Definition: The use of interest rate and other instruments by the Central Bank to influence money supply to achieve certain macroeconomic goals. It basically is a process by which the monetary body of the central bank of a country controls the supply of money in the market, often eyeing a rate of interest. The major goals usually include relative price stability and lower the unemployment for the economic development of the country.
Monetary policies are basically classified into two categories, namely: is referred to as either being expansionary, or a contractionary. An expansionary monetary policy increases the total supply of money in the economy rapidly than usual, while a contractionary policy expands the money supply more slowly than usual and more often even shrinks it. Expansionary policy is traditionally used to cope up with and lower down unemployment in times of recession by lowering the interest rates. What basically happens due to this is that the easy credit allows businesses an opportunity to expand. On the other hand contractionary policy is implemented to slow inflation to curb the distortions and deterioration of asset values.
Monetary policy is basically contrasted with the fiscal policy, which includes taxation, government spending, and associated borrowing.
Objectives of Monetary Policy: The monetary policy is primarily implemented to control the growing unemployment in the conditions of recession and to lower the rising rates in the time of inflation.
The tools available to the RBI to affect the monetary policy are:
(a) Bank Rate.
(b) Reserve Ratio.
(c) Open Market Operations.
(d) Interventions in For-ex market.
(e) Moral Suasion.
Open market Operations
Monetary policy can be implemented to change the size of monetary base. Central banks use open market operations to change the monetary base. The central bank or the RBI buys or sells reserve assets (financial instruments such as bonds) in exchange for money on deposit at the central bank. Those deposits are convertible to currency. Together the currency and deposits constitute the monetary base of a country. Basically it constitutes the general liabilities of the central bank in its own monetary unit.
For-ex intervention: The RBI by policy implementation assesses the value of Rupee and it makes the value of rupee appreciate or devalue accordingly to meet the requirements. The change in the value of currency brings about change in the scenario of the exports and the imports and thus helps us adjust the balance of the payments. It also affects the demand of the currency in the local and the foreign market.
Reserve Requirements: Reserve Banks keep a fraction of the total deposits managed by the commercial banks as reserves with it and this amount of money isn't to be lent. There are two ways associated. One of them is the Statuary lending rate, designed to satisfy various needs like providing loans to the Govt. (SLR). This deposit is kept by the commercial banks by themselves. While the other rate is the Cash Reserve Ratio and it is kept in the bank with the RBI or the central bank. The cash reserve ratio has to be collected and deposited to the RBI within a fortnight or it is weekly. The CRR has to be in cash while the SLR can be cash or kinds.
Bank Rate: It is the rate at which RBI lends the loan to commercial banks. It is a blunt instrument and isn't changed unless the demand is extraordinary. It is also known by the name of the Discount window lending.
Discount window lending is the method where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank or the RBI. This rate is more or less set below short term market rates (T-bills). This facility allows the institutions to vary credit conditions (i.e., the amount of money they have to loan out) according to the benefit they can earn, and thereby affecting the money supply. Most importantly, the Discount Window is the only instrument or tool, which the Central Banks can't have total control over.
By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates, and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.
Selective Credit controls: Certain business are given more and certain other may get less credit from banks or their interest rates get specifically revised on the orders of RBI. It is imposed to discourage hoarding, black marketing. This is a kind of a prioritization of the needs and thus by serving a particular sector and inhibiting the growth of a particular sector, the RBI is able to maintain balanced growth and stop mal practices which hurt the economy of the country.
Moral Suasion: A persuasion measure used by the RBI to influence the Government bank to influence and pressure banks to stick to several policies in the time of crisis or so, so as to implement the monetary policy.
Various Types of Monetary Policies
The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.
Monetary Policy:
Target Market Variable:
Long Term Objective:
Inflation Targeting
Interest rate on overnight debt
A given rate of change in the CPI
Price Level Targeting
Interest rate on overnight debt
A specific CPI number
Monetary Aggregates
The growth in money supply
A given rate of change in the CPI
Fixed Exchange Rate
The spot price of the currency
The spot price of the currency
Gold Standard
The spot price of gold
Low inflation as measured by the gold price
Mixed Policy
Usually interest rates
Usually unemployment + CPI change
- Wikipedia
