MONETARY POLICY
Monetary policy is the policy used by the central bank to regulate the supply of money in
the economy. The central bank of India that is Reserve bank of India plays the controlling
authority here. This is a tool used to control even the inflation and the interest rates to
ensure price stability and trust in the currency of a nation. The goals of monetary policy
also include the contribution to the economic growth and stability, to lower
unemployment rates and to maintain stability in the exchange rates with the currencies of
other nations. The best monetary policy is termed as the optimal monetary policy for
which optimal inflation rate should be applicable in a nation.
Monetary policies are generally of two types:
1) Expansionary Policy- This type of policy increases the total supply of money in the economy. This was traditionally used to remove unemployment during recessionary period by lowering the interest rates having the belief that easy credit will help business expand.
2) Contractionary Policy- This policy increases or expands the money supply but at a pace less even less than the normal and in certain cases even shrinks it. It is intended to slow inflation and to avoid the resulting distortion of asset values.
Monetary Policy uses the following tactical approaches to maintain financial stability:
Money Supply- This practice involves the money supply by buying and selling government bonds. These are also known as open market operations as the central bank make purchases and sales of government bonds in public markets. These involve generally the short term bonds.
Money demand- This practice plays on the rule that the demand is dependent on the price. The price is the interest rate to be paid by the borrower. Therefore through this rule the central bank keeps on altering the interest rates to regulate the economy and bring in stability.
Banking risk- This practice manages the risk within the banking system. In this it specifies the reserve requirements of the banks than those reserves may be with the central bank or with the commercial banks only. They regulate the economy under this approach through the reserve ratio’s. To primary tools are Cash reserve ratio and statutory reserve ratio. The following three approaches namely open market operations, regulating interest rate and reserve ratios are the normal methods used by the reserve bank of India to ensure adequate supply of money in the economy with price stability.
Meaning and objectives of Monetary Policy
Monetary Policy refers to the mechanism through which the monetary authority regulates the supply of money in the economy by using instruments such as that of interest rates to maintain the price stability and achieve better economic growth. This monetary authority is generally the central bank of the country. RBI (Reserve Bank of India) is the central bank of India.
Objectives of Monetary Policy Beside price stability monetary policy accomplish the following tasks as well:
1) Full employment- Full employment is a situation favorable for any economy not only because it increases output but also for the credit standing of a nation. Monetary policy helps achieving this target.
2) Price stability- Another main objective of monetary policy is the price stability. Price stability is promoted to reduce the fluctuations in prices as these fluctuations in prices bring uncertainty and instability in the economy. The focus of monetary policy is to facilitate the enviournment which is favorable to the economic development to run the projects swiftly along with maintaining the stability.
3) Economic Growth- Economic growth is a situation where real GDP of a nation that is the per capita income of the nation increases over a period of time. Monetary policy aims at it.
4) Balance of Payment- This objective of monetary policy tries to achieve the equilibrium between the exports and the imports
5) Expansion of bank credit- One another important function of RBI is the controlled expansion of credit to commercial banks according to their seasonal requirements without affecting the output.
6) Fixed Investment- This objective of RBI focuses on the productivity of investments by having a control on non essential fixed investment.
7) Promote Efficiency-RBI tries to increase the efficiency in the financial system by regulating and deregulating interest rates, ease operational constraints, introduce money market instruments, etc.
8) Restriction of inventories and stocks-Excess stocking of inventories is not beneficial for any economy as it may make the stock outdated over a period of time and hence may lead to a loss. To avoid this kind of problem the central bank carries out this special function of regulating the economic inventories.
9) Reducing the rigidity- RBI bring flexibility in the operations which provide autonomy. It maintains its control on all the areas where prudence is required in the financial system.
Instruments of Monetary Policy
The instruments of monetary policy are of two types:
1) Quantitative or general or indirect- They are meant to regulate the quantity of credit in the economy through commercial banks. The various instruments used under this are bank ate operations, open market operations and changing reserve requirements.
2) Qualitative or selective or direct- They are meant to regulate the type of credit from the central bank to the commercial banks. They include changing margin requirements and regulation of consumer credit. Both these methods are discussed here forth:
I) Bank rate Policy- Bank rate is the rate at which the central bank rediscounts the government securities such as that of bills of exchange and other government securities held by the commercial banks..This goes this way when the central bank wants to control the inflationary situation in the economy it raises the bank rate. This way the demand of credit from the commercial banks reduces which reduces the spare money in the hands of general public, which corrects the inflationary pressure. Similarly when deflationary pressure is corrected by reducing the bank rates, economy is brought back to the equilibrium.
II) Open Market Operations- It refers to sale and purchase of securities from the commercial banks by the central bank to regulate the economy. The reserve bank starts selling the securities held for the same to commercial banks, when the prices starts rising, this way money is extracted from circulating in the economy and kept with the central bank as reserves. Similarly when recessionary forces start in the economy, the central bank starts purchasing securities from the commercial banks to induce more money in the economy.
III) Changes in Reserve Ratios- This is suggested by Keynes. This method says that every bank is required to keep certain reserves with them as well as with the central bank from the total deposits in the form of reserve fund. When prices rise, the central bank raise the reserve ratios as well, now as more money is in the form it reduces the money in circulation and hence economy moves towards the equilibrium. In the opposite, when the reserve ratio is lowered, the reserve with the commercial banks is reduced but their lending ratio increases which in turn bring more money in circulation. Equilibrium is achieved.
IV)Selective Credit Controls- Selective credit controls are used to regulate certain specific types of credit for particular purposes. They can be in the form of margin requirements as if there is specific speculative activity in the economy in particular sector in certain commodities, the RBI raise the margin requirement on them to reduce the investment in that particular commodity. Similarly it reduces the margin on commodities which it wants to encourage investment in.
Inflation Targets
Reserve bank of India uses inflation targeting as a tool of monetary policy to regulate the medium term inflation target. The underlying assumption in this is that the long term economy is the be maintained and a price stability is desired. The central bank uses interest rates as its short term monetary instrument. In inflation targeting central bank keeps revising the interest rates to achieve the target, like they raise the interest rates based on above target inflation and lower the interest rates based on below target inflation. The basic principle is raising interest rates cools the economy and lowering it accelerates the same. Benefits:
Helps monetary policy to focus on domestic considerations and face the economic shocks in a better way, which is difficult under fixed exchange rate system.
Investors uncertainty gets reduced.
More transparency is the system is the key benefit of inflation targeting. This is possible because the inflation targeting tends to maintain regular channels of communication with the public.
It helps in better decision making by individuals, households and businesses.
Reduces financial and economic uncertainty.
Helps in increasing the accountability of central bank.
Leads to a higher economic growth. Limitations Inflation targeting has been criticized on various grounds. One of the major amongst them is as follows:
Being criticized on neglecting the output shocks as it solely focuses on the price level.
Monetary policies are generally of two types:
1) Expansionary Policy- This type of policy increases the total supply of money in the economy. This was traditionally used to remove unemployment during recessionary period by lowering the interest rates having the belief that easy credit will help business expand.
2) Contractionary Policy- This policy increases or expands the money supply but at a pace less even less than the normal and in certain cases even shrinks it. It is intended to slow inflation and to avoid the resulting distortion of asset values.
Monetary Policy uses the following tactical approaches to maintain financial stability:
Money Supply- This practice involves the money supply by buying and selling government bonds. These are also known as open market operations as the central bank make purchases and sales of government bonds in public markets. These involve generally the short term bonds.
Money demand- This practice plays on the rule that the demand is dependent on the price. The price is the interest rate to be paid by the borrower. Therefore through this rule the central bank keeps on altering the interest rates to regulate the economy and bring in stability.
Banking risk- This practice manages the risk within the banking system. In this it specifies the reserve requirements of the banks than those reserves may be with the central bank or with the commercial banks only. They regulate the economy under this approach through the reserve ratio’s. To primary tools are Cash reserve ratio and statutory reserve ratio. The following three approaches namely open market operations, regulating interest rate and reserve ratios are the normal methods used by the reserve bank of India to ensure adequate supply of money in the economy with price stability.
Meaning and objectives of Monetary Policy
Monetary Policy refers to the mechanism through which the monetary authority regulates the supply of money in the economy by using instruments such as that of interest rates to maintain the price stability and achieve better economic growth. This monetary authority is generally the central bank of the country. RBI (Reserve Bank of India) is the central bank of India.
Objectives of Monetary Policy Beside price stability monetary policy accomplish the following tasks as well:
1) Full employment- Full employment is a situation favorable for any economy not only because it increases output but also for the credit standing of a nation. Monetary policy helps achieving this target.
2) Price stability- Another main objective of monetary policy is the price stability. Price stability is promoted to reduce the fluctuations in prices as these fluctuations in prices bring uncertainty and instability in the economy. The focus of monetary policy is to facilitate the enviournment which is favorable to the economic development to run the projects swiftly along with maintaining the stability.
3) Economic Growth- Economic growth is a situation where real GDP of a nation that is the per capita income of the nation increases over a period of time. Monetary policy aims at it.
4) Balance of Payment- This objective of monetary policy tries to achieve the equilibrium between the exports and the imports
5) Expansion of bank credit- One another important function of RBI is the controlled expansion of credit to commercial banks according to their seasonal requirements without affecting the output.
6) Fixed Investment- This objective of RBI focuses on the productivity of investments by having a control on non essential fixed investment.
7) Promote Efficiency-RBI tries to increase the efficiency in the financial system by regulating and deregulating interest rates, ease operational constraints, introduce money market instruments, etc.
8) Restriction of inventories and stocks-Excess stocking of inventories is not beneficial for any economy as it may make the stock outdated over a period of time and hence may lead to a loss. To avoid this kind of problem the central bank carries out this special function of regulating the economic inventories.
9) Reducing the rigidity- RBI bring flexibility in the operations which provide autonomy. It maintains its control on all the areas where prudence is required in the financial system.
Instruments of Monetary Policy
The instruments of monetary policy are of two types:
1) Quantitative or general or indirect- They are meant to regulate the quantity of credit in the economy through commercial banks. The various instruments used under this are bank ate operations, open market operations and changing reserve requirements.
2) Qualitative or selective or direct- They are meant to regulate the type of credit from the central bank to the commercial banks. They include changing margin requirements and regulation of consumer credit. Both these methods are discussed here forth:
I) Bank rate Policy- Bank rate is the rate at which the central bank rediscounts the government securities such as that of bills of exchange and other government securities held by the commercial banks..This goes this way when the central bank wants to control the inflationary situation in the economy it raises the bank rate. This way the demand of credit from the commercial banks reduces which reduces the spare money in the hands of general public, which corrects the inflationary pressure. Similarly when deflationary pressure is corrected by reducing the bank rates, economy is brought back to the equilibrium.
II) Open Market Operations- It refers to sale and purchase of securities from the commercial banks by the central bank to regulate the economy. The reserve bank starts selling the securities held for the same to commercial banks, when the prices starts rising, this way money is extracted from circulating in the economy and kept with the central bank as reserves. Similarly when recessionary forces start in the economy, the central bank starts purchasing securities from the commercial banks to induce more money in the economy.
III) Changes in Reserve Ratios- This is suggested by Keynes. This method says that every bank is required to keep certain reserves with them as well as with the central bank from the total deposits in the form of reserve fund. When prices rise, the central bank raise the reserve ratios as well, now as more money is in the form it reduces the money in circulation and hence economy moves towards the equilibrium. In the opposite, when the reserve ratio is lowered, the reserve with the commercial banks is reduced but their lending ratio increases which in turn bring more money in circulation. Equilibrium is achieved.
IV)Selective Credit Controls- Selective credit controls are used to regulate certain specific types of credit for particular purposes. They can be in the form of margin requirements as if there is specific speculative activity in the economy in particular sector in certain commodities, the RBI raise the margin requirement on them to reduce the investment in that particular commodity. Similarly it reduces the margin on commodities which it wants to encourage investment in.
Inflation Targets
Reserve bank of India uses inflation targeting as a tool of monetary policy to regulate the medium term inflation target. The underlying assumption in this is that the long term economy is the be maintained and a price stability is desired. The central bank uses interest rates as its short term monetary instrument. In inflation targeting central bank keeps revising the interest rates to achieve the target, like they raise the interest rates based on above target inflation and lower the interest rates based on below target inflation. The basic principle is raising interest rates cools the economy and lowering it accelerates the same. Benefits:
Helps monetary policy to focus on domestic considerations and face the economic shocks in a better way, which is difficult under fixed exchange rate system.
Investors uncertainty gets reduced.
More transparency is the system is the key benefit of inflation targeting. This is possible because the inflation targeting tends to maintain regular channels of communication with the public.
It helps in better decision making by individuals, households and businesses.
Reduces financial and economic uncertainty.
Helps in increasing the accountability of central bank.
Leads to a higher economic growth. Limitations Inflation targeting has been criticized on various grounds. One of the major amongst them is as follows:
Being criticized on neglecting the output shocks as it solely focuses on the price level.
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