and Policy, 3rd ed., New Delhi: Tata McGraw Hill Education Pvt. Ltd..
9. Saleem ,Shaikh. (2010),Business Environment ,2nd ed.,New Delhi: Pearson.
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18. www.yourarticlelibrary.comwww.allbankingsolutions.com/
21. www.yourarticlelibrary.com/policies
22.www.vuzs.info/mcqs/…mcqs
23.www.tippie.uiowa.edu/…/fedpolicy
24.www.kyle.aem.cornell.edu/…/Revised.
Points to Ponder
- Meaning of Monetary Policy.
- Objectives of Monetary Policy.
- Instruments of Monetary Policy.
- Monetary Policy related terminology
- Monetary Policies during different time periods