MONETARY POLICY

Monetary policy involves the influence on the level and composition of aggregate demand by manipulating interest rate and the availability of credit. The monetary policy means regulatory policy whereby the central bank maintains its control over the supply of money to achieve general economic objectives.

Objectives of Monetary Policy

1)      Growth with Stability – In developing countries, the maximum of monetary policy is controlled expansion of money supply. Monetary policy not only promotes investment but also discourage investment to less productive and less useful activities. Thus, monetary measures can be adopted to encourage or discourage investment according to the requirement of business activities.

2)      Price Stability- Money supply should be in such a manner that it comes with price stability. Violent fluctuation in price may lead to inflation or deflation. Inflation has undesirable effect and reduces the investment. Deflation has adverse effects on production and employment. Thus, monetary authority can bring stability in the price level by adjusting the money supply.

3)      Exchange Rate Stability- Disturbances in exchange rate unfavorably influence international trade. If disturbances are violent, then price, production and employment affected badly. Therefore, it is essential to maintain stability of exchange rate through devaluation or overvaluation of the currency.

4)      Full Employment- Periodical fluctuations in the business activities may result in unemployment in the economic system. Monetary authority must ensure a stable level of employment if government wants to live up to the expectations of the people.

5)      Capital Formation- Monetary policy promotes and mobilizes savings in the developing countries by offering high rate of interest and safety of deposits.

6)      Favorable Balance of Payment (BOP) - The goods are imported to meet various requirements of the country. If imports exceed exports, BOP becomes unfavorable. Therefore, the monetary policy should be directed towards maintaining stability in the exchange rate to remove BOP.
       
Instruments of Monetary Policy


Quantitative Instruments or Quantitative Credit Control


1)      Bank Rate- Bank rate is that minimum interest rate at which central bank is ready to give loan to the commercial bank of the country. Bank rate is the minimum rate at which the central bank rediscounts the approved securities or advances loans to other commercial banks. The rate of interest increases with increase in bank rate. The demand of credit will reduce with increase in bank rate and vice versa.

2)      Open Market Operations- Open market operations refers to the sale and purchases of securities by the central bank in the open market. If the central bank wants to contract the credit, it begins to sell securities in the open market. People buy securities issued by the central bank from their savings or withdrawing their money from the banks. In this way, money begins to flow in the central bank and cash reserve of commercial banks begins to fall. If the central bank wants to expand the credit, it begins to purchase securities in the open market.

3)      Change in Minimum Reserve Ratio- Change in minimum reserve ratio refers to change in the minimum percentage of the deposits to be kept as reserve funds by the commercial banks with the central bank. If central bank increases minimum reserve ratio, then commercial bank will have to maintain more cash holdings with central bank which will reduce their loan providing capacity. Thus, reducing credit in the market. If Central bank decreases minimum reserve ratio, banks will have surplus cash to grant loan.

4)      Change in Liquidity Ratio- Every bank has to keep compulsorily a certain portion of their assets in the form of cash or government securities. When central bank has to contract credit, it increases the liquidity ratio. When central bank has to expand the credit, it decreases the liquidity ratio.

Qualitative Instruments or Qualitative Credit Control

1)      Change in the Marginal Requirements of Loan- Marginal requirement is the difference between the value of the security and the amount of loan sanctioned against that security. Suppose a person pledges goods worth Rs.100000 with a bank and gets loan of Rs.80000, then Rs.20000 is marginal requirement. The marginal requirement is increased to contract the credit and vice versa.

2)      Rationing of the Credit- Central bank of the country also functions as a lender of the last resort. It can ration the credit with view to controlling credit. Central bank can introduce rationing of credit in four ways
-          It can decline to give loans to a particular bank.
-          It can scale down the amount of loans to be given to different banks.
-          It can fix quota of the credit to be given to different bank.
-          It can fix the limits of loans to be given different industries and traders.

3)      Moral Persuasion- Sometimes central bank by exercising moral persuasion over other banks get them agree to control credit. Central bank has its influence on almost all banks.

4)      Direct Action- When all other methods prove ineffective, central bank is obliged to take direct action against other bank to carry out their activities in a specified manner.

Monetary Policy to Correct Deficient Demand and Excess Demand

Monetary Policy
Deficient Demand
Excess Demand
1) Bank Rate
Reduced
Increased
2) Open Market Operation
Purchase securities
Sell securities
3) Change in Minimum Reserve Ratio          
Reduced
Increased
4) Change in Liquidity Ratio
Reduced
Increased
5) Change in the Marginal Requirements of Loan
Reduced
Increased
6) Rationing of the Credit
Not introduced
Is introduced
7) Moral Persuasion
To expand credit
To contract credit
8) Direct Action
To expand credit
To contract credit





Difference between Fiscal Policy and Monetary Policy

BASIS FOR COMPARISON
              Fiscal Policy
          Monetary Policy
1) Meaning
The tool used by the government in which it uses its tax revenue and expenditure policies to affect the economy is known as Fiscal Policy.
The tool used by the central bank to regulate the money supply in the economy is known as Monetary Policy.
2) Administered by
Administered by
Central Bank
3) Nature
The fiscal policy changes every year
The change in monetary policy depends on the economic status of the nation.
4) Related to
Government Revenue & Expenditure
Banks & Credit Control
5) Focus on
Economic Growth
Economic Stability
6) Policy instruments
Taxation Policy and Government Expenditure Policy
Qualitative and Quantitative credit control Policy
7) Political influence
Yes
No


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