Monetary Policy – Free BBA Notes/ MBA Notes

Monetary Policy

Meaning, Objectives, Instruments, Transmission mechanism and limitations in developed and developing economies.

 

Meaning

Monetary policy includes the actions of a central bank, currency board or any other regulatory committee that determines the size and rate of growth of the money supply, which in turn affects interest rates. It implies the regulation of money supply and the cost of credit by the central bank of the country for achieving the objectives of general economic policy. The main objectives of the monetary policy are price stability and high rate of economic growth.

Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the reserves. The present banking system is called a “fractional reserve banking system”, as the banks are required to keep only a fraction of their deposit liabilities in the form of liquid cash with the central bank for ensuring safety and liquidity of deposits.

Definitions

According to Harry Johnson

Monetary policy is a policy employing central bank’s control of the supply of money as an instrument of achieving the objectives of general economic policy.

According to G.K. Shaw

Monetary policy is any conscious action undertaken by the monetary authorities to change the quantity, availability or cost (interest rate) of money.

According to D.C. Aston

Monetary policy involves the influence on the level of composition of aggregate demand by the manipulation of interest rates and the availability of credit.

According to R.P. Kent

Monetary policy is the management of the expansion and contraction of the volume of money in circulation for the explicit purposes of attaining a specific objective such as full employment.

According to D.C. Rowan

The monetary policy is defined as discretion-any action undertaken by the authorities designed to influence the supply of money, cost of money i.e. rate of interest and the availability of money.

Objectives

The principal objectives of monetary policy are:

1. Price stability i.e. to check deflation and inflation in the economy.

2. External economic stability i.e. to maintain exchange rate.

3. Full employment.

4. Economic development.

Instruments

The instruments of monetary policy (methods of credit control) may be broadly divided into-

1. General (Quantitative) methods; and

2. Selective (Qualitative) methods.

1. General (Quantitative) methods

The general methods affect the total quantity of credit and affect the economy generally. The selective methods, on the other hand, affect certain select sectors. In other words, under the selective methods, certain qualitative distinctions are made between different sectors and segments of the economy; and selectivity is applied in regulating the flow of credit.

There are three general or quantitative instruments of credit control:

i. The Bank Rate

ii. Open Market Operations

iii. Variable Reserve Requirements

In considering the general methods of credit control, it is important to stress that these are closely inter-related and have to be operated in co-ordination. All the three instruments affect the level of bank reserves. Open Market Operations and the Reserve Requirements directly affect the reserve base, while the Bank Rate produces its impact indirectly by variations in the cost of acquiring the reserve.

i. The Bank Rate

Also called the discount rate, bank rate refers to the rate at which the Central bank rediscounts or lends money to commercial banks. As increase in the Bank Rate means an increase in the rate of interest charged by the central bank on its advances to commercial banks. Hence, an increase in the bank  Rate compels commercial bank to raise the rate of interest they charge on their loan and advances to their customers and vice-versa. During inflationary periods, the bank rate is hiked so as to increase the rates of interest on borrowings. This will have a dampening effect on the borrowers. The reverse course of action is taken during the periods of falling prices.

An increase in the Bank Rate implies an increase in the cost of credit and vice-versa. The demand for credit usually varies with the variation in the cost of credit. The Central bank can, therefore, hope to bring about a contraction in the money supply by raising the Bank rate and an expansion in the money supply by lowering.

ii. Open Market Operations

Open market operations refer to the purchase or sale of securities, foreign exchange and gold by the government. Purchase of securities and gold from public results in the expansion of money. Sale of securities and gold results in the contraction of money supply.

The effectiveness of open market operation as a weapon of monetary control depends on the following factors.

(a) When commercial banks possess excess liquidity, the open market operation does not work effectively.

(b) In a buoyant market situation, the effective control of demand for credit through the open market operation is doubtful. And. during the period of depression, open market operations are not effective for lack of demand for credit.

(c) If banking system of the country’ is not fairly developed and security and capital markets arc not interdependent, open market operations have a limited effectiveness. This is the case of underdeveloped countries.

(d) The popularity of government bonds and securities with the public also matters a lot. The government debt instruments arc generally not popular due to low rate of return. The central bank then has to use coercive measures and force the commercial banks to buy the government bonds, as is the case in India.

iii. Variable Reserve Requirements

Commercial Banks in every country maintain, either by the requirement of law by or custom, a certain percentage of their deposits in the form of balances with the central bank. The central bank has the power to vary this reserve requirement; and the variation in the reserve requirements affect the credit creating capacity of commercial banks. For instance, if the reserve requirement is 10%, the maximum amount the bank can lend is equivalent to 90% of the total reserves. If the reserve ratio is raised to 20 %, the bank cannot lend more than 80% of the total reserves.

The Reserve Bank of India is empowered to vary the cash reserve ratio between 3% and 15%  of the total demand and time liabilities. To facilitate the flexible operation of this system, the RBI has also been vested with the power to require the scheduled banks to maintain with it additional cash reserves, computed with reference to the excess of their total demand and time liabilities over the level of such liabilities on the base date to be notified by the Reserve Bank, subject to the proviso that the total reserve to be maintained with the Bank should not exceed 15% of their demand, and time liabilities.

The statutory basis for the regulation of credit in India is embodied in the Reserve Bank of India Act and the Banking Regulation Act. The former Act confers on the Bank the usual powers available to central banks generally, while the latter provides special powers of direct regulation of the operation of commercial and co-operative banks.

SLR: Action has also been taken to prevent banks from offsetting the impact of variable reserve requirements by liquidating their Government security holdings. The Banking Regulation Act has been amended, requiring all banks to maintain a minimum amount of liquid assets which shall not be less than a certain specified percentage of their demand and time liabilities in India, exclusive of the cash balances maintained under Section 42 of the Reserve bank of India Act in the case of schedule banks, and exclusive of the cash balances maintained under Section 18 of the Banking Regulation Act in the case of non-scheduled banks. This ensures that with every increase in the cash reserve requirements, the overall liquidity obligations are also correspondingly raised.

2. Selective (Qualitative) methods

Selective and qualitative credit control refers to regulation of credit for specific purposes or branches of economic activity. While general credit controls operate on the cost and total volume of credit, selective controls relate to the distribution or direction of available credit supplies. It may be mentioned here that some element of selectivity can be imparted to general credit controls also by giving concessions to priority sectors or activities. This has often been done in India.

The aim of selective controls is to discourage such forms of activity as are considered to be relatively inessential or less desirable. Selective credit controls have been used in the Western countries to prevent the demand for durable consumer goods outrunning the supply, and generating inflationary pressure. This method is very popular in India, though USA has stopped using this tool. Selective credit controls are considered to be useful supplement to general credit regulation. From available experience, it appears that their effectiveness is greatly enhanced when they are used together with general credit controls. They are designed specifically to curb excess in selected area without affecting other types of credit. They attempt to achieve a reasonable stabilization of the prices of particular commodities on the demand side, by regulating the availability of bank credit for purchasing and holding them. It should, however be noted that prices are determined by the interaction of supply and demand, and that when supply is substantially short, what selective credit controls are likely to accomplish is to moderated the price rise rather than arrest the basic trend.

Qualitative or selective instruments arc used to influence specific types of credit for particular purposes. These tools are as under:

i. Moral Persuasion or Advice

 The central bank gives advice to other banks, on moral grounds, about the credit control and therefore the objectives and needs of the money supply and by publishing and analyzing the statistics about the economic situation of the country. The central bank tells them about the dangerous consequences of the credit expansion so that it may seek the cooperation of the commercial banks in coping with the situation of economic emergency. The central bank gives advice not only to control credit but also the objectives of the credit.

ii. Rationing of Credit

When there is shortage of institutional credit available for the business sector, the large and financially strong sectors or industries tend to capture the lion’s share in the total institutional credit. As a result, the priority sectors and weaker but essential industries arc starved of necessary fluids, mainly because bank credit goes to the non-priority sectors. In order to curb this tendency, the central bank resorts to credit rationing measures. Generally, three measures are adopted: (a) imposition of upper limits on the credit available to large industries and firms, (b) charging a higher or progressive interest rate on bank loans beyond a certain limit, with a view to making bank credit available to relatively weaker sectors, and (c) providing credit to weaker sectors at lower internal rates.

iii. Direct Action

When some commercial banks do not cooperate with the central bank in controlling the credit then the central bank has to take some direct action against such banks. The direct action can be in many forms. Sometimes the central bank refuses to give loans or discount the bills of exchange of the commercial banks and sometimes the central bank starts imposing some extra fines other than the rates of discounting (or bank rate) on the commercial banks. Due to this, the reputation of the commercial banks and also their business are affected badly in the market.

iv. Change in lending margins

In general, banks advance money against a mortgage of property- land, building, jewelry, shares, stock of goods, etc. the banks provide loans only up to a certain percentage of the value of the mortgaged property. The gap between the value of the mortgaged property and amount advanced is called ‘lending margin’.

Repo and Reverse Repo Rates

In addition to traditional monetary control measures, RBI uses repo rate (repurchase operation rate) and reverse repo rate under its Liquidity Adjustment Facility (LAF) programme. Repo rate is the rate at which RBI lends short-term money to the commercial banks when they borrow from the RBI. Reverse repo rate is the rate that RBI offers to the banks willing to keep their money with it. Depending on the need of the country; the RBI keeps changing these rates. The current Repo Rate as on 7 August 2019 as fixed by the RBI is 5.40%.

Monetary Policy – Free BBA Notes/ MBA Notes

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