OverviewWhen we use the term bank it generally means ‘commercial bank’ that collects the Deposit from surplus unit of the society and then lends the deposits to the deficit units of the society. From very first emergence and inception of modern civilization, Bank plays a pivotal role in case of overall financial and socioeconomic development of any modern country.The basic functions of bank are deposit extraction and credit extension. Credit is the nub of banking business. It helps this kind of organizations to earn around 80% of the total revenue. Managing credit operation, thus, is the crying need for any bank. In case of failure in credit management, a bank may face extinction. It is, therefore, necessary that a bank has a proper credit profile that guides the credit operation of the bank in an effective manner. For proper management of credit each and every bank follows the profile for smooth approval, direction, monitoring and review of lending operation.Bank’s may fall into engulfing crisis or may wind up with consumption of capital if they do not practice proper Appraisal and approval process and loan classification and provisioning system on their advance. Appraisal and approval process of a bank loan application involve a series of activities. These activities reveal a true element of banking intermediation ranging from establishing relationship with a stranger (walk-in customer) to structuring a credit line for the existing clients. In order to manage the risk inherent in lending, banks across the world developed many tools. The central bank, as a controller of financial discipline, usually issues guidelines on loan appraisal and approval as well as loan classification and provisioning system and supervises the same for making credit discipline strong and confident. This paper attempts to discuss the guidelines of loan classification and provisioning system prescribed so far by Bangladesh bank and some important tools used in loan approval and appraisal process includes such of these tools like LRA and CRG model With a view to ensuring financial soundness of the banking sector .

Introduction:

The name bank derives from the Italian word banco “desk/bench”, used during the Renaissance by Florentines bankers, who used to make their transactions above a desk covered by a green tablecloth. However, there are traces of banking activity even in ancient times.In fact, the word traces its origins back to the Ancient Roman Empire, where moneylenders would set up their stalls in the middle of enclosed courtyards called macella on a long bench called a bancu, from which the words banco and bank are derived. As a moneychanger, the

merchant at the bancu did not so much invest money as merely convert the foreign currency into the only legal tender in Rome- that of the Imperial Mint.The definition of a bank varies from country to country. Under English law; a bank is defined as a person who carries on the business of banking, which is specified as:Conducting current accounts for his customersPaying cheque drawn on him,And collecting cheque for his customers.Banking sector in Bangladesh:  Classification of Banking Industry  Services: Accounts, Savings, Current, Deposit Scheme, FDR, and PDS Classification of Banking IndustryThe number of banks in all now stands at 49 in Bangladesh. Out of the 49 banks, four are Nationalized Commercial Banks (NCBs), 28 local private commercial banks, 12 foreign banks and the rest five are Development Financial Institutions (DFIs).Sonali Bank is the largest among the NCBs while Pubali is leading in the private ones. Among the 12 foreign banks, Standard Chartered has become the largest in the country. Besides the scheduled banks, Samabai (Cooperative) Bank, Ansar-VDP Bank, Karmasansthan (Employment) Bank and Grameen bank are functioning in the financial sector. The number of total branches of all scheduled banks is 6,038 as of June 2000. Of the branches, 39.95 per cent (2,412) are located in the urban areas and 60.05 per cent (3,626) in the rural areas. Of the branches NCBs hold 3,616, private commercial banks 1,214, foreign banks 31 and specialized banks 1,177.Bangladesh Bank (BB) regulates and supervises the activities of all banks. The BB is now carrying out a reform programmed to ensure quality services by the banks.

  Bangladesh Bank (BB)   Nationalized Commercial Banks (NCBs)   Private Commercial Banks (PCBs)   Specialized Banks

Bangladesh BankBangladesh Bank (BB) has been working as the central bank since the country’s independence. Its prime jobs include issuing of currency, maintaining foreign exchange reserve and providing transaction facilities of all public monetary matters. BB is also responsible for planning the government’s monetary policy and implementing it thereby.

The BB has a governing body comprising of nine members with the Governor as its chief. Apart from the head office in Dhaka, it has nine more branches, of which two in Dhaka and one each in Chittagong, Rajshahi, Khulna, Bogra, Sylhet, Rangpur and Barisal.History & role of Bangladesh BankThe central bank and monetary authority of the country. It came into existence under the Bangladesh Bank Order 1972 (Presidential Order No. 127 of 1972) which took effect on 16 December 1971. Through this order, the entire operation of the former State Bank of Pakistan in the eastern wing was transferred to Bangladesh Bank.Bangladesh Bank has been entrusted with all the traditional central banking functions including the sole responsibilities of issuing currency, keeping the reserves, formulating and managing the monetary policy and regulating the credit system of Bangladesh with a view to stabilizing domestic and external monetary value and promoting and maintaining a high level of production, employment and real income in the country. The bank acts as the banker to the government and accepts government deposits, cheques and drafts, and undertakes collection of cheques and drafts drawn on other banks. The government deposits all its cash balances with the Bangladesh Bank free of interest. The bank transfers government funds from one place to another as requested by the government and its agencies. It makes ways and means for advances to the government, which is repayable not later than three months. It acts as the public debt manager and runs a public debt office (PDO) within itself. The bank also sells government treasury bills on tender, prize bonds and different types of saving certificates (sanchayapatra). The bank acts as the clearing house of the scheduled banksThe purchase, sale and rediscount of bill of exchange and promissory notes drawn on and payable in Bangladesh are also included in the activity of the bank. The bank acts as the lender of last resort for the government as well as for the country’s scheduled banks. All scheduled banks are required to maintain a minimum reserve with the Bangladesh Bank. The present statutory liquidity reserve (SLR) requirement is 20% of total demand and time liabilities, 4% of which is to be maintained as cash reserve ratio (CRR), and the rest 16% as approved securities. The SLR requirement for Islamic banks is 10% and they are to keep 4% of this reserve as CRR and the rest 6% in approved securities.Bangladesh Bank exercises its wide range of power in credit control through different types of traditional and non-traditional methods. In addition to bank rate and open market operations, it uses a number of other weapons. It can vary the minimum reserve requirements of scheduled banks whenever circumstance so warrant. Being responsible for maintaining external value of Bangladesh currency, the bank also handles the exchange control. It ensures

that all foreign exchange inflows are accounted for, and surrendered to the authorized dealers. It allocates and rations foreign exchange in line with the set priorities. Bangladesh Bank is empowered to manage the country’s international reserves, which represent aggregate of its holding of gold, foreign exchange, SDR and reserve position in the IMF. The bank also acts as the representative of the government in different international agencies and other forums such as World Bank, IMF, Asian Clearing Union, ADB, etc.Bangladesh Bank is empowered to act as the watchdog of the country’s banking system, and all scheduled banks are accountable to Bangladesh Bank, which has extensive powers to ensure soundness of the banking system. No bank can commence banking business in Bangladesh and no existing bank can open a new branch in or outside the country or shift any branch from one place to another without obtaining a licence/permission from the Bangladesh Bank.Bangladesh Bank runs a Deposit Insurance Scheme established under the Deposit Insurance Ordinance 1984. The objective of the scheme is to safeguard the deposits of the customers with both local and foreign deposit money banks doing business in Bangladesh. The deposits amounting up to Tk 100,000 of all customers in a scheduled bank are insured under the scheme. All scheduled banks in Bangladesh are required to be members of the scheme and pay premium on their deposits at a rate determined by the Bangladesh Bank from time to time. Bangladesh Bank accumulates the premiums in the Deposit Insurance Fund.The paid up capital of Bangladesh Bank is Tk 30 million divided into 300,000 shares of Tk 100 each that are fully paid up by the government. A nine-member board of directors comprising the governor as chairman, one deputy governor and seven members oversees the affairs of the bank. The governor and the deputy governors of the Bank are appointed by the government for a period not exceeding five years and are eligible for reappointment.Bangladesh Bank has 9 branch offices, two in Dhaka city (sadarghat and Motijheel), and one each in chittagong, khulna, rajshahi, sylhet, bogra, rangpur and barisal. The head office discharges its duties with 28 departments. The departments are International, Law, Financial Institutions, Computer (2), Agricultural Credit, Agricultural Credit Inspection, Agricultural Credit Project, Credit Information Bureau, Research (3), Public Relations and Publications, Audit and Inspection, Statistics (2), Engineering, Problem Bank Monitoring, Administration, Training Academy, Foreign Exchange Policy, Foreign Exchange Inspection, Foreign Exchange Investment, Administration and Expenditure, Banking Inspection, Banking Regulation and Policy, Banking Operation and Development, Monetary Management and

Technical Unit, Currency Management and Accounts, Industrial Credit, and Security Management.Bangladesh Bank has correspondent relationships with one international and 8 foreign central banks viz., the Federal Reserve Bank of New York, Bank of Canada, Bank of England, Bank De France, Deutsche Bundes Bank, Bank of Japan, Svereges Riks Bank of Stockholm, Reserve Bank of India and the Bank for International Settlements, Basle. Besides, Bangladesh Bank has now invested its foreign exchange reserves with 14 banks at different international financial centers.To reduce the huge costs of printing currency notes from foreign countries Bangladesh Bank had initiated a Security Printing Project, which was converted into a limited company of the name The Security Printing Corporation (Bangladesh) Ltd. on 18th October 1992. The corporation is now working as a commercial concern and prints all currency and bank notes in Bangladesh. Other security papers, such as judicial and non-judicial stamps, prize bonds, revenue stamps, postal envelope and stamps, band rolls for customs and excise department, and cheque books of different private banks in Bangladesh are also printed by this company. The company however, does not have a minting plant and the country still remains dependent on foreign mint companies for minting the coinage.The powers and functions of Bangladesh Bank are governed by various laws and acts including the Banker’s Books Evidence Act 1891, Insolvency Act 1920, Banking Companies Ordinance 1962, Bangladesh Bank Order 1972, Foreign Exchange (Regulation) Act 1986, Money Loan Court Act 1990, Banking Companies Act 1991, Financial Institutions Act 1993 and Rules 1994, Companies Act 1994 and Bankruptcy Act 1997. [S M Mahfuzur Rahman]Some common services of schedule banks (Accounts, FDR, PDS,Deposit scheme)Current AccountGenerally this sort of account opens for business purpose. Customers can withdraw money once or more against their deposit. No interest can be paid to the customers in this account. If the amount of deposit is below taka 1,000 on an average the bank has authority to cut taka 50 from each account as incidental charge after every six months. Against this account loan facility can be ensured. Usually one can open this account with taka 500. One can open this sort of account through cash or check/bill. All the banks follow almost the same rules for opening current account.Savings Bank AccountUsually customers open this sort of account at a low interest for only security. This is also an initiative to create people’s savings tendency. Generally, this account is to be opened at taka

100. Interest is to be paid in June and December after every six months. If money is withdrawn twice a week or more than taka 10,000 is withdrawn (if 25% more compared to total deposit) then interest is not paid. This account guarantees loan. Almost all the banks follow the same rules in the field of savings account, except foreign banks for varying deposit. On an average, all the banks give around six percent interest.Special Services of BankSpecial ServicesSome Banks render special services to the customers attracting other banks.Internet Banking:Customers need an Internet access service. As an Internet Banking customer, he will be given a specific user ID and a confident password. The customer can then view his account balances online. It is the industry-standard method used to protect communications over the Internet.To ensure that customers’ personal data cannot be accessed by anyone but them, all reporting information has been secured using Version and Secure Sockets Layer (SSL).Home Banking:Home banking frees customers of visiting branches and most transactions will be automated to enable them to check their account activities transfer fund and to open L/C sitting in their own desk with the help of a PC and a telephone.Electronic Banking Services For Windows (EBSW)Electronic Banking Service for Windows (EBSW) provides a full range of reporting capabilities, and a comprehensive range of transaction initiation options.The customers will be able to process all payments as well as initiate L/Cs and amendments, through EBSW. They will be able to view the balances of all accounts, whether with Standard Chartered or with any other banks using SWIFT. Additionally, transactions may be approved by remote authorization even if the approver is out of station.Automated Teller Machine (ATM)Automated Teller Machine (ATM), a new concept in modern banking, has already been introduced to facilitate subscribers 24 hour cash access through a plastic card. The network of ATM installations will be adequately extended to enable customers to non-branch banking beyond banking.Tele Banking:Tele Banking allows customers to get access into their respective banking information 24 hours a day. Subscribers can update themselves by making a phone call. They can transfer any amount of deposit to other accounts irrespective of location either from home or office.

SWIFT:Swift is a Bank owned non-profit co-operative based in Belgium servicing the financial community worldwide. It ensures secure messaging having a global reach of 6,495 Banks and Financial Institutions in 178 countries, 24 hours a day. SWIFT global network carries an average 4 million message daily and estimated average value of payment messages is USD 2 trillion.Swift is a highly secured messaging network enables Banks to send and receive Fund Transfer, L/C related and other free format messages to and from any banks active in the network.Having SWIFT facility, Bank will be able to serve its customers more profitable by providing L/C, Payment and other messages efficiently and with utmost security. Especially it will be of great help for our clients dealing with Imports, Exports and Remittances etc.

Objectives of the paper:With giving an overview of what the monetary policy really is and narrating how the central bank formulates the monetary policies and takes the necessary steps for its implementation in Bangladesh, this paper targets to analyze the impact of monetary policy on the inflationary situation.Methodology:The study depends onI.            Extensive literature review of external sources on central banks on formulation and implementation ofmonetary policy for the countryII.            Publications of Bangladesh BankScope of the paper:

1.  First of all, monetary policy is a deep sea to swim through. Though Bangladesh practices and implements a limited number of instruments, the mix is always complex to grab the main idea behind it. Extensive analysis of the mix is beyond the scope of the paper.

2. Framing of indices of central bank policies is beyond the limit of this paper.3. Structured data is hard to collect from the departments of Bangladesh Bank, so complex

calculations and data analysis is deliberately avoided.Bangladesh Bank (BB):The central bank of the country, was established as a corporate body by the Bangladesh Bank Order, 1972 (P.O. No. 127 of 1972) with effect from 16 December, 1971 by acquiring the liabilities and assets of erstwhile State bank of Pakistan in East Pakistan.

Bangladesh Bank is the central bank of the country

There is a cross departmental committee on monetary policy (MPD) headed by a deputy governor, which includes the officials of the core departments of the bank for monitoringof the money market and exchange rate operations in the short term.Inflation:In economics, inflation is the rise in the general level of prices of goods and services in an economy over a period of time.  When the general price level rises,each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index, CPI) over time.Bangladesh has been facing an upward trend in inflation over the last couple of years. Inflation expands the wealth of the asset owners while it reduces the net consumption of the poor as the prices of goods and services go up. If a poor wants to maintain the same level of food consumption, it reduces his or her other consumption, including health, education and investment. Such increments in price without corresponding rise in disposable income restrain the government’s goal of reduction of poverty. So, our government tries to control inflation but with little success. For example, the inflation overshot the target of 6.5% in FY2008 –09.Sources of Inflation:The factors that affect the movement of the prices upward in Bangladesh include:

1.  Increased prices of inputs2. Upward price movements in the country of origin3.  Anticipated upward pressure on prices of gas, fuel and power4. Undervalued exchange rate5. Continuous pile-up of remittances vis-à-vis decreasing import6. Increased non-development expenditure7. Lack of prudential management of liquidity

 Monetary policy:Monetary policy is the main macro-economic policy formulated and implemented by the central bank. Bangladesh Bank has the authority to increase or decrease the volume of money in the economy and therefore, is responsible for formulating and implementing the monetary policy for the country. The wheel of development moves by taking forces from this policy. The aim of monetary policy is to keep inflation low and steady. Though, in a developing

country like Bangladesh, the effectiveness of monetary policies is always uncertain, but effectiveness of these policies is treated as signal for policy makers.Monetary Policy and Inflation:In a market oriented economy, central banks cannot control inflation directly. They have to use different instruments such as open market operation, legal reserve ratio, bank rate etc. Bangladesh Bank wants to stabilize the existing inflationary pressure by putting a break on money supply growth. The suggested tools to influence the growth of money stocks are:             I.            Restriction of broad money growth path          II.            Adjustment in cash reserve ratio (CRR)       III.            Statutory liquidity requirements (SLR)       IV.            Restriction in the capital accounts

Source: Debapriya Bhattacharya, Towfiqul Islam Khan: Recent Monetary Policy Statement of Bangladesh Bank (July 2009): An Analytical Commentary

All the banks were required to maintain 5% of their total demand and time liabilities to Bangladesh Bank as CRR and no less than 18.5 percent as SLR. But BB has raised the CRR and SLR for scheduled banks by one half percentage point from May2010 to restrain the expansion of monetary base.BB plans to continue to support sufficient credit availability to agriculture, small and medium enterprises (SMEs), renewable energy and other productive sectors, but it also intends to strongly discourage lending expansion for wasteful consumption and unproductive speculative investment. It also has stated that workers’ remittance growth would settle down and import growth would increase at a moderate level to ease out the inflows driven appreciation pressure of taka and also the monetary expansion, resulting out of such pressures.The policy target:In the backdrop of market economy, it is necessary that the monetary policy framework be articulated for greater clarity and transparency benefitting both the policy makers as well as the stake holders. The leading central banks in the industrial world have increasingly adopted the unitary goal of fighting inflation. However, the following objectives are also kept in mind:                               I.            The promotion  of price stability                            II.            GDP Growth                         III.            Ensuring full or near full employment                         IV.            Supporting national and global economic and financial stability

Inflation target:It is the general wisdom that the monetary policy tools are of immediate potency in controlling inflation. However, contemporary evidences imply that monetary policy cannot deal well with the inflationary impacts of external shocks such as the recent international price of oil and related energy products.Many central banks, as a consequence, focus on the core inflation, which is typically constructed by subtracting the most volatile components from the Consumer Price Index (CPI). Hence, as a policy goal, core inflation may be a more credible target than CPI inflation.It is quite relevant to set an indicative target band that will be realizable over the medium term. Inflation in Bangladesh has been moderate. The full CPI for the above period was about 6.77.In a floating rate system, there is no question of a target band for the currency par value and hence the short term adjustments in the exchange rate system are necessary. In order to maintain export competitiveness, one has to keep an eye on the evolving pattern of sectorial productivity changes in the competitor countries. If inflation is allowed to slip, the subsequent depreciation in the par value of the currency will fuel further inflation.Growth Target:As long as Bangladesh remains within the National Strategy for Accelerated Poverty Reduction (NSAPR) – Poverty Reduction Growth Facility (PRGF)framework, the growth target is already built in there. The latter is based on the medium term macro-economic framework (MTMF). Hence, inflation targets must be based on level of investment and Balance of Payment (BOP). The major constraint here is the lack of timely data on macro-economic indicators.Conductof Monetary Policy:Modern practices appear to be a rule based approach to the Conduct of Monetary Policy. John Taylor (1998) defines a monetary policy rule as a description of how the instruments of policy change in response to target economic variables. It routinely monitors the inflationary outlook by examining the evolving pattern of a broad index namely GDP Deflator and periodically decides to adjust the central bank rate or leave it unchanged. BB puts more emphasis on controlling inflation via the money multiplier, M2. The success of targeting broadmoney in controlling in inflation is premised on the long term equilibrium relationship between money and prices.Instruments of monetary policy:

BB has moved from regulations and control based monetary instruments towards market based policy. Directed lending has been reduced to minimum level except agriculture sector.The central bank has, in its disposal, a number of policy instruments. These can affect certain intermediate targets such a reserves, money supply, interest rates etc. The instruments of monetary policy are as follows:          I.            Bank Rate: The rediscount rate of discounting first class bills such as Treasury Bills. To check the credit operation (contractionary monetary policy), central banks increase bank rate. Borrowing becomes more expensive, hence demand for loans will be reduced.       II.            Open Market Operation: It refers to the buying or selling of securities and treasury bills by central bank in the open market so as far to influence the size of bank deposits. In times of inflation, BB will reduce the cash reserves of commercial banks by selling more treasury bills.    III.            Variation in Legal Reserve Requirement:  It means cash and liquidity ratios or reserve-asset ratios. The central bank has the authority to vary the cash and liquidity ratios in times of inflation. For instance it could increase the cash and liquidity ratios in times of inflation and the policy is reverse in times of deflation.    IV.            Selective Credit Control: The central bank may resort to credit rationing. It may prescribe absolute limits upto which specific sector of the economy may get credit from the banking system.       V.            Setting Marginal Requirements: Central bank may insist on marginal requirements. For instance, banks may be asked not to give loans exceeding 60% of the goods pledged on a particular good. It may instruct to set different interest rates to be charged on loans of different categories.    VI.            Moral Suasion: It is sometimes called Jaw Bone Control. BB, in times of inflation, may persuade the commercial banks to restrict their lending policy.Monetary Policy and macro-economic management:Monetary policy is used for achieving the objectives of macro-economic management and for providing a sound macro-economic environment. It refers to the overall economic measurement of a country with the purpose of achieving a target growth rate of the economy while:             I.            Maintaining price stability          II.            Making progress towards poverty alleviation and employment generation       III.            Achieving balance of payments viability

As described above, the broad money M2 can be influenced indirectly by changes in the monetary policy instruments that target and monitor the reserve money via the money multiplier, M. The cash reserve requirement ratio, (CRR) and the statutory liquidity ratio (SLR) are effective means of announcing the monetary policy stance.Anchor(s) of the Monetary PolicyIntermediate objectives (anchors) are important for monetary policy. They provide guidelines to policy-makers at times when ultimate objective (inflation or growth or both) responds with a lag. It also reduces the uncertainty and ensures transparency in policy making (Crockett, 2004) and (Lindsey and Wallach, 1989). In this context, three most popular approaches in a monetary policy regime are the following:             I.            Exchange rate targeting          II.            Monetary aggregate targeting       III.            Inflation targetingCentral bank independence and Inflation:The studies on whether increased central bank independence lead to a lower inflation show that countries with legally more independent central banks tend to have lower inflation which in the long run is not at the expense of lower economic growth.Consequences of the Monetary Policy:1.      Increase in the Average Interest RateAccording to the theory of liquidity preference espoused by the IMF, the interest rate rises when the central bank decreases the money supply. Since the average commercial lending rate in Bangladesh is almost close to 12.75% (FY 2010) and further raise may hamper the aggregate demand because the cost of borrowing would increase and firms spending on new factories and equipment would also reduce. This may also discourage them to hire more workers. Thus less hiring means lower employment.2.      Devaluation of BDT against U.S. DollarIn FY 2008-2009 and FY 2009-2010, continuous depreciation of Bangladeshi taka was observed due to the negative growth in the export sector. On an average, in 2008-2009 taka was depreciated by -0.066 points and in 2009-2010 taka was depreciated by -0.046 points. That is why the weighted average exchange rate against the U.S. dollar was 69.006 taka (on average) in FY 2008-09 and 69.4410 taka (on average), with Tk.0.435 difference and .63 percentage change in a year. Thus this undervalued exchange rate favors the export sector at the cost of inflation. Because the devaluation of money creates excess demand of domestically produced goods and thus shortage of supply increases the market prices.

 3.      Credit squeeze to private sector due to monetary contractionAccording to the MPS of FY2011, credit to the private sector will be squeezed by 28.25% at the end of FY 2011. Increase in govt. expenditure, mainly financed through borrowing, by 19.6 % to BDT 1321.7 billion will also result in crowding out of private sector. Thus unavailability of credit and unfavorable investment may hamper the growth generated by the private sector, therebyimpacting on the overall GDP growth.As Bangladesh economy is in need of higher investment, the average increase in the interest rate from the existing rate may not only increase the capital inflow but also dampen the business confidence of the investors as they would face credit squeeze due to the MPS’s instruments.4.      Impact on the Employment GenerationIn recent year, the unemployed population in Bangladesh has increased by 28.57% and the shifting of employed population from agriculture to non-agriculture has also increased by 4.50%. Poverty reduction is not possible without employment generation. If the service and industry sector cannot increase labor absorption capacity, the monetary policy may fail to fulfill one of its dual objectives.5.      Impact on AgricultureThe credit disbursement rate of agriculture for the recently completed FY 2009-10 is 97% of the target which is satisfactory in terms of disbursed amount. The disbursement record shows mismatch in disbursement time which in turn force the agricultural growth to shrink, with lower contribution to GDP.6.      Impact on IndustryThe contribution of the industrial sector in GDP was 29.95% in FY2009-10. The aim is to raisethis contribution in GDP to 40% by 2021. In order to keep the RMG sector alive, availability of credit must be ensured. As this sector holds a huge number of labors, the government should also pay attention about the employment condition of the labor forces.The availability of loan must be strictly ensured for the proper growth of SME sector by the local private and state-owned banks. NBFIs must also be encouraged for more contribution.7.      Impact on Power SectorBangladesh is facing severe power crisis in recent times. The per capita energy consumption is one of the lowest (165.32 kWh) in the world. Only 47% of the total population has access to electricity. Due to rental power plants with high per unit cost, the government has to bear huge cost per year for buying electricity from the private operators. The amount is almost BDT 5,000 crore per year.

The government may avoid huge subsidy by increasing the power tariff for the consumers. If the government provides the entire amount of extra payment, this might be resulted as higher budget deficit with higher borrowing for the government. On the other hand if the government decides to make higher the tariff level for avoiding higher subsidy, this might result with an inflationary pressure.Conclusion:As the ultimate goal of the macro-economic policy is to achieve optimal social welfare, instrument independence can ensure the requisite transparency, accountability and long term benefit in controlling inflation. An explicit declaration of inflation target can be instrumental.In a fiscal dominant country Bangladesh, where the fiscal authority sets its budget independently of public sector liabilities fiscal policy can affect monetary policy in different ways: Firstly through the impact of government inter-temporal budget constraint on monetary policy, secondly through the effect of fiscal policy on a number of monetary variables, such as interest rates, interest spreads and exchange rates.In the backdrop of easing inflationary pressure, the famous trade-off between growth and inflation may have taken a back seat for the moment. However, as global economic development continues to show signs of recovery, BB needs to be vigilant to maintain macroeconomic stability. The effectiveness of this monetary policy statement will largely depend on the capacity of BB to carry out its stated objectives and the effectiveness of related policy implementation. A pragmatic mix between fiscal and monetary policy can help us achieve that goal.References:        I.            The Bangladesh bank Order, 1972(amended upto march, 2003): President’s order No. 127 of 1972, Ministry of law and parliamentary Affairs, Govt. of Peoples’ Republic of Bangladesh.     II.            Gartner, Manfred (2002): Monetary policy and central bank behavior, September 2002, discussion paper no:2002-24III.            Md. MostaGausulHoque Deputy Secretary (Finance & Service) Bangladesh Public Service Commission (BPSC)Tel: 880-2-9334274(R), 9117265 (Off), 01715074409 (cell)IV.            Khan, Mohsin S. (2000): Current issue in the design and conduct of monetary policy, IMF working paper, IMF Institute, WP/03/56V.            Mankiw, N. Gregory (1997): Principles of Macroeconomics

VI.            ShubhasishBarua and Md. Habibour Rahman: Monetary Policy and Capital Market Development in Bangladesh. Policy Note: PN 0708

1. Md.MahmudulAlam, ShakilaYasmin, Mahmudur Rahman, and Md. Gazi Salah Uddin: Effect of Policy Reforms onMarket Efficiency: Evidence fromDhaka Stock Exchange

2. Bangladesh Economic Update Monetary Policy Statement, Real sector and Power, Vol.1. No.2, August 2010.

IX.            Debapriya Bhattacharya, Towfiqul Islam Khan: Recent Monetary Policy Statement of Bangladesh Bank (July 2009): An Analytical CommentaryX. www.bangladesh-bank.org/XI. www.cpd.org.bd/

1. www.mof.gov.bd/2. www.imf.org/3. www.worldbank.org/

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The Role of Central Banks in Promoting Sustainable Growth

Address delivered by Emsley D. Tromp, President of the Bank van de Nederlandse Antillen, on the occasion of the Seminar on Current Issues in Central Banking, organized by the Centrale

Bank van Aruba and the Universiteit van Aruba14 november 2002

 Ladies and gentlemen, good afternoon, Introduction It was with a great deal of pleasure that I accepted the invitation to address you on this seminar on “Current Issues in Central Banking” on the occasion of the inauguration of the new office building of the Central Bank of Aruba. The Central Bank of Aruba and the Bank van de Nederlandse Antillen share a common history that goes back to 1828. In 1828 the then King of the Netherlands, King William I established the Curacaosche Bank to finance and promote trade in the colony Curacao. Over time, this Bank grew into a full fledged Central Bank responsible for the conduct of monetary policy and the supervision of financial institutions in the Netherlands Antilles—including Aruba. With departure of Aruba from the Antillean constellation, the Bank van de Nederlandse Antillen was divided into two autonomous institutions entrusted with the conduct of monetary policy and the supervision of financial institutions in the two respective countries of the Kingdom.   Despite this legal separation, the two central banks continue to cooperate  on various matters. It is for this reason that I am glad that Hassalani Meheran who initiated and promoted this process of collaboration between the two central banks, is also present here today. This cooperation includes technical assistance, policy coordination and the exchange of ideas and experiences in various areas of central banking. Given our close ties, it is probably no coincidence that we both moved into a new office building this year. I would like to use this occasion to congratulate my Aruban colleagues with this milestone in their twelve years of existence. I am also very pleased to see so many of my colleagues and friends with whom I had and still have frequent contact as a central banker. This creates an excellent opportunity for a productive and fruitful exchange of views and ideas on current issues in central banking, which is the topic of this seminar. Ladies and gentlemen, I have been asked to talk about the role of central banks in promoting sustainable growth. Let me start by saying that central bank’s policy in small open economies as ours should be based on two overriding principles: (i) the protection of the value of the national currency and (ii) the preservation of overall financial stability.  In periods of economic difficulties however, central banks may be subjected to increasing pressure to pursue policies that may not be consistent with the two principles mentioned earlier. Central banks may be pressured to provide financing to the government, provide credit to the private sector and pursue policies to lower interest rates that may be inconsistent with the underlying economic fundamentals. However, as history taught us monetary policy can provide only temporary stimulus to the economy. Subsequently monetary policy must be followed by corrective measures. Central banks should refrain also from engaging in activities that may put them in direct

competition with commercial banks. This is tantamount to un-leveling the playing field and will interfere with the effective performance of central bank functions. To avoid this, central banks should have a medium-term horizon in the conduct of policies aimed at promoting sustainable growth and job creation. Ladies and gentlemen, I will continue my address by focusing on the necessary conditions for creating an environment conducive to more investments and, hence, economic growth. As we shall see, these conditions are closely related to the main objectives of central banks that I mentioned earlier, underpinning the role of central banks in promoting sustainable growth. The regional pattern and composition of capital flows suggest that investors have become more sensitive to economic fundamentals in host countries. What I mean to say is that investors are factoring macroeconomic variables into their investment decisions. These macroeconomic variables include among other the size of the current account deficits in relation to foreign exchange reserves, government debt, government deficits, inflation, domestic savings, growth potential, and the soundness of the banking system. This implies that a stable macroeconomic environment is critical for a stable and sound development of the financial sector. A stable financial sector and the sound development of the financial system in the long run depend on the quality of our financial institutions and the effectiveness of banking supervision.  Therefore, macroeconomic stability, high quality financial institutions, and effective banking supervision are necessary conditions and key success factors for sustainable growth. Let me elaborate on this issue further. Macroeconomic stabilityA stable macroeconomic environment promotes savings necessary to finance investments--a precondition for achieving sustainable economic growth. In today’s global environment, market perceptions are important explanatory variables in determining where capital flows. Thus, if we are to attract the needed capital to sustain the growth of our economies, we have to pursue policies that the market perceives as credible and will result in growth and stability. This means: (i) sound macroeconomic policies, (ii) comprehensive structural reform, and (iii) good governance. The economies of Aruba and of the Netherlands Antilles are characterized by their smallness and openness. External economic relations account for a substantial part of national expenditures, while economic activities are concentrated around only a few important pillars such as tourism, financial services, and oil refining, which are mostly dependent on foreign markets.  Our region has been beset by adverse macroeconomic conditions in the 1980s and 1990s: terms of trade shocks, rising debts, natural disasters, loss of international competitiveness in key export industries, and inappropriate macroeconomic policies –particularly fiscal policies– were largely responsible for the persistence of balance of payments deficits. The appropriate response to these external shocks to our economies would have been consistent monetary, fiscal and trade policies, combined with policies to promote savings, investment, and the enhancement of our foreign exchange generating capacity. Of course, we must allow for

differences in emphasis and intensity, depending on the specific economic circumstances and characteristics of the various countries. However, we have not always responded timely and adequately to these shocks. The Netherlands Antilles did not escape the winds of adverse macroeconomic conditions. The origins of the current financial-economic crisis started some 15 years ago with a series of large external shocks which hit the three main pillars of our economy. In this respect I can mention the repeal of the withholding tax in the United States, which caused the collapse of a number of highly profitable activities in the international financial and business services sector. Another major shock was the oil crisis, which affected us in two ways. First, it caused a large devaluation of the Bolivar, which ended the buoyant shopping tourism from Venezuela to our islands. Second, it prompted the closure of Shell’s Curacao refinery. These two major shocks were aggravated by a number of smaller shocks, such as several devastating hurricanes on the Windward Islands, the discontinuation of certain trade privileges on the European market, and the uncertainties surrounding the change of the Tax Arrangement for the Kingdom. The impact of the shocks and inadequate policy responses by the authorities resulted in large macro-economic imbalances. It became evident that only a major restructuring of the economy would create a basis for sustainable growth. At the end of 1995, the Netherlands Antilles embarked on a structural adjustment program in close cooperation with international organizations, such as the IMF, the IDB, the FIAS, and the World Bank. Our structural adjustment strategy entailed a three-pronged approach: (i) re-establishing confidence in the public sector by pursuing fiscal consolidation and structural reform, (ii) a growth strategy, and (iii) a social policy.  During the past six years, we have made considerable progress in restructuring the public finances and implementing structural reform. The government bureaucracy has been reduced, wage costs have been brought under control, and the civil servants pension scheme has been partially reformed. The improvement of cost efficiency in the government apparatus has further reduced expenditures. On the revenue side, a shift from direct to indirect taxes was initiated with the introduction of the turnover tax, the base of which has been broadened gradually. Tax assessment and collection have been improved, while arrears have been reduced. Furthermore, user fees for government services are applied more broadly. In addition, public sector financial administration and reporting has been enhanced. I have to note here that while considerable progress has been made, we still need to go a long way to get our budgets in equilibrium. I like to stress here on the need to take timely measures. In the field of structural reform, various measures have been implemented to foster competition and to create a business climate conducive to more investments. Labor legislation has been modernized and the product market is being made more competitive. Progress also has been made in the capital market: disclosures have improved, and the interest rate level has declined. The privatization process has also started. All of this has been done with the objective of improving our business climate and, hence, restoring economic growth. 

Given the involvement of the IMF in the structural adjustment of the Antillean economy, strong emphasis was placed on fiscal adjustment and an appropriately tight monetary policy. Our significant internal and external macroeconomic disequilibria warranted this approach. However, the accompanying growth strategy and social policies were neither timely nor fully implemented. As a consequence, it is only now that we are seeing signs of recovery from the recession we endured during the adjustment process. This lack of synchronization of policies resulted in a large part of our population migrating to Holland in the hope of a better future. The experience of the Netherlands Antilles serves to illustrate that the timing and sequencing of the policy measures in adjustment programs are of critical importance. Furthermore, adjustment programs should be appropriately tailored, taking into account differences in economic structure, institutional arrangements, and institutional capacity when implementing and monitoring the program. If these points are overlooked, it can lead to unnecessary derailment of the program and will consequently affect authority’s credibility and commitment to adjustment. Aside from these country specific points, ladies and gentlemen, there are some overriding principles that apply to all countries in promoting a stable macroeconomic environment. First, economic discipline is the cornerstone of success. It helps shape the market perception and investors’ confidence in the policies pursued by a country. Second, policies should be consistently implemented to assure economic agents that the favorable business climate will last. Third, credibility is very important: once lost, it takes great efforts and time to regain.  The central bank’s role in promoting a stable macroeconomic environment is reflected through the design and implementation of its monetary policy, representing one of the main pillars of overall macroeconomic policy. This role is extended further in the coordination of monetary and fiscal policies and the advising of government on overall macroeconomic policy. On the long run, financial stability cannot be maintained unless monetary policy is complemented by sound fiscal policy.  Having said this, I now would like to turn to the issue of the quality of the financial sector. 

Quality of the financial sectorA stable macroeconomic environment is a necessary, but not sufficient condition to create a climate conducive to sustainable growth. The second key factor for success is quality financial institutions. Financial institutions of high quality are usually the driving force behind a stable financial system. To maintain quality financial institutions, several things are needed: (i) an adequate admission and licensing policy, (ii) a comprehensive and effective supervisory framework, and (iii) appropriate mechanisms to resolve distressed financial institutions. The main regional financial centers, including the Netherlands Antilles, have a well-developed banking system as well as various non-banking financial intermediaries. The commercial banks are equipped with trust, insurance and investment departments that provide both local and international services.  

The main banking sectors of the region are comprised of both domestic and international banks that are mainly subsidiaries and affiliates of major international banks of industrialized countries such as the United States, the United Kingdom, the Netherlands, and other European countries. However, noteworthy is the nascent development of Caribbean financial institutions with regional ambitions, of which RBTT Bank is a good example. Notwithstanding the numerous financial institutions, there is a lack of well-developed money and capital markets in the Caribbean. Therefore, in comparison with the industrialized countries, financial institutions, especially banks, still play a very prominent role in the allocation of resources in our economies, and are the main channels through which economic development is financed. Due to the globalization of the marketplace and technological advancements, especially in the application of computer technology and telecommunication systems, our local financial sectors have undergone substantial changes becoming more dynamic and innovative. The number of new financial products and services has expanded dramatically, and modern technology has added a new dimension to the activities in this sector. Several other factors have contributed to the broadening of financial intermediation and monetization in the Caribbean economies. For example, the growth and expansion of non-bank financial intermediaries, such as credit unions, insurance companies and mutual funds forced commercial banks to seek innovative ways to expand and diversify their operations in order to maintain their competitiveness and profitability. In this regard, commercial banks are increasingly diversifying into non-traditional financial activities such as leasing and insurance services. As a consequence, distinctions between commercial banks and other financial institutions are blurring and as financial assets become more accessible, the difficulties of maintaining monetary control are increasing. However, despite the rapid growth in the activities of non-bank financial intermediaries, commercial banks still dominate the financial system in the Caribbean, and bank loans are still the primary source of financing. In addition, another important factor is the oligopolistic nature of the bank-based financial system in the Caribbean and its consequent implications for the pricing of financial services. Another interesting feature in the Caribbean financial infrastructure is the fact that most loans are collaterized. The phenomena can be best explained by informational asymmetries in the credit market. There is some evidence that problems related to imperfect or asymmetric information may be more severe in small economies like those in the Caribbean, particularly with regard to foreign investors. Indeed, the sources of information in the Caribbean countries are still limited compared to other countries. Moreover, most banks in the Caribbean are not equipped with a financial-economic research unit and, consequently, do not engage actively in research on investment prospects. This limits their ability to pursue innovative and flexible policies to bring about sectoral shifts in the employment of their resources. 

Hence, because of internal limitations and the fact that the information bases of the banks in the Caribbean region are not very extensive, they rely heavily on collateral security as an information acquisition device and a means of protection against credit risk. The role of the central bank in promoting quality financial institutions lies in the design and implementation of policies, which encourage domestic savings to remain at home and to flow to the local financial institutions. Thus, more local resources can be mobilized to finance the investment required for sustainable economic development. Moreover, savers must be assured of the liquidity of the instruments issued by financial institutions as well as about the soundness of the institutions themselves. Furthermore, the financial instruments offered must provide reasonable earnings, competitive with alternative uses of funds. Particular attention should be paid to the liquidity of financial assets, which can be promoted by the further development of the capital market. In this respect, the Bank van de Nederlandse Antillen has made significant progress in the development of an active secondary market in government securities. With the gradual broadening of the capital market with, for example, securities issued by development finance institutions, we can further contribute to the channeling of funds for development and growth. The Bank van de Nederlandse Antillen also strives to promote domestic savings by exempting long-term deposits –more than two years to maturity– from the calculation of the reserve requirement commercial banks have to hold. Banking regulation and supervisionIn addition to creating a stable macroeconomic environment and quality financial institutions, an adequate regulatory and supervisory framework to guarantee a sound financial system is imperative. Thus, the third key factor for success in creating a stable climate conducive to sustainable growth is effective banking regulation and supervision. In terms of public policy, the need for adequate prudential supervision arises ultimately from four fundamental policy concerns: (i) safety and soundness of individual banks, (ii) maintaining healthy competition and a level playing field, (iii) consumer protection, and (iv) systemic stability. In other words, prudential supervision should provide reasonable assurances for efficient banking in a healthy competitive environment, protect depositors, and promote the stability of the financial system in the long run. In order to accomplish these goals, the supervisory authority should have a transparent and effective regulatory framework to exercise adequate and comprehensive supervision on a consolidated basis. The benefits of having a banking supervisory framework, which regulates the entrance, supervision and liquidation of institutions in the banking sector in an efficient and effective manner, is self-evident. To avoid weak banks from entering the financial system, adequate admission and licensing policies must be implemented, based on a sound legal framework. In this regard, in 1990, the Netherlands Antilles adopted the policy that in principle, only international banking institutions belonging to the World Top 1000 –based on total assets– will be admitted to the banking sector. I have to say that this policy has served us well. Despite the trying economic times that we went through during the last six years, our banks have weathered the financial storms with impressive resiliency. 

 This policy was a qualitative decision to guarantee admission of only quality banks into the financial system. By making this decision, the Netherlands Antilles chose a policy of controlled growth in the banking sector, given the benefits for financial stability in the long run.  In addition to the admission policies and guidelines, stringent licensing requirements to operate a banking institution should be in place to guarantee the safety and soundness of the financial institutions. These requirements should at least cover minimum capitalization in line with international standards, good liquidity ratios, a sound business plan for the medium and long term, and fit and proper shareholders. Moreover, also management has to be fit and proper and with the necessary professional training and experience supported by an adequate internal audit systems and good corporate governance. Finally, in order to prevent bank failures as much as possible and to resolve failing banks in a timely manner, an effective intervention framework is necessary. Taking the importance of banking in our society and its role in the process of economic development into account, the implementation of the concept of adequate and comprehensive financial supervision in the Netherlands Antilles has been one of the main focal points for the supervisory authorities and its main stakeholders. A word of caution is at the order.  Banks should not be forced to operate in an over-regulated and over-restrained structure. But still the elements needed for the proper transmission of monetary policy through a safe and sound banking system should be maintained. In addition to appropriate legislation and regulations, adequate supervision also comprises effective off-site surveillance and on-site inspection. It is known and acknowledged that desk supervision without periodic investigation of the books and records of the institutions is ineffective, since misstatements, omissions, overstatement of the value of assets, or understatement of the liabilities will necessarily lead to an overstatement of the institution’s solvency position.  Despite the efforts of banking supervisors, international practice has shown over and over again that failing or distressed financial institutions may threaten the stability of the financial system from time to time. Therefore, in addition to adequate preventive measures, an adequate system of curative or problem-resolution measures with respect to troubled financial institutions is imperative in maintaining the stability of the financial system. Also, with the increasing globalization of our economies and financial systems, threats to the financial system may come from a variety sources--both internal and external. Hence, the legal supervisory framework should provide for adequate mechanisms for liquidation and the restructuring of distressed institutions. While liquidation is an administrative measure not directed at continuity, the liquidation process is a natural response to a failed institution and must be handled well to preserve confidence in the system as a whole. On the other hand, restructuring a failing entity is directed towards its continuation as a financial institution in the financial sector. At an early stage there may still be some value in selling a distressed institution or turning it around into a profitable institution.  

Evidently, central banks must have full responsibility for bank regulation and supervision, particularly in Caribbean economies, to realize economies of scale in staff and information technology necessary to exercise their supervisory tasks efficiently and effectively. Banking institutions, sanctioned by a license from the central bank, share in the responsibilities to protect the value of the currency. They indeed become the conduit through which monetary policy is transmitted and their special relations with the central bank, for example through borrowing facilities, are of vital importance for maintaining overall financial stability. Concluding remarksLadies and gentlemen, it must be clear to all of us that central banks play an important role in promoting sustainable growth and development. This role should not be exercised directly, since this tends to conflict with the effective performance of the core central bank functions. Therefore, central banks should focus on creating the necessary conditions in which growth and development can prosper. These conditions are based on the two overriding principles of: (i) protecting the value of the national currency and (ii) the preservation of overall financial stability.  This means that, first, we must pursue sound and appropriately coordinated economic policies to minimize potential sources of instability. Fiscal consolidation is not enough. It is the quality of expenditures that is important. Structural adjustment is no instant cure. Once we have achieved a healthy macroeconomic environment, we should muster permanent discipline. To be able to react quickly and effectively to new opportunities in the world economy, we have to promote private sector activities and open up our markets. This will create an investment climate that both domestic and foreign investors find attractive to invest to bolster growth and development.  Second, we must have a stable and sound financial system. From the discussion above, it is abundantly clear that it is not possible to have a sound financial system with quality financial institutions without adequate and effective supervisory policies, including adequate policies to resolve distressed financial institutions effectively and efficiently. The concerns for safety and soundness of individual banks, maintaining healthy competition and a level playing field, consumer protection, and systemic stability call for a transparent and comprehensive regulatory framework. And in a world that is constantly changing, we must subject our regulatory and surveillance activities to constant reforms to maintain a sound regulatory and supervisory environment. By pursuing these policies we will make a lasting contribution to growth and development. It is through this channel that we as central bankers can contribute to the enhancement of the general welfare of our community. 

 

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What are the important roles played by Central Bank in developing countries ?APARIJITA SINHA

In the developing countries, the central bank has to play a much wider role. Besides performing the traditional functions, the central bank has to undertake responsibility of economic growth with stability in these economies. Moreover, since the developing countries do not have well- organised money and capital markets, the central bank has a crucial function to develop the banking and financial system of the country. The central bank performs the following developmental and promotional functions in the developing countries.

1. Traditional Functions:

The central banks in the developing countries perform both traditional and non-traditional functions. The traditional functions of the central bank are : having the monopoly of note-issue; acting as banker to the government; serving as bankers' bank; functioning as the lender of the last resort; controlling and regulating the credit; and maintaining the external stability.

2. Economic Growth:The central banks in the developing countries should aim at promoting the process of economic growth. Economic growth requires sufficient financial resources. The central bank can ensure adequate monetary expansion in the country. Moreover, as a banker to the government, the central bank can provide funds for initiating investment in the public sector.3. Internal Stability:Along with the objective of economic growth, the central bank should also attempt to maintain internal price stability. The developing countries are susceptible to inflationary pressures mainly due to supply -in elasticities in the short period. The central bank should adopt such a monetary policy that can control inflationary tendencies and ensure price stability.4. Development of Banking System:The developing and underdeveloped countries do not have well-developed banking system. In such an economy, the central bank should not only take measures to develop an integrated commercial banking system, but also should not hesitate undertaking directly the commercial banking functions.5. Branch Expansion:In developing countries, the commercial banks generally concentrate their branches in the urban areas. In order to extend credit facilities to the agricultural sector, the central bank should prepare programme for branch expansion in the rural areas.6. Development of Financial Institutions:Development of the leading sectors of the economy such as agriculture, industry, foreign trade, etc. requires long-term finances. For this, the specialised financial institutions should be established which provide term-loans to these sectors.7. Development of Banking Habits:Through its various credit control instruments (i.e., bank rate, variable cash-reserve ratio, etc.) and by providing discounting facilities to the commercial banks, the central bank exercises full control over the activities of commercial banks. This creates public confidence in the banking system and helps in the development of banking habits of the people.8. Training Facilities:

A major difficulty in developing the banking system in developing countries is the lack of trained staff. The central bank can provide training facilities to meet the personnel requirements of the banks.9. Proper Interest Rate Structure:

The central bank can help in establishing a suitable interest rate structure to influence the direction of investment in the country. In underdeveloped countries, a policy of low interest rate is necessary for encouraging investment and promoting development activities. Again, by adopting different interest rates, the central bank can increase productive investment and discourage unproductive investment.

10. Other Promotional Roles:

The central bank can provide a number of other promotional facilities. For example, (a) it can adopt policies to provide help to the various priority sectors, such as agriculture;, cooperative sector, small scale sector, export sector, etc. (b) it can provide guidelines to be followed by the planners about some definite patterns of economic and investment policies; (c) it can publish information regarding the state of the economy and promote research in money and banking.

Conclusion:

In short, the central bank has to play not only regulatory, but also developmental role in the developing countries. In the words of Planning Commission of India, the central bank has to take "a direct and active role (a) in creating or helping to create the machinery needed for financing development activities all over the country, and (b) in ensuring that the finance available flows in the directions intended."

The Role of Central Bank in a Developing Economy of a Country

by Saritha Pujari Central Bank

Read this article to learn about the role of central bank in a developing economy of a country!The central bank in a developing economy performs both traditional and non-traditional functions. The principal traditional functions performed by it are the monopoly of note issue, banker to the government, bankers’ bank, lender of the last resort, controller of credit and maintaining stable exchange rate.

But all these functions are related to the foremost function of helping in the economic development of the country.

Role of Central Bank in Economic Development:The central bank in a developing country aims at the promotion and maintenance of a rising level of production, employment and real income in the country. The central banks in the majority of

underdeveloped countries have been given wide powers to promote the growth of such economies. They, therefore, perform the following functions towards this end.

Creation and Expansion of Financial Institutions:One of the aims of a central bank in an underdeveloped country is to improve its currency and credit system. More banks and financial institutions are required to be set up to provide larger credit facilities and to divert voluntary savings into productive channels. Financial institutions are localised in big cities in underdeveloped countries and provide credit facilities to estates, plantations, big industrial and commercial houses.

In order to remedy this, the central bank should extend branch banking to rural areas to make credit available to peasants, small businessmen and traders. In underdeveloped countries, the commercial banks provide only short-term loans. Credit facilities in rural areas are mostly non-existent. The only source is the village moneylender who charges exorbitant interest rates.

The hold of the village moneylender in rural areas can be slackened if new institutional arrangements are made by the central bank in providing short-term, medium term and long-term credit at lower interest rates to the cultivators. A network of co-operative credit societies with apex banks financed by the central bank can help solve the problem.

Similarly, it can help the establishment of lead banks and through them regional rural banks for providing credit facilities to marginal farmers, landless agricultural workers and other weaker sections. With the vast resources at its command, the central bank can also help in establishing industrial banks and financial corporations in order to finance large and small industries.

Proper Adjustment between Demand for and Supply of Money:The central bank plays an important role in bringing about a proper adjustment between demand for and supply of money. An imbalance between the two is reflected in the price level. A shortage of money supply will inhibit growth while an excess of it will lead to inflation. As the economy develops, the demand for money is likely to go up due to gradual monetization of the non-monetized sector and the increase in agricultural and industrial production and prices.

The demand for money for transactions and speculative motives will also rise. So the increase in money supply will have to be more than proportionate to the increase in the demand for money in order to avoid inflation. There is, however, the likelihood of increased money supply being used for speculative purposes, thereby inhibiting growth and causing inflation.

The central bank controls the uses of money and credit by an appropriate monetary policy. Thus in an underdeveloped economy, the central bank should control the supply of money in such a way that the price level is prevented from rising without affecting investment and production adversely.

A Suitable Interest Rate Policy:In an underdeveloped country the interest rate structure stands at a very high level. There are also vast disparities between long-term and short-term interest rates and between interest rates in different sectors of the economy. The existence of high interest rates acts as an obstacle to the growth of both private and public investment, in an underdeveloped economy.

A low interest rate is, therefore, essential for encouraging private investment in agriculture and industry. Since in underdeveloped country businessmen have little savings out of undistributed profits, they have to borrow from the banks or from the capital market for purposes of investment and they would borrow only if the interest rate is low. A low interest rate policy is also essential for encouraging public investment. A low interest rate policy is a cheap money policy. It makes public borrowing cheap, keeps the cost of servicing public debt low and thus helps in financing economic development.

In order to discourage the flow of resources into speculative borrowing and investment, the central bank should follow a policy of discriminatory interest rates, charging high rates for non-essential and unproductive loans and low rates for productive loans. But this does not imply that savings are interest-elastic in an underdeveloped economy.

Since the level of income is low in such economies, a high rate of interest is not likely to raise the propensity to save. In the context of economic growth, as the economy develops, a progressive rise in the price level is inevitable. The value of money falls and the propensity to save declines further. Money conditions become tight and there is a tendency for the rate of interest to rise automatically. This would result in inflation. In such a situation any effort to control inflation by raising the rate of interest would be disastrous. A stable price level is, therefore, essential for the success of a low interest rate policy which can be maintained by following a judicious monetary policy by the central bank.Debt Management:Debt management is one of the important functions of the central bank in an underdeveloped country. It should aim at proper timing and issuing of government bonds, stabilizing their prices and minimizing the cost of servicing public debt. It is the central bank which undertakes the

selling and buying of government bonds and making timely changes in the structure and composition of public debt.

In order to strengthen and stabilize the market for government bonds, the policy of low interest rates is essential. For, a low rate of interest raises the price of government bonds, thereby making them more attractive to the public and giving an impetus to the public borrowing programmes of the government. The maintenance of structure of low interest rates is also called for minimizing the cost of servicing the national debt.

Further, it encourages funding of debt by private firms. However, the success of debt management would depend upon the existence of well-developed money and capital markets in which wide range of securities exist both for short and long periods. It is the central bank which can help in the development of these markets.

Credit Control:Central Bank should also aim at controlling credit in order to influence the patterns of investment and production in a developing economy. Its main objective is to control inflationary pressures arising in the process of development. This requires the use of both quantitative and qualitative methods of credit control.

Open market operations are not successful in controlling inflation in underdeveloped countries because the bill market is small and undeveloped. Commercial banks keep an elastic cash-deposit ratio because the central bank’s control over them is not complete. They are also reluctant to invest in government securities due to their relatively low interest rates.

Moreover, instead of investing in government securities, they prefer to keep their reserves in liquid form such as gold, foreign exchange and cash. Commercial banks are also not in the habit of rediscounting or borrowing from the central bank.

The bank rate policy is also not so effective in controlling credit in LDCs due to: (a) the lack of bills of discount; (b) the narrow size of the bill market; (c) a large non-monetised sector where barter transactions take place; (d) the existence of a large unorganised money market; (e) the existence of indigenous banks which do not discount bills with the central banks; and (f) the habit of commercial banks to keep large cash reserves.

The use of variable reserve ratio as method of credit control is more effective than open market operations and bank rate policy in LDCs. Since the market for securities is very small, open

market operations are not successful. But a rise or fall in the reserve ratio by the central bank reduces or increases the cash available with the commercial banks without affecting adversely the prices of securities.

Again, the commercial banks keep large cash reserves which cannot be reduced by a raise in the bank rate or sale of securities by the central bank. But raising the cash-reserve ratio reduces liquidity with the banks. However, the use of variable reserve ratio has certain limitations in LDCs.

First, the non-banking financial intermediaries do not keep deposits with the central bank so they are not affected by it. Second, banks which do not maintain excess liquidity are not affected than those who maintain it.

The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the allocation of credit, and thereby the pattern of investment. In underdeveloped countries, there is a strong tendency to invest in gold, jewellery, inventories, real estate, etc., instead of in alternative productive channels available in agriculture, mining, plantations and industry.

The selective credit controls are more appropriate for controlling and limiting credit facilitates for such unproductive purposes. They are beneficial in controlling speculative activities in food-grains and raw materials. They prove more useful in controlling ‘sectional inflations’ in the economy.

They curtail the demand for imports by making it obligatory on importers to deposit in advance an amount equal to the value of foreign currency. This has also the effect of reducing the reserves of the banks in so far as their deposits are transferred to the central banks in the process. The selective credit control measures may take the form of changing the margin requirements against certain types of collateral, the regulation of consumer credit and the rationing of credit.

Solving the Balance of Payments Problem:The central bank should also aim at preventing and solving the balance of payments problem in a developing economy. Such economies face serious balance of payments difficulties to fulfil the targets of development plans. An imbalance is created between imports and exports which continue to widen with development.

The central bank manages and controls the foreign exchange of the country and also acts as the technical adviser to the government on foreign exchange policy. It is the function of the central bank to avoid fluctuations in the foreign exchange rates and to maintain stability. It does so through exchange controls and variations in the bank rate. For instance, if the value of the national currency continues to fall, it may raise the bank rate and thus encourage the inflow of foreign currencies.

Conclusion:Thus the central bank plays an important role in achieving economic growth of a developing country through the various measures discussed above. It should promote economic growth with stability, help in attaining full employment of resources, in overcoming balance of payments disequilibrium, and in stabilising exchange rates.

4 Methods used by the Central Bank for Credit Control | Banking

by Smriti Chand Central Bank

The four important methods used by the Central Bank for Credit Control are as follows:1. Bank Rate or Discount Rate Policy:The bank rate or the discount rate is the rate fixed by the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial banks. The bank rate is the interest rate charged by the central bank at which it provides rediscount to banks through the discount window. The central bank controls credit by making variations in the bank rate.

If the need of the economy is to expand credit, the central bank lowers the bank rate. Borrowing from the central bank becomes cheap and easy. So the commercial banks will borrow more. They will, in turn, advance loans to customers at a lower rate. The market rate of interest will be reduced.

This encourages business activity, and expansion of credit follows which encourages the rise in prices. The opposite happens when credit is to be contracted in the economy. The central bank raises the bank rate which makes borrowing costly from it. So the banks borrow less. They, in turn, raise their lending rates to customers.

The market rate of interest also rises because of the tight money market. This discourages fresh loans and puts pressure on borrowers to pay their past debts. This discourages business activity.

There is contraction of credit which depresses the rise in price. Thus lowering the bank rate offsets deflationary tendencies and raising the bank rate controls inflation.

But how do changes in the bank rate affect prices and production? There are two views which explain this process. One held by R.G. Hawtrey and the other by Keynes.

Hawtrey’s View:According to Hawtrey, changes in the bank rate affect changes in the short-term rates of interest which, in turn, affect the behaviour of dealers and producers in holding short of finished and semi-finished goods. Suppose the bank rate rises. It raises the stock-term interest rates. Consequently, the cost of borrowing and of holding stocks of goods increases.

The dealers will, therefore, try to reduce their stocks of goods, and place less orders to the producers of goods. The sales of producers will start declining. So they will lower prices to induce dealers to buy more of their goods. Or, they will reduce output. As they curtail output, some of the factors of production become unemployed.

Money incomes fall due to unemployment. This further reduces the sale of goods, and the dealers reduce their orders to the producers further who in turn, reduce their production. So ultimately there will be a fall in prices, production and employment in the economy. The converse will be the case when the bank rate falls which will reduce the short-term interest rates, and encourage prices, production and employment through the encouraging behaviour of traders and producers.

Keynes’s View:Keynes in his Treatise on Money gives an alternative view-based upon changes in the volume of fixed capital following a change in the long-term rate of interest. According to him when the bank rate changes, the long-term interest rates also change in the same direction and will affect investment, prices and employment in the following manner.

Suppose the bank rate is increased. It will raise the short-term interest rates in the money market, while the long-term interest rates remain unchanged. As a result, short-term securities become more attractive because they carry high rates of interest. But the value of long-term securities declines because they now carry low rates of interest than at which they were purchased in the past.

The holders of long-term securities will, therefore, sell their securities and invest in short-term securities. This will adversely affect long-term investments in the economy. Consequently, long-term rates of interest will also rise. With the rise in the long-term interest rates, businessmen and producers will reduce investment on fixed capital assets. Employment falls in the capital goods industries. Money income declines.

Expenditure on consumption goods is reduced. This leads to fall in their prices and production. Conversely, a fall in the bank rate will lower the long-term interest rates, investment, employment, income, prices and production.

It is not possible to verify empirically these two views. They presuppose that businessmen and producers are very sensitive to interest rate changes and interest charges form a considerable part of the cost of holding and production of goods. Both the assumptions are unrealistic.

First, prices and production are not so sensitive to changes in interest rates. Second, interest rates form an insignificant part of the total cost of holding and production of goods. Interest rate is only one of the factors which determine the volume of investment in stocks of goods and in fixed capital goods.

Further, the two views are neither contrary nor mutually exclusive. Hawtrey lays emphasis on changes in the short-term interest rates and Keynes on the long-term interest rates, as a result of changes in the bank rate. But ultimately both lead to the same results, though the process of causation is a little different in each case. For instance, a change in the bank rate may affect the holdings of stocks of goods as well as the volume of fixed capital goods whether the short-term or the long-term interest rates change.

Views of Radcliffe Committee:The Radcliffe Committee appointed by the British Government in 1959 analysed two effects of the bank rate policy upon business activity. The first is the interest-incentive effect. When the bank rate changes, it brings changes in the market rates of interest, thereby inducing a change in the incentive of investment expenditures of business firms. A rise in the bank rate raises interest rates. The Cost of holding capital goods increases which causes a disincentive for investors and business firms to borrow funds. Thus with the increase in the cost of borrowing funds, there will be a disincentive for investors and business firms to borrow from the commercial banks.

The opposite will be the case when the bank rate falls. It reduces market interest rates, thereby reducing the cost of borrowing from the banks. This provides an incentive to investors and

businessmen to get more advances from the banks. But the Committee ruled out the interest-incentive effect because business decisions are primarily independent of changes in interest rates. Moreover, interest-payments form an insignificant proportion of total costs of business firms.

The Committee analysed a more important effect of the bank rate changes, known as the ‘general liquidity effect’. According to the Committee, the interest-incentive effect of a change in the bank rate being small, there may take place a ‘valuation effect’ or general liquidity effect. Bank rate changes affect the capital values of the assets of business firms, and consequently, their balance sheets and their ability to lend.

A rise in the bank rates raises the market rates, thereby reducing the value of capital assets of financial institutions. Thus they are willing to lend less. On the other hand, a fall in the bank rate lowers the market rates, and the value of capital assets increases. It encourages lenders to seek new business.

The real force of changes in the bank rate lies in its effects on the liquidity of the various groups of financial institutions through market interest rates which (i.e. liquidity), in turn, affects the liquidity of others. This is the general liquidity effect of changes in the bank rate. While analysing this effect, the Committee takes into view the interrelationship of short, medium and long-term interest rates.

Limitations of Bank Rate Policy:The efficacy of the bank rate policy as an instrument of controlling credit is limited by the following factors:

1. Market Rates do not change with Bank Rate:The success of the bank rate policy depends upon the extent to which other market rates of interest change along with the bank rate. The theory of bank rate policy pre-supposes that other rates of interest prevailing in the money market change in the direction of the change in the bank rate. If this condition is not satisfied, the bank rate policy will be totally ineffective as an instrument of credit control.

2. Wages, Costs and Prices not Elastic:The success of the bank rate policy requires elasticity not only in interest rates but also in wages, costs and prices. It implies that when suppose the bank rate is raised wages, costs and prices should automatically adjust themselves to a lower level. But this was possible only under gold standard. Now-a-days the emergence of strong trade unions has made wages rigid during

deflationary trends. And they also lag behind when there are inflationary tendencies because it takes time for unions to get a wage rise from employers. So the bank rate policy cannot be a success in a rigid society.

3. Banks do not approach Central Bank:The effectiveness of the bank rate policy as a tool of credit control is also limited by the behaviour of the commercial banks. It is only if the commercial banks approach the central bank for rediscounting facilities that this policy can be a success. But the banks keep with them large amounts of liquid assets and do not find it necessary to approach the central bank for financial help.

4. Bills of Exchange not used:As a corollary to the above, the effectiveness of the bank rate policy depends on the existence of eligible bills of exchange. In recent years, the bill of exchange as an instrument of financing commerce and trade has fallen into disuse. Businessmen and banks prefer cash credit and overdrafts. This makes the bank rate policy less effective for controlling credit in the country.

5. Pessimism or Optimism:The efficacy of the bank rate policy also depends on waves of pessimism or optimism among businessmen. If the bank rate is raised, they will continue to borrow even at a higher rate of interest if there are boom conditions in the economy, and prices are expected to rise further. On the other hand, a reduction in the bank rate will not induce them to borrow during periods of falling prices. Thus businessmen are not very sensitive to changes in interest rates and they are influenced more by business expectations.

6. Power to Control Deflation Limited:Another limitation of the bank rate policy is that the power of a central bank to force a reduction in the market rates of interest is limited. For instance, a lowering of bank rate below 3 per cent will not lead to a decline in the market rates of interest below 3 per cent. So the bank rate policy is ineffective in controlling deflation. It may, however, control inflationary tendencies by forcing an increase in the market rates of interest.

7. Level of Bank Rate in relation to Market Rate:The efficacy of the discount rate policy as an instrument of credit control depends upon its level in relation to the market rate. If in a boom the bank rate is not raised to such an extent as to make borrowing costly from the central bank, and it is not lowered during a recession so as to make borrowing cheaper from it, it would have a destabilising effect on economic activity.

8. Non-Discriminatory:The bank rate policy is non-discriminatory because it does not distinguish between productive and unproductive activities in the country.

9. Not Successful in Controlling BOP Disequilibrium:The bank rate policy is not effective in controlling balance of payments disequilibrium in a country because it requires the removal of all restrictions on foreign exchange and movements of international capital.

Conclusion:The above points have led the majority of economists to conclude that the power to alter the bank rate is an extremely weak weapon of monetary management. Friedman even went to the extent of proposing outright elimination of the “discount window” itself.

2. Open Market Operations:Open market operations are another method of quantitative credit control used by a central bank. This method refers to the sale and purchase of securities, bills and bonds of government as well as private financial institutions by the central bank. But in its narrow sense, it simply means dealing only in government securities and bonds.

There are two principal motives of open market operations. One to influence the reserves of commercial banks in order to control their power of credit creation. Two to affect the market rates of interest so as to control the commercial bank credit.

Its method of operation is as follows. Suppose the central bank of a country wants to control expansion of credit by the commercial banks for the purpose of controlling inflationary pressures within the economy. It sells government securities in the money market amounting to, say, Rs 10 crores.

The latter give the central bank cheques for this amount drawn against the commercial banks in which the public have their accounts. The central bank reduces this amount in their accounts with it. This applies equally if the commercial banks have also purchased securities from the central bank.

The sale of securities in the open market has thus reduced their cash holdings with the central bank. This tends to reduce the actual cash ratio of the commercial banks by Rs. 10 crores. So the banks are forced to curtail their lending.

Suppose that initially the commercial banks have assets worth Rs 1000 crores and the cash-deposit ratio is 10. This means that Rs 1000 crores are divided between Rs 100 crores cash and Rs 900 crores as deposits or loans. As a result of the sale of securities by the central bank worth Rs 10 crores, the cash is reduced by Rs 100 crores. So the total cash with banks remains Rs 900 crores and loans are also reduced by the same percentage, that is, to Rs 810 crores.

This reduction in the cash holding of the commercial banks causes a decrease in the supply of bank money, as .shown in Figure 74.1. In this figure, 5 is the supply curve of bank money which shifts to the left as S1showing a decrease in the supply of bank money from В to A, given the level of interest rate r.

On the other hand, when the central bank aims at an expansionary policy during a recessionary period, it purchases government securities from the commercial banks and institution dealing with such securities. The central bank pays the sellers its cheques drawn against itself which are deposited into their accounts with the commercial banks. The reserves of the latter increase with the central bank which are just like cash. As a result the supply curve of bank money shifts to the right from S to S2 showing an increase in the supply of bank money from В to C, as shown in Figure 2. The banks will now lend more at the given rate of interest, r.Another aspect of the open market policy is that when the supply of money changes as a result of open market operations, the market rates of interest also change. A decrease in the supply of bank money through the sale of securities will have the effect of raising the market interest rates. On the other hand, an increase in the supply of bank money through the purchase of securities will reduce the market interest rates. Thus open market operations have a direct influence on the market rates of interest also.

Limitations of Open Market Operations:The effectiveness of open market operations as a method of credit control is dependent upon the existence of a number of conditions the absence of which limits the full working of this policy.

1. Lack of Securities Market:

The first condition is the existence of a large and well-organised security market. This condition is very essential for open market operations because without a well developed security market the central bank will not be able to buy and sell securities on a large scale, and thereby influence the reserves of the commercial banks. Further, the central bank must have enough saleable securities with it.

2. Cash Reserve Ratio not Stable:The success of open market operations also requires the maintenance of a stable cash-reserve ratio by the commercial bank. It implies that when the central bank sells or buys securities, the reserves of the commercial banks decrease or increase accordingly to maintain the fixed ratio. But usually the banks do not stick to the legal minimum reserve ratio and keep a higher ratio than this. This makes open market operations less effective in controlling the volume of credit.

3. Penal Bank Rate:According to Prof. Aschheim, one of the necessary conditions for the success of open market operations is a penal bank rate. If there is no penal discount rate fixed by the central bank, the commercial banks can increase their borrowings from it when the demand for credit is strong on the part of the latter. In this situation, the scale of securities by the central bank to restrict monetary expansion will be unsuccessful. But if there is a penal rate of discount, which is a rate higher than the market rates of interest, the banks will be reluctant to approach the central bank for additional financial help easily.

4. Banks Act Differently:Open market operations are successful only if the people also act the way the central bank expects them. When the central bank sells securities, it expects the business community and financial institutions to restrict the use of credit. If they simultaneously start dishoarding money, the act of selling securities by the central banks will not be a success in restricting credit. Similarly, the purchase of securities by the central bank will not be effective if people start hoarding money.

5. Pessimistic or Optimistic Attitude:Pessimistic or optimistic attitude of the business community also limits the operation of open market policy. When the central bank purchases securities and increases the supply of bank money, businessmen may be unwilling to take loans during a depression because of the prevailing pessimism among them.

As aptly put by Crowther, banks may place plenty of water before the public horse, but the horse cannot be forced to drink, if it is afraid of loss through drinking water. On the other hand, if businessmen are optimistic during a boom, the sale of securities by the central bank to contract the supply of bank money and even the rise in market rates cannot discourage them from getting loans from the banks. On the whole, this policy is more successful in controlling booms than depressions.

6. Velocity of Credit Money not Constant:The success of open market operations depends upon a constant velocity of circulation of bank money. But the velocity of credit money is not constant. It increases during periods of brisk business activity and decreases in periods of falling prices. Thus a policy of contracting credit by the sale of securities by the central bank may not be successful by increased velocity of circulation of bank credit.

Despite these limitations, open market operations are more effective than the other instruments of credit control available with the central bank. This method is being successfully used for controlling credit in developed countries where the securities market is highly developed.

Open Market Operations vs. Bank Rate Policy:The question arises whether the bank rate is more effective as an instrument of credit control or open market operations. The bank rate policy influences the cost and supply of commercial bank credit, while open market operations affect the cash reserves of the commercial banks. Changes in the bank rate affect the credit creation power of the commercial bank only if they rediscount their bills with the central bank.

If the banks do not feel the necessity of availing rediscounting facilities of the central bank, a rise in the bank rate will have no effect on the commercial banks. On the other hand, the lending power of the commercial banks is directly related to their cash reserves, and open market operations influence their cash reserves directly and immediately thereby affecting their credit creation power.

Further, “from the standpoint of their strategic value to the central bank, open market operations possess a degree of superiority over rediscount policy because of the fact that initiative is in the hands of the monetary authority in the case of the former, whereas bank rate policy is passive in the sense that its effectiveness depends on the responses of commercial banks and their customers to changes in bank rates.”

Again, open market operations are flexible with respect to timing and magnitude as compared with the bank rate policy. They are carried on continuously and do not have any destabilising effects on the economy that accompany changes in the bank rate.

It is further argued that since bank rate changes have destabilising effects on the economy, this policy should be used to correct permanent maladjustments in the money market rather than temporary maladjustments. On the other hand, open market policy can be used for correcting both temporary and permanent maladjustments in the money market.

But the experience of developed countries like the USA and the UK tells us that these two policies are not competitive but complementary to each other. If they are supplemented, they can control credit more effectively than individually.

For instance, if the central bank raises the discount rate for the purpose of contracting credit, it will not be effective when the commercial bank have large excess reserves with them. They will continue to expand credit irrespective of the rise in the bank rate. But if the central bank first draws away to itself the excess reserves of the commercial banks by the sale of securities and then raises the bank rate, it will have the effect of contracting credit.

Similarly, the sale of securities alone will not be so effective in contracting credit unless the bank rate is also raised. The sale of securities by the central bank will reduce the cash reserves of commercial banks but if the discount rate is low, the latter will get funds from the “discount window” of the central bank. So for an effective policy credit control, bank rate policy and open market operations should be judiciously supplemented.

3. Variable Reserve Ratio:Variable reserve ratio (or required reserve ratio or legal minimum requirements), as a method of credit control was first suggested by Keynes in his Treatise on Money (1930) and was adopted by the Federal Reserve System of the United States in 1935.

Every commercial bank is required by law to maintain a minimum percentage of its deposits with the central bank. The minimum amount of reserve with the central bank may be either a percentage of its time and demand deposits separately or of total deposits. Whatever the amount of money remains with the commercial bank over and above these minimum reserves is known as the excess reserves.

It is on the basis of these excess reserves that the commercial bank is able to create credit. The larger the size of the excess reserves, the greater is the power of a bank to create credit, and vice versa. It can also be said that the larger the required reserve ratio, the lower the power of a bank to create credit, and vice versa.

When the central bank raises the reserve ratio of the commercial banks, it means that the latter are required to keep more money with the former. Consequently, the excess reserves with the commercial banks are reduced and they can lend less than before.

This can be explained with the help of the deposit multiplier formula. If a commercial bank has Rs 100 crores as deposits and 10 per cent is the required reserve ratio, then it will have to keep Rs 10 crores with the central bank. Its excess reserves will be Rs 90 crores. It can thus create credit to the extent of Rs 900 crores in this way ER/RRr where ER is the excess reserves, and RRr the required reserve ratio… 90×1/10% = 90 x 100/10 = Rs 900 crores. When the central bank raises the required reserve ratio to 20 per cent, the bank’s power to create credit will be reduced to Rs 400 crores = 80 x 100/20.

On the contrary, if the central bank wants to expand credit, it lowers the reserve ratio so as to increase the credit creation power of the commercial banks. Thus by varying the reserve ratio of the commercial banks the central bank influences their power of credit creation and thereby controls credit in the economy.

Limitations of Variable Reserve Ratio:The variable reserve ratio as a method of credit control has a number of limitations.

1. Excess Reserves:The commercial banks usually possess large excessive reserves which make the policy of variable reserve ratio ineffective. When the banks keep excessive reserves, an increase in the reserve ratio will not affect their lending operations. They will stick to the legal minimum requirements of cash to deposits and at the same time continue to create credit on the strength of the excessive reserves.

2. Clumsy Method:It is a clumsy method of credit control as compared with open market operations. This is because it lacks definiteness in the sense that it is inexact and uncertain as regards changes not only in the amounts of reserves but also the place where these changes can be made effective. It is not possible to tell “how much of active or potential reserve base” has been affected by changes in

the reserve ratio. Moreover, the changes in reserves involve far larger sums than in the case of open market operations.

3. Discriminatory:It is discriminatory and affects different banks differently. A rise in the required reserve ratio will not affect those banks which have large excess reserves. On the other hand, it will hit hard the banks with little or no excess reserves. This policy is also discriminatory in the sense that non-banking financial intermediaries like co-operative societies, insurance companies, building societies, development banks, etc. are not affected by variations in reserve requirements, though they compete with the commercial banks for lending purposes.

4. Inflexible:This policy is inflexible because the minimum reserve ratio fixed by the central banks is applicable to banks located in all regions of the country. More credit may be needed in one region where there is monetary stringency, and it may be superfluous in the other region. Raising the reserve ratio for all banks is not justified in the former region though it is appropriate for the latter region.

5. Business Climate:The success of the method of credit control also depends on the business climate in the economy. If the businessmen are pessimistic about the future, as under a depression, even a sizable lowering of the reserve ratio will not encourage them to ask for loan. Similarly, if they are optimistic about profit expectations, a considerable rise in the variable ratio will not prevent them from asking for more loans from the banks.

6. Stability of Reserve Ratio:The effectiveness of this technique depends upon the degree of stability of the reserve ratio. If the commercial banks are authorised to keep widely fluctuating ratio, say between 10 per cent to 17 per cent and change in the upper or lower limit will have no effect on the credit creation power of the banks.

7. Other Factors:The reserve ratio held by the commercial banks is determined not only by legal requirements but also by how much they want to hold in relation to their deposits in addition to such requirements. This, in turn, will depend upon their expectations about future developments, their competition with other banks, and so on.

8. Depressive Effect:The variable reserve ratio has been criticised for exercising a depressive effect on the securities market. When the central bank suddenly directs the commercial banks to increase their reserve ratios, they may be forced to sell securities to maintain that ratio. This widespread selling of securities will bring down the prices of securities and may even lead to an utter collapse of the bond market.

9. Rigid:It is rigid in its operations because it does not distinguish between desired and undesired credit flows and can affect them equally.

10. Not for Small Changes:This method is more like an axe than a scalpel. It cannot be used for day-to- day and week-to-week adjustments but can be used to bring about large changes in the reserve positions of the commercial banks. Thus it cannot help in ‘fine tuning’ of the money and credit systems by making small changes.

Conclusion:The variable reserve ratios as a method of credit control are a very delicate and sensitive tool which not only produces a state of uncertainty among the banks but also adversely affects their liquidity and profitability. Therefore, according to De Kock, “it should be used with moderation and discretion and only under obvious abnormal conditions.”

Variable Reserve Ratio vs. Open Market Operations:There are divergent views about the superiority of variable reserve ratio over open market operations. To those who consider the former as a superior instrument of credit control, it is “a battery of the most improved type that a central bank can add to its armoury.” They give the following arguments.

The variable reserve ratio affects the power of credit creation of the commercial banks more directly, immediately, and simultaneously than open market operations. The central bank has simply to make a declaration for changing the reserve requirements of the banks and they have to implement it immediately. But open market operations require sale or purchase of securities which is a time consuming process.

When the central bank sells securities to the banks to control inflation, they are forced to buy them. They are, therefore, prevented from giving more loans to the private credit market. On the

other hand, if the reserve ratio is raised, the banks will be required to keep larger balances with the central bank.

They will also be faced with reduced earnings. They will, therefore, be induced to sell government securities and give more loans to the private credit market. Thus open market operations are more effective for controlling inflation than the change in reserve ratio.

In another sense, open market operations are more effective as an instrument of credit control than variations in the reserve ratio. In every country there are non-banking financial intermediaries which deal in securities, bonds, etc. and also advance loans and accept deposits from the public.

But they are outside the legal control of the central bank. Since they also deal in government securities, open market sale and purchase of such securities by the central bank also affect their liquidity position. But they are not required to keep any reserves with the central bank, unlike the commercial banks.

Again, variations in the reserve ratio are meant for making major and long-run adjustments in the liquidity position of the commercial banks. They are, therefore, not suited for making short-run adjustments in the volume of available bank reserves, as are done under open market operations.

The effectiveness of open market operations depends upon the existence of a broad and well-organised market for securities. Thus this instrument of credit control cannot be operative in countries which lack such a market. On the other hand, the method of variable reserve ratio does not require any such market for its operation and is applicable equally in developed and underdeveloped markets, and is thus superior to open market operations.

Further, since open market operations involve the sale and purchase of securities on a day-to-day and week-to-week basis, the commercial banks and the central bank which deal in them are likely to incur losses. But variations in the reserve ratio do not involve any tosses.

Despite the superiority of variable reserve ratio over open market operations, economists like Prof. Aschheim have argued that open market operations are more effective as a tool in controlling credit than variable reserve ratio. Therefore, changes in the reserve ratio do not have any effect on their lending power. Thus open market operations are superior to variable ratio because they also influence non-banking financial institutions.

Further, as a technique, reserve ratio can only influence the volume of reserves of the commercial banks. On the other hand, open market operations can influence not only the reserves of the commercial banks but also the pattern of the interest rate structure. Thus open market operations are more effective in influencing the reserves and the credit creation power of the banks than variations in reserve ratio.

Last but not the least, the technique of variations in reserve ratio is clumsy, inflexible, and discriminatory whereas that of open market operations is simple, flexible and non-discriminatory in its effects.

It can be concluded from the above discussion of the relative merits and demerits of the two techniques that in order to have the best of the two, they should be used jointly rather than independently. If the central bank raises the reserve ratio, it should simultaneously start purchasing, and not selling, securities in those areas of the country where there is monetary stringency. On the contrary, when the central bank lowers the reserve requirements of the banks, it should also sell securities to those banks which already have excess reserves with them, and have been engaged in excessive lending. The joint application of the two policies will not be contradictory but complementary to each other.

4. Selective Credit Controls:Selective or qualitative methods of credit control are meant to regulate and control the supply of credit among its possible users and uses. They are different from quantitative or general methods which aim at controlling the cost and quantity of credit. Unlike the general instruments, selective instruments do not affect the total amount of credit but the amount that is put to use in a particular sector of the economy.

The aim of selective credit control is to channelise the flow of bank credit from speculative and other undesirable purposes to socially desirable and economically useful uses. They also restrict the demand for money by laying down certain conditions for borrowers.

They therefore, embody the view that the monopoly of credit should in fact become a discriminating monopoly. Prof. Chandler defines selective credit controls as those measures “that would influence the allocation of credit, at least to the point of decreasing the volume of credit used for selected purposes without the necessity of decreasing the supply and raising the cost of credit for all purposes.” We discuss below the main types of selective credit controls generally used by the central banks in different countries.

(A) Regulation of Margin Requirements:This method is employed to prevent excessive use of credit to purchase or carry securities by speculators. The central bank fixes minimum margin requirements on loans for purchasing or carrying securities. They are, in fact, the percentage of the value of the security that cannot be borrowed or lent. In other words, it is the maximum value of loan which a borrower can have from the banks on the basis of the security (or collateral).

For example, if the central bank fixes a 10 per cent margin on the value of a security worth Rs 1.0, then the commercial bank can lend only Rs 900 to the holder of the security and keep Rs 100 with it. If the central bank raises the margin to 25 per cent, the bank can lend only Rs 750 against a security of Rs 1.0. If the central bank wants to curb speculative activities, it will raise the margin requirements. On the other hand, if it wants to expand credit, it reduces the margin requirements.

Its Merits:This method of selective credit control has certain merits which make it unique.

1. It is non-discriminatory because it applies equally to borrowers and lenders. Thus it limits both the supply and demand for credit simultaneously.

2. It is equally applicable to commercial banks and non-banking financial intermediaries.

3. It increases the supply of credit for more productive uses.

4. It is a very effective anti-inflationary device because it controls the expansion of credit in those sectors of the economy which breed inflation.

5. It is simple and easy to administer since this device is meant to regulate the use of credit for specific purposes.

But the success of this technique requires that there are no leakages of bank credit for non-purpose loans to speculators.

Its Weaknesses:However, a number of leakages have appeared in this method over the years.

1. A borrower may not show any intention of purchasing stocks with his borrowed funds and pledge other assets as security for the loan. But it may purchase stocks through some other source.

2. The borrower may purchase stocks with cash which he would normally use to purchase materials and supplies and then borrow money to finance the materials and supplies already purchased, pledging the stocks he already has as security for the loan.

3. Lenders, other than commercial banks and brokers, who are not subject to margin requirements, may increase their security loans when commercial banks and brokers are being controlled by high margin requirements. Further, some of these non-regulated lenders may be getting the funds they lent to finance the purchase of securities from commercial banks themselves.

Despite these weaknesses in practice, margin requirements are a useful device of credit control.

(B) Regulation of Consumer Credit:This is another method of selective credit control which aims at the regulation of consumer instalment credit or hire-purchase finance. The main objective of this instrument is to regulate the demand for durable consumer goods in the interest of economic stability. The central bank regulates the use of bank credit by consumers in order to buy durable consumer goods on instalments and hire-purchase. For this purpose, it employs two devices: minimum down payments, and maximum periods of repayment.

Suppose a bicycle costs Rs 500 and credit is available from the commercial bank for its purchase. The central bank may fix the minimum down payment to 50 per cent of the price, and the maximum period of repayment to 10 months. So Rs 250 will be the minimum which the consumer will have to pay to the bank at the time of purchase of the bicycle and the remaining amount in ten equal instalments of Rs 25 each. This facility will create demand tor bicycles.

The bicycle industry would expand along with the related industries such as tyres, tubes, spare parts, etc. and thus lead to inflationary situation in this and other sectors of the economy. To control it, the central bank raises the minimum down payment to 70 per cent and the maximum period of repayment to three instalements. So the buyer of a bicycle will have to pay Rs 350 in the beginning and remaining amount in three installments of Rs 50 each. Thus if the central bank finds slump in particular industries of the economy, it reduces the amount of down payments and increases the maximum periods of repayment.

Reducing the down payments tends to increase the demand for credit for particular durable consumer goods on which the central bank regulation is applied. Increasing the maximum period of repayment, which reduces monthly payments, tends to increase the demand for loans, thereby encouraging consumer credit. On the other hand, the central bank raises the amount of down payments and reduces the maximum periods of repayment in boom.

The regulation of consumer credit is more effective in controlling credit in the case of durable consumer goods during both booms and slumps, whereas general credit controls fail in this area. The reason is that the latter operate with a time lag. Moreover, the demand for consumer credit in the case of durable consumer goods is interest inelastic. Consumers are motivated to buy such goods under the influence of the demonstration effect and the rate of interest has little consideration for them.

But this instrument has its drawbacks.

It is cumbersome, technically defective and difficult to administer because it has a narrow base. In other words, it is applicable to a particular class of borrowers whose demand for credit forms an insignificant part of the total credit requirements. It, therefore, discriminates between different types of borrowers. This method affects only persons with limited incomes and leaves out higher income groups. Finally, it tends to malallocate resources by shifting them away from industries which are covered by credit regulations and lead to the expansion of other industries which do not have any credit restrictions.

(C) Rationing of Credit:Rationing of credit is another selective method of controlling and regulating the purpose for which credit is granted by the commercial banks. It is generally of four types. The first is the variable portfolio ceiling. According to this method, the central bank fixes a ceiling on the aggregate portfolios of the commercial banks and they cannot advance loans beyond this ceiling. The second method is known as the variable capital assets ratio. This is the ratio which the central bank fixes in relation to the capital of a commercial bank to its total assets. In keeping with the economic exigencies, the central bank may raise or lower the portfolio ceiling, and also vary the capital assets ratio.

Rationing of credit has been used very effectively in Russia and Mexico. It is, therefore, ‘a logical concomitant of the intensive and extensive planning adopted in regimented economies.’ The technique also involves discrimination against larger banks because it restricts their lending power more than the smaller banks. Lastly, by rationing of credit for selective purposes, the

central bank ceases to be the lender of the last resort. Therefore, central banks in mixed economies do not use this technique except under extreme inflationary situations and emergencies.

(D) Direct Action:Central banks in all countries frequently resort to direction action against commercial banks. Direction action is in the form of “directives” issued from time to time to the commercial banks to follow a particular policy which the central bank wants to enforce immediately. This policy may not be used against all banks but against erring banks.

For example, the central bank refuses rediscounting facilities to certain banks which may be granting too much credit for speculative purposes, or in excess of their capital and reserves, or restrains them from granting advances against the collateral of certain commodities, etc. It may also charge a penal rate of interest from those banks which want to borrow from it beyond the prescribed limit. The central bank may even threaten a commercial bank to be taken over by it in case it fails to follow its policies and instructions.

But this method of credit suffers from several limitations which have been enumerated by De Kock as “the difficulty for both central and commercial bank to make clear-cut distinctions at all times and in all cases between essential and non-essential industries, productive and unproductive activities, investment and speculation, or between legitimate and excessive speculation or consumption; the further difficulty of controlling the ultimate use of credit by second, third or fourth parties; the dangers involved in the division of responsibility between the central bank and commercial bank for the soundness of the lending operations of the latter; and the possibility of forfeiting the whole-hearted and active co-operations of the commercial banks as a result of undue control and intervention.”

(E) Moral Suasion:Moral suasion in the method of persuasion, of request, of informal suggestion, and of advice to the commercial bank usually adopted by the central bank. The executive head of the central bank calls a meeting of the heads of the commercial banks wherein he explains them the need for the adoption of a particular monetary policy in the context of the current economic situation, and then appeals to them to follow it. This “jawbone control” or “slaps on the wrist” method has been found to be highly effective as a selective method of credit control in India, New Zealand, Canada and Australia, though it failed in the USA.

Its Limitations:

Moral suasion is a method “without any teeth” and hence its effectiveness is limited.

1. Its success depends upon the extent to which the commercial banks accept the central bank as their leader and need accommodation from it.

2. If the banks possess excessive reserves they may not follow the advice of the central bank, as is the case with the commercial banks in the USA.

3. Further, moral suasion may not be successful during booms and depressions when the economy is passing through waves of optimism and pessimism respectively. The bank may not heed to the advice of the central bank in such a situation.

4. In fact, moral suasion is not a control device at all, as it involves cooperation by the commercial banks rather than their coercion.

It may, however, be a success where the central bank commands prestige on the strength of the wide statutory powers vested in it by the government of the country.

(F) Publicity:The central bank also uses publicity as an instrument of credit control. It publishes weekly or monthly statements of the assets and liabilities of the commercial bank for the information of the public. It also publishes statistical data relating to money supply, prices, production and employment, and of capital and money market, etc. This is another way of exerting moral pressure on the commercial bank. The aim is to make the public aware of the policies being adopted by the commercial bank vis-a-vis the central bank in the light of the prevailing economic conditions in the country.

It cannot be said with definiteness about the success of this method. It presupposes the existence of an educated and knowledgeable public about the monetary phenomena. But even in advanced countries, the percentage of such persons is negligible. It is, therefore, highly doubtful if they can exert any moral pressure on the banks to strictly follow the policies of the central bank. Hence, publicity as an instrument of selective credit control is only of academic interest.

Limitations of Selective Credit Controls:Though regarded superior to quantitative credit controls, yet selective credit controls are not free from certain limitations.

1. Limited Coverage:Like general credit controls, selective credit controls have a limited coverage. They are only applicable to the commercial banks but not to non-banking financial institutions. But in the case of the regulation of consumer credit which is applicable both to banking and non-banking institutions, it becomes cumbersome to administer this technique.

2. No Specificity:Selective credit controls fail to fulfill the specificity function. There is no guarantee that the bank loans would be used for the specific purpose for which they are sanctioned.

3. Difficult to distinguish between Essential and Non-essential Factors:It may be difficult for the central bank to distinguish precisely between essential and non-essential sectors and between speculative and productive investment for the purpose of enforcing selective credit controls. The same reasoning applies to the commercial banks for the purpose of advancing loans unless they are specifically laid down by the central bank.

4. Require Large Staff:The commercial banks, for the purpose of earning large profits, may advance loans for purposes other than laid down by the central bank. This is particularly so if the central bank does not have a large staff to check minutely the accounts of the commercial banks. As a matter of fact, no central bank can afford to check their accounts. Hence selective credit controls are liable to be ineffective in the case of unscrupulous banks.

5. Discriminatory:Selective controls unnecessarily restrict the freedom of borrowers and lenders. They also discriminate between different types of borrowers and banks. Often small borrowers and small banks are hit harder by selective control than big borrowers and large banks.

6. Malallocation of Resources:Selective credit controls also lead to malallocation of resources when they are applied to selected sectors, areas and industries while leaving others to operate freely. They place undue restrictions on the freedom of the former and affect their production.

7. Not Successful in Unit Banking:Unit banks being independent one-office banks in the USA operate on a small scale in small towns and meet the financial needs of the local people. Such banks are not affected by the

selective credit controls of the FRS (central bank of the USA) because they are able to finance their activities by borrowing from big banks. So this policy is not effective in unit banking.

Conclusion:From the above discussion, it should not be concluded that selective credit controls are used to the total exclusion of general credit controls. Their demerits primarily arise from this thinking. In fact, they are an adjunct to general quantitative controls. They are meant to supplement the latter and are regarded only as a “second-line instrument”. “The vital point is not the question of general vs. selective credit control the assessment of the pros and cons as between the two methods, but that of integrating them. Indeed the coordination of selective and general controls appears to have been more effective than the use of any one of them singly and by itself.

The Major Role of Monetary Policy in a Development Economy | Economics

by Smriti Chand Money

Read this article to learn about the major role of monetary policy in a development economy:Monetary policy in an underdeveloped country plays an important role in increasing the growth rate of the economy by influencing the cost and availability of credit, by controlling inflation and maintaining equilibrium the balance of payments.

So the principal objectives of monetary policy in such a country are to control credit for controlling inflation and to stabilise the price level, to stabilise the exchange rate, to achieve equilibrium in the balance of payments and to promote economic development.

To Control Inflationary Pressures:To control inflationary pressures arising in the process of development, monetary policy requires the use of both quantitative and qualitative methods of credit control. Of the instruments of monetary policy, the open market operations are not successful in controlling inflation in underdevelopment countries because the bill market is small and undeveloped.

Commercial banks keep an elastic cash-deposit ratio because the central bank’s control over them is not complete. They are also reluctant to invest in government securities due to their relatively low interest rates. Moreover, instead of investing in government securities, they prefer to keep their reserves in liquid form such as gold, foreign exchange and cash. Commercial banks are also not in the habit of redics counting or borrowing from the central bank.

The bank rate policy is also not so effective in such countries due to: (i) the lack of bills of discount; (ii) the narrow size of the bill market; (iii) a large non-monetised sector where barter transactions take place; (iv) the existence of indigenous banks which do not discount bills with the central bank; (v) the habit of the commercial banks to keep large cash reserves; and (vi) the existence of a large unorganised money market.

The use of variable reserve ratio as an instrument of monetary policy is more effective than open market operations and bank rate policy in LDCs. Since the market for securities is very small, open market operations are not successful. But a rise or fall in the variable reserve ratio by the central bank reduces or increases the cash available with the commercial banks without affecting adversely the prices of securities.

Again, the commercial banks keep large cash reserves which cannot be reduced by an increase in bank rate or sale of securities by the central bank. But raising the cash reserve ratio reduces liquidity with the banks. The use of variable reserve ratio has certain limitations in LDCs.

The non-banking financial intermediaries do not keep deposits with the central bank so they are not affected by it. Second, banks which do not maintain excess liquidity are more affected than those who maintain it.

The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the allocation of credit, and thereby the pattern of investment. In LDCs, there is a strong tendency to invest in gold, jewellery, inventories, real estate, etc., instead of in alternative productive changes available in agriculture, mining, plantations and industry. The selective credit controls are more appropriate for controlling and limiting credit facilities for such unproductive purposes. They are beneficial in controlling speculative activities in food-grains and raw materials. They prove more useful in controlling ‘sectional inflations’ in the economy.

They curtail the demand for imports by making it obligatory on importers to deposit in advance an amount equal to the value of foreign currency. This has also the effect of reducing the reserves of the banks in so far as their deposits are transferred to the central bank in the process. The selective credit control measures may take the form of changing the margin requirements against certain types of collateral the regulation of consumer credit and the rationing of credit.

To Achieve Price Stability:Monetary policy is an important instrument for achieving price stability k brings a proper adjustment between the demand for and supply of money. An imbalance between the two will be

reflected in the price level. A shortage of money supply will retard growth while an excess of it will lead to inflation. As the economy develops, the demand for money increases due to the gradual monetization of the non-monetized sector, and the increase in agricultural and industrial production. These will lead to increase in the demand for transactions and speculative motives. So the monetary authority will have to raise the money supply more than proportionate to the demand for money in order to avoid inflation.To Bridge BOP Deficit:Monetary policy in the form of interest rate policy plays an important role in bridging the balance of payments deficit. Underdeveloped countries develop serious balance of payments difficulties to fulfill the planned targets of development. To establish infrastructure like power, irrigation, transport, etc. and directly productive activities like iron and steel, chemicals, electrical, fertilisers, etc., underdeveloped countries have to import capital equipment, machinery, raw materials, spares and components thereby raising their imports. But exports are almost stagnant. They are high-price due to inflation. As a result, an imbalance is created between imports and exports which lead to disequilibrium in the balance in payments. Monetary policy can help in narrowing the balance of payments deficit through high rate of interest. A high interest rate attracts the inflow of foreign investments and helps in bridging the balance of payments gap.

Interest Rate Policy:A policy to high interest rate in an underdeveloped country also acts as an incentive to higher savings, develops banking habits and speeds up the monetization of the economy which are essential for capital formation and economic growth. A high interest rate policy is also anti-inflationary in nature, for it discourages borrowing and investment for speculative purposes, and in foreign currencies.

Further, it promotes the allocation of scarce capital resources in more productive channels. Certain economists favour a low interest rate policy in such countries because high interest rates discourage investment. But empirical evidence suggests that investment in business and industry is interest-inelastic in underdeveloped countries because interest forms a very low proportion of the total cost of investment. Despite these opposite views, it is advisable for the monetary authority to follow a policy of discriminatory interest rate-charging high interest rates for non-essential and unproductive uses and low interest rates for productive uses.

To Create Banking and Financial Institutions:One of the objectives of monetary policy in an underdeveloped country is to create and develop banking and financial institutions in order to encourage, mobilise and channelise savings for capital formation. The monetary authority should encourage the establishment of branch banking in rural and urban areas. Such a policy will help in monetizing the non-monetized sector and encourage saving and investment for capital formation. It should also organise and develop money an capital market. These are essential for the success of a development oriented monetary policy which also includes debt management.

Debt Management:Debt management is one of the important functions of monetary policy in an underdeveloped country. It aims at proper timing and issuing of government bonds, stabilising their prices and minimising the cost of servicing the public debt.

The primary aim of debt management is to create conditions in which public borrowing can increase from year to year. Public borrowing is essential in such countries in order to finance development programmes and to control the money supply. But public borrowing must be at cheap rates. Low interest rates raise the price of government bonds and make them more attractive to the public. They also keep the burden of the debt low.

Thus an appropriate monetary policy, as outlined above, helps in controlling inflation, bridging balance of payments gap, encouraging capital formation and promoting economic growth.

Monetary Policy: Meaning, Objectives and Instruments of Monetary Policy

by Saritha Pujari Policies

Read this article to learn about monetary policy: it’s meaning, objectives and instruments!Meaning of Monetary Policy:Monetary policy refers to the credit control measures adopted by the central bank of a country.

Johnson defines monetary policy “as policy employing central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy.” G.K. Shaw defines it as “any conscious action undertaken by the monetary authorities to change the quantity, availability or cost of money.”

Objectives or Goals of Monetary Policy:The following are the principal objectives of monetary policy:

1. Full Employment:Full employment has been ranked among the foremost objectives of monetary policy. It is an important goal not only because unemployment leads to wastage of potential output, but also because of the loss of social standing and self-respect.

2. Price Stability:One of the policy objectives of monetary policy is to stabilise the price level. Both economists and laymen favour this policy because fluctuations in prices bring uncertainty and instability to the economy.

3. Economic Growth:One of the most important objectives of monetary policy in recent years has been the rapid economic growth of an economy. Economic growth is defined as “the process whereby the real per capita income of a country increases over a long period of time.”

4. Balance of Payments:Another objective of monetary policy since the 1950s has been to maintain equilibrium in the balance of payments.

Instruments of Monetary Policy:The instruments of monetary policy are of two types: first, quantitative, general or indirect; and second, qualitative, selective or direct. They affect the level of aggregate demand through the supply of money, cost of money and availability of credit. Of the two types of instruments, the first category includes bank rate variations, open market operations and changing reserve requirements. They are meant to regulate the overall level of credit in the economy through commercial banks. The selective credit controls aim at controlling specific types of credit. They include changing margin requirements and regulation of consumer credit. We discuss them as under:

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. When the central bank finds that inflationary pressures have started emerging within the economy, it raises the bank rate. Borrowing from the central bank becomes costly and commercial banks borrow less from it.

The commercial banks, in turn, raise their lending rates to the business community and borrowers borrow less from the commercial banks. There is contraction of credit and prices are checked from rising further. On the contrary, when prices are depressed, the central bank lowers the bank rate.

It is cheap to borrow from the central bank on the part of commercial banks. The latter also lower their lending rates. Businessmen are encouraged to borrow more. Investment is encouraged. Output, employment, income and demand start rising and the downward movement of prices is checked.

Open Market Operations:Open market operations refer to sale and purchase of securities in the money market by the central bank. When prices are rising and there is need to control them, the central bank sells securities. The reserves of commercial banks are reduced and they are not in a position to lend more to the business community.

Further investment is discouraged and the rise in prices is checked. Contrariwise, when recessionary forces start in the economy, the central bank buys securities. The reserves of commercial banks are raised. They lend more. Investment, output, employment, income and demand rise and fall in price is checked.

Changes in Reserve Ratios:This weapon was suggested by Keynes in his Treatise on Money and the USA was the first to adopt it as a monetary device. 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.

When prices are rising, the central bank raises the reserve ratio. Banks are required to keep more with the central bank. Their reserves are reduced and they lend less. The volume of investment, output and employment are adversely affected. In the opposite case, when the reserve ratio is lowered, the reserves of commercial banks are raised. They lend more and the economic activity is favourably affected.

Selective Credit Controls:Selective credit controls are used to influence specific types of credit for particular purposes. They usually take the form of changing margin requirements to control speculative activities within the economy. When there is brisk speculative activity in the economy or in particular

sectors in certain commodities and prices start rising, the central bank raises the margin requirement on them.

The result is that the borrowers are given less money in loans against specified securities. For instance, raising the margin requirement to 60% means that the pledger of securities of the value of Rs 10,000 will be given 40% of their value, i.e. Rs 4,000 as loan. In case of recession in a particular sector, the central bank encourages borrowing by lowering margin requirements.

Conclusion:For an effective anti-cyclical monetary policy, bank rate, open market operations, reserve ratio and selective control measures are required to be adopted simultaneously. But it has been accepted by all monetary theorists that (i) the success of monetary policy is nil in a depression when business confidence is at its lowest ebb; and (ii) it is successful against inflation. The monetarists contend that as against fiscal policy, monetary policy possesses greater flexibility and it can be implemented rapidly.

The Central Bank controls credit to achieve the Following Objectives

by Smriti Chand Central Bank

The central bank controls credit to achieve the following objectives: 1. To Stabilise the Internal Price Level:One of the objectives of controlling credit is to stabilise the price level in the country. Frequent changes in prices adversely affect the economy. Inflationary or deflationary trends need to be prevented. This can be achieved by adopting a judicious policy of credit control.

2. To Stabilise the Rate of Foreign Exchange:With the change in the internal prices level, exports and imports of the country are affected. When prices fall, exports increase and imports decline. Consequently, the demand for domestic currency increases in the foreign market and its exchange rate rises. On the contrary, a rise in domestic prices leads to a decline in exports and an increase in imports. As a result, the demand for foreign currency increases and that of domestic currency falls, thereby lowering the exchange rate of the domestic currency. Since it is the volume of credit money that affects prices, the central bank can stabilise the rate of foreign exchange by controlling bank credit.

3. To Protect the Outflow of Gold:The central bank holds the gold reserves of the country in its vaults. Expansion of bank credit leads to rise in prices which reduce exports and increase imports, thereby creating an

unfavourable balance of payments. This necessitates the export of gold to other countries. The central bank has to control credit in order to prevent such outflows of gold to other countries.

4. To Control Business Cycles:Business cycles are a common phenomenon of capitalist countries which lead to periodic fluctuations in production, employment and prices. They are characterised by alternating periods of prosperity and depression. During prosperity, there is large expansion in the volume of credit, and production, employment and prices rise. During depression, credit contracts, and production, employment and prices fall. The central bank can counteract such cyclical fluctuations through contraction of bank credit during boom periods, and expansion of bank credit during depression.

5. To Meet Business Needs:According to Burgess, one of the important objectives of credit control is the “adjustment of the volume of credit to the volume of business.” Credit is needed to meet the requirements of trade and industry. As business expands, larger quantity of credit is needed, and when business contracts less credit is needed. Therefore, it is the central bank which can meet the requirements of business by controlling credit.

6. To Have Growth with Stability:In recent years, the principal objective of credit control is to have growth with stability. The other objectives such as price stability, foreign exchange rate stability, etc., are regarded as secondary. The aim of credit control is to help in achieving full employment and accelerated growth with stability in the economy without inflationary pressures and balance of payments deficits.