Monetary Policy , Instuments of Monetary Policy And

8/9/2019 Monetary Policy , Instuments of Monetary Policy And

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MONETARY POLICY ,

INSTUMENTS OF MONETARY

POLICY AND ROLE OF RBI


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MEANING OF MONETARY

POLICY

Monetary policy is essentially a programme of action

undertaken by the monetary authorities, generally the

CENTRAL BANK, to control and regulate the supply

of money with the public and the flow of credit with a

view to achieve the predetermined macroeconomic

goals.


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Objectives & Scope

To ensure economic stability at potential level of

output.

To achieve price stability by controlling inflation and

deflation.

To promote and encourage economic growth


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Scope of monetary policy largely depends on two

factors : -

Level of monetization of the economy and Level of

development of capital market.

In the first factor , all economic transactions are

carried out with money as a medium of exchange .

The monetary policy works by changing the general

price levels and so affects all economic activities

In case of second factor , instruments of policy work

through the capital market.


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INSTRUMENTS OF MONETARY

POLICY

The instruments refers to the economic variable that

the central bank can change at its discretion with a

view to control and regulate the money supply and

availability of credit.

Instruments are classified into :

a) QUANTITATIVE MEASURES

b) QUALITATIVE MEASURES.


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QUALITATIVE MEASURES

BANK RATE POLICY

It is the minimum rate at which the central bank of a

country provides loans to the commercial bank of the

country. Changes in the bank rate influences in the creation of

credit by the commercial banks.

Changes in the money supply affects the aggregate

demand and thereby output and prices.


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Changes in the bank rate

INCREASE IN BANK RATE

Used at the time of inflation

Cost of borrowing increases

for commercial banks

C.BS also increase theirLENDING RATE.

Discourages borrowing

Results in reduction of

aggregate demand or money

expenditure.

DECREASE IN BANK RATE

Used at the time of

depression

Cost of borrowing decreases

C.BS also reduce theirlending rate

Credits or loans from banks

become cheaper.

Leads to increase in

aggregate demand for goodsand services


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Limitations

Successful working of the bank rate is possible

only if

All the other rates should follow the bank rate in its

movement so that bank credit should expand orcontract as desired.

Money market must be well organised.

The reponsiveness of businessmen to the changes in

the lending rates.


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OPEN MARKET OPERATIONS

Open market operation is sale and purchase of

government securities , treasury bills and bonds.

The buyers and sellers are commercial banks,

financial corporations, big business corporations and

individuals with high savings.

The sale of government bonds and securities affects

both the supply of and demand for credit.


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When people buy the government bonds & securities

through cheques drawn in commercial banks in

favour of the central bank , there is a transfer from

the buyers account to the central banks account

This reduces the total deposits with the C.Bs.Resultsin decrease of credit capacity and flow of bank credit.

When the central bank decides to increase money

supply , it buys back the bonds and securities.

As a result cash is transferred to the peoples account

with C.Bs and so deposits and cash reserves

increase.


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Some of the limitations are

When commercial banks possess excess liqiudity ,

the open market does not work.

The Contraction and expansion of credit byThe Contraction and expansion of credit bycommercial banks depends on the economic andcommercial banks depends on the economic and

political conditionspolitical conditions


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CASH RESERVE RATIO

The Cash Reserve Ratio is the percentage of total

deposits which commercial banks are required to

maintain in the form of cash reserve with the central

bank. Normally depends on the banks experience

regarding the cash demand by depositors.

When economic conditions demand monetary

expansion , the central bank cuts down the CRRwhich results availability in more funds to lend


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When contractionary monetary policy is required

there is an increase in the CRR.

STATUTORY LIQUIDITY REQUIREMENT:

The SLR is the proportion of the total deposits which

the C.B s are statutorily required to maintain in the

form of liquid assets in addition to CRR.

This is undertaken to prevent the C.B s from

liquidating their liquid assets when CRR is raised.


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SELECTIVE CREDIT CONTROLS

CREDIT RATIONING

It views to avail bank credit to relative weaker

business sector.

Steps for this are the Central banks imposes upper limits on the credit

available to large firms and industries

Charging higher interest rate on bank loans beyond a

certain limit.


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Change in lending marginsChange in lending margins

The gap between the value of mortgaged property andThe gap between the value of mortgaged property and

amount of loans advanced by the bank is called lendingamount of loans advanced by the bank is called lending

margin.margin. The Central bank changes the lending margin to regulate theThe Central bank changes the lending margin to regulate the

credit availability.credit availability.

Moral SuasionMoral Suasion

Method of persuading and convincing the commercial banksMethod of persuading and convincing the commercial banksaccordance to some directives for the economic welfare ofaccordance to some directives for the economic welfare of

the country.the country.

Done by writing letters to the commercial banks.Done by writing letters to the commercial banks.

Direct controlsDirect controls When all other methods go ineffective, the banks opt thisWhen all other methods go ineffective, the banks opt this

method. Done rarelymethod. Done rarely


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M1 M2

Quantity of Money

Md

r1

r2

RateofInte

rest

I1 I2Investment demand

I

r1

r2

RateofInterest

Y1 Y2

National Income

C+I+G

E2

Z

E1

C+I2+G1

C+I1+G1

WORKING OF EXPANSIONARY MONETARY POLICY


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M1 M2

Quantity of Money

Md

r1

r2

RateofInte

rest

I1 I2Investment demand

I

r1

r2

RateofInterest

Y1 Y2

National Income

C+I+G

E2

Z

E1

C+I2+G1

C+I1+G1

WORKING OF CONTRACTIONARY MONETARY POLICY

Y=C+S

45


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MONETARY POLICY:

KEYNESIAN VIEW

EASY MONETARYPOLICY

RECESSION (problem)

Central bank buys

securities by open mkt.

Reduces CRR

Lowers bank rate

TIGHT MONETARYPOLICY

INFLATION

Central bank sells

securities through openmky

Raises CRR & SLR

Raises Bank rate

Raises max marginagainst holding stock of

goods.


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LIMITATIONS OF MONETARY

POLICY

The time lag in planing the policy and its

implementation and working time

Correct assessment of the problem recession or

inflation and the magnitude of the problem is

required.

The presence of non-banking financial

intermediairies.

Underdevelopment of money and capital markets.


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Monetary Policy In a developed country

INDIA.

In a developed Economy - Overcome depression and

inflation situations

In a developing economy Promote economic growth

OBJECTIVES OF MONETARY POLICY BY RBI:

1.Ensure price stability

2.Encourage economic growth

3.Encourage stability of exchange rate of rupee


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1.Price Stabilising

Contain inflation

Does not mean absolutely no change in price at all

Means reasonable rate of inflation

High degree of inflation

Raises the cost of living of the people

Makes exports costlier

Makes value of money fall

Encourages businessmen to invest


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2.Economic Growth

Ensuring adequate availability of credit

Lowering the cost of credit

Two types of credit requirement

Finance working capital

Finance investment in projects for building fixed costs

Prior to 1991

Tight credit policy

Restrict credit availability to private sector


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3.Exchange Rate Stability

Before 1991-Fixed Exchange Rate System

After 1991-Floating Exchange Rate System

Exchange rate of rupee volatile

Cause fluctuations in foreign exchange rate

Need to prevent large appreciation and depreciation of money

Exchange rate of rupee is determined by demand and supply of foreign exchange

Mismatch external value of rupee changes


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Depreciation of rupee caused as against US Dollars increase in

demand for Dollars from

Corporate sector to finance imports

FII to take out their dollars from India

Increase in demand for Dollars by Indian Banks to finance imports

from abroad

To arrest the fall of rupee, RBI

Raises the bank rate

Raises the CRR


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Cost of Credit rises, availability reduces, borrowingsdiscouraged, investments abroad discouraged,demand for dollars reduced

Release more dollars from Foreign exchange

reserves Increase supply of US Dollar in foreign

Exchange Market

To prevent appreciation of rupee

Raise prices of Indian Exports-uncompetitive


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Role of Monetary policy in Economic

Growth

Expansion of productive capacity

Accelerate rate of savings and investment

Steps

Increase aggregate rate of savings

Mobilization of savings to make it available forinvestment and production

Increase in the rate of investment

Allocation of investment for productive purpose

and priority sectors


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1.Monetary policy and Savings

High interest policy-promote savings

To promote economic growth-raise the rate of saving

Real rate of interest =Nominal rate vof interest-rate of inflation

Expand banking facility

Surplus incomes consumed -unsaved and unproductive-induced to be saved

To facilitate mobilisation of savings it is essential to maintain reasonable price stability


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2.Monetary Policy and Investment

Cost of credit Keynesian theory of Monetary Policy

Effect of a change in money supply on the level of production andinvestment operates through changes in rate of interest

Increase in money supply - rate of interest falls - more investment Decrease in money supply rate of interest rises - less investment

Credit Availability Effect Increase in money supply enlarges availability of bank credit for

investment purposes - raises the level of investment Decrease in money supply reduces the availability of bank credit for

investment purposes - lowers the level of investment


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In Public Investment

Ensure that banking system contributes to planned

public investment

Part of bank deposits should be invested in

government and other approved securities

Tool to develop infrastructure and increase demand

for industrial products

Stimulate private investments

Technique of SLR banks are required to keep apart of total demand and time deposits as liquid

assets government and other securities


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In Private Investment

Banks must provide credit to meet the working capital

requirements of agriculture and industry - large and

medium scale

Ensure full utilisation of existing capacity and build up

more capacity


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3.Allocation of Investment Funds

Ensure proper canalisation of savings into suitable directions

Discriminate between productive and unproductive outlays

1. Vary the reserve requirements

2.Credit Control

Lengthening the period of repayment Lowering margin requirements

Provision of special loans to banks

Helps in 2 ways

1.Prevent savings from being wasted in unproductive channels2.Help the economic growth to controlling inflation


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Monetary Policy of RBI

1.Of Controlled Expansion 1951-1972

2.Of Pre-Reforms Period 1972-1991

3.Of Post-Reforms Period 1991-2000


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Monetary policy to check Inflation and

ensure Price Stability

In India, RBI plays both regulatory and promotional roles

Promotes saving and investment

Influences the cost of credit and growth of money supply

Working of bank rate policy , open market operations function

effectively only if there is an organised bill market andmaintainence of fixed cash reserve ratios

Method of variable cash reserve ratio is more effective

RBI can exercise effective control over commercial banks to

restrict their credit expansion through compulsory increase in

CRR


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1.Pre Reform Period

Mixed economy with both public and private players

RBI regulated expansion of money supply and bank

credit

RBI was called as controlled expansion as it restricted

excessive supply of credit to private sectors

Steps taken to control prices were

Changes in bank rate

Changes in CRR

Restrict the flow of credit to particular sectors

commodities or activities


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2.Of Controlled Expansion

Monetary policy was framed in response to the fiscal policy ofthe government

Fiscal deficits were incurred and a good part of it was financed

by borrowings from RBI

Resulted in large increase in RBIs credit to the governmentwith rapid growth in money supply

Excess liquidity in banking system was mopped up by raising

CRR and SLR to maximum

The basic goal of the policy was to neutralise the impact of

fiscal deficit


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3.Post Reform Period

Monetary policy was framed to achieve price stability and economicgrowth

Rupee was floated to determine exchange rate

Indian economy was opened up to private foreign investment

Access to foreign capital market by Indian companies

CRR and SLR were used Lending rates of interest were fixed at low level for priority sectors like

agriculture, small scale industries, exports

Introduction of liquidity Adjustment Facility to adjust daily basis liquidity inthe bank system

Increase in foreign exchange reserves issue Indian money liquidity in

banking system Capital inflows have come through exports, FIIs, FDIs


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