MONETARY POLICY AND ITS INSTRUMENTS

Definition:
Monetary policy is the macroeconomic policy laid down by the central bank. It
involves management of money supply and interest rate and is the demand side
economic policy used by the government of a country to achieve macroeconomic
objectives like inflation, consumption, growth and liquidity.
Monetary policy is essentially a programme of action undertaken by the monetary
authorities, generally the central bank, to control and regulate the demand for
and supply of money with the public and the flow of credit with a view to
achieving predetermined macroeconomic goals.

Many economists have given various definitions of monetary policy. Some

prominent definitions are as follows.

According to Prof. Harry Johnson,

A policy employing the central banks control of the supply of money as an

instrument for achieving the objectives of general economic policy is a monetary
policy.

According to A.G. Hart,

A policy which influences the public stock of money substitute of public demand
for such assets of both that is policy which influences public liquidity position is
known as a monetary policy.
Simply, it is clear that a monetary policy is related to the availability and cost of
money supply in the economy in order to attain certain broad objectives. The
Central Bank of a nation keeps control on the supply of money to attain the
objectives of its monetary policy.
The term monetary policy is also known as the RBI's money management policy in
India. In India, monetary policy of the Reserve Bank of India is aimed at managing
the quantity of money in order to meet the requirements of different sectors of
the economy and to increase the pace of economic growth.

The RBI implements the monetary policy through open market operations, bank
rate policy, reserve system, credit control policy, moral persuasion and through
many other instruments. Using any of these instruments will lead to changes in
the interest rate, or the money supply in the economy. Monetary policy can be
expansionary and contractionary in nature. Increasing money supply and reducing
interest rates indicate an expansionary policy. The reverse of this is a
contractionary monetary policy.
OBJECTIVE OF MONETARY POLICY-
The objectives of monetary policy are the same as the objectives of fiscal policy
like growth, employment, stability of price and also foreign exchange and balance
of payment equilibrium. The objectives of a monetary policy in India are similar to
the objectives of its five year plans. In a nutshell planning in India aims at growth,
stability and social justice.

Main objectives are-:

Rapid Economic Growth
Price Stability
Exchange Rate Stability
Balance of Payments (BOP) Equilibrium
Full Employment
Neutrality of Money
Equal Income Distribution

INSTRUMENTS OF MONETARY POLICY-:

The instruments of monetary policy refer to the monetary variables that the
central bank can change at its discretion with a view to controlling and regulating
the money supply and the availability of credit. The instrument of monetary policy
are tools which are used by the monetary authority in order to attain some
predetermined objectives.

The instruments are also called ‘weapons of monetary control’. Samuelson and
Nordhaus call these factors as “The Nuts and Bolts of monetary policy”.
The instruments of Monetary policy are generally classified under two categories-
1. Quantitative Instruments or General Tools
2. Qualitative Instruments or Selective Tools (Selective Credits Controls)

1. Quantitative Instruments -:

The Quantitative Instruments are also known as the General Tools of monetary
policy. These tools are related to the Quantity or Volume of the money. The
Quantitative Tools of credit control are also called as General Tools for credit
control. They are designed to regulate or control the total volume of bank credit in
the economy. These tools are indirect in nature and are employed for influencing
the quantity of credit in the country.

A. Open Market Operations >>> OMO refers to the sale and purchases of
Government securities and treasury bills by the central bank of the country.

When the central bank decides to increase the supply of Money with the public, it
purchases the Government securities.

When the central bank decides to reduce money in circulation, it sells the
Government bonds and securities.

This is very effective and popular instrument of the monetary policy. The OMO is
used to wipe out shortage of money in the money market, to influence the term
and structure of the interest rate and to stabilize the market for government
securities, etc.

It is important to understand the working of the OMO. If the RBI sells securities in
an open market, commercial banks and private individuals buy it. This reduces the
existing money supply as money gets transferred from commercial banks to the
RBI. Contrary to this when the RBI buys the securities from commercial banks in the
open market, commercial banks sell it and get back the money they had invested
in them. Obviously the stock of money in the economy increases. This way when
the RBI enters in the OMO transactions, the actual stock of money gets changed.
Normally during the inflation period in order to reduce the purchasing power, the
RBI sells securities and during the recession or depression phase she buys securities
and makes more money available in the economy through the banking system.
Thus under OMO there is continuous buying and selling of securities taking place
leading to changes in the availability of credit in an economy.

B. Discount Rate or Bank Rate Policy >>>

The Bank Rate Policy (BRP) is a very important technique used in the monetary
policy for influencing the volume or the quantity of the credit in a country. The bank
rate refers to rate at which the central bank (i.e. RBI) rediscounts bills and prepares
of commercial banks or provides advance to commercial banks against approved
securities. It is "the standard rate at which the bank is prepared to buy or rediscount
bills of exchange or other commercial paper eligible for purchase under the RBI
Act". Infect when commercial banks are faced with a shortage of cash reserves,
they approach to central bank to get their bills of exchange rediscounted. It is a
common method of borrowing by the commercial banks from the central bank.
Bank rate is also known as discount rate. However, for all practical purposes, bank
rate is the rate which the central bank charges on the loans and advances to the
commercial banks.

The Bank Rate affects the actual availability and the cost of the credit. Any change
in the bank rate necessarily brings out a resultant change in the cost of credit
available to commercial banks. If the RBI increases the bank rate than it reduces
the volume of commercial banks borrowing from the RBI. It deters banks from
further credit expansion as it becomes a costlier affair. Even with increased bank
rate the actual interest rates for a short term lending go up checking the credit
expansion. On the other hand, if the RBI reduces the bank rate, borrowing for
commercial banks will be easy and cheaper. This will boost the credit creation. Thus
any change in the bank rate is normally associated with the resulting changes in the
lending rate and in the market rate of interest. However, the efficiency of the bank
rate as a tool of monetary policy depends on existing banking network, interest
elasticity of investment demand, size and strength of the money market,
international flow of funds, etc.

The working of Bank rate policy or Discount rate policy is very simple. When Central
bank changes its discount rate, commercial banks also change their own discount
rate.

Central Discount Rate Commercial Bank Discount rate

C. Cash Reserve Ratio or Statutory Reserve Ratio >>>

The Commercial Banks have to keep a certain proportion of their total assets in the
form of Cash Reserves. Some part of these cash reserves are their total assets in
the form of cash. Apart of these cash reserves are also to be kept with the RBI for
the purpose of maintaining liquidity and controlling credit in an economy. These
reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity
Ratio (SLR).

The CRR refers to some percentage of total deposits which commercial banks are
required to maintain in the form of cash reserve with the central bank. The
objective of CRR to prevent shortage of cash in meeting the demand for cash by
the depositors.

By changing the CRR, the central bank can change the money supply overnight.
When economic conditions demand contractionary monetary policy, the central
bank raises the CRR, and when economic condition demands an expansion
monetary policy, the central bank cut downs the CRR.

In India, the RBI has imposed another kind of reserve requirement in addition to
CRR, Called Statuary Liquid Ratio. SLR refers to some percent of reserves to be
maintained in the form of gold or foreign securities. This measure was undertaken
to prevent the commercial banks from liquidating their liquid assets when CRR is
raised.
CRR effect on Supply of money and credit can be explained by an example- suppose
KISAN BANK possess a total deposit of INR 100 and CRR is 20%. It means bank can
loan RS 80 and the credit or deposit multiplier equals to Five.

Deposit Multiplier (Dm) = 1/CRR = 1/ (20/100) = 5

Total Credit Creation (TCC) = Deposit/CRR = 100/ (20/100) = INR 500

2. Qualitative Instruments (Selective Credit Controls).

The Qualitative Instruments are also known as the Selective Tools of monetary
policy. These tools are not directed towards the quality of credit or the use of the
credit. They are used for discriminating between different uses of credit. It can be
discrimination favoring export over import or essential over non-essential credit
supply. This method can have influence over the lender and borrower of the credit.

A. Credit Rationing >>> Central Bank fixes credit amount to be granted. Credit
is rationed by limiting the amount available for each commercial bank. This method
controls even bill rediscounting. For certain purpose, upper limit of credit can be
fixed and banks are told to stick to this limit. This can help in lowering banks credit
exposure to unwanted sectors.

When there is a shortage of credit available for the business sector, the large and
strong sectors tend to capture the lion’s share in the total credit. As a result, priority
and weaker sector face shortage of necessary funds, mainly because of bank credit
goes to non-priority sectors. In order to curb this situation, the central bank uses
this instruments. This is done by three methods (a) By imposing upper limits on the
credit available to large sector or firms, (b) Charging a higher or progressive interest
rate on bank loans beyond a certain limit and (C) by providing credit to weaker at
lower interest rates.

B. Change in Lending Margins >>> The Banks provide loans up to a certain

percentage of the value of the mortgaged property. The gap between value of
Mortgaged property and amount advanced/loan given is called ‘lending Margin’.
For example, value of land is INR 100 and amount advanced is only INR 60, then the
lending margin is 40 per cent. The central bank is empowered to increase or
decrease the lending margin with a view to decreasing or increasing the bank
credit. A change in a margin implies a change in the loan size. This method is used
to encourage credit supply for the needy sector and discourage it for other non-
necessary sectors. This can be done by increasing margin for the non-necessary
sectors and by reducing it for other needy sectors. Example: - If the RBI feels that
more credit supply should be allocated to agriculture sector, then it will reduce the
margin and even 85-90 percent loan can be given. However, it is important to note
that this selective credit controls were eliminated in october1996.

C. Control Through Directives >>>

Under this method the central bank issue frequent directives to commercial banks.
These directives guide commercial banks in framing their lending policy. Through a
directive the central bank can influence credit structures, supply of credit to certain
limit for a specific purpose. The RBI issues directives to commercial banks for not
lending loans to speculative sector such as securities, etc. beyond a certain limit.

D. Direct Action >>>

Under this method the RBI can impose an action against a bank. If certain banks are
not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and
securities. Secondly, RBI may refuse credit supply to those banks whose borrowings
are in excess to their capital. Central bank can penalize a bank by changing some
rates. At last it can even put a ban on a particular bank if it does not follow its
directives and work against the objectives of the monetary policy.

E. Moral suasion >>>

The moral suasion is a method of persuading and convincing the commercial banks
to advance credit in accordance with the directive of the central bank in the
economic interest of the country. This method is adopted to addition to
quantitative and selective control measures, particularly when effectiveness of
these methods is doubtful. Under this method, the central bank writes letters to
and holds meeting with the banks on money and credit matters with the objective
of persuading banks to act according to the instructions and advise of the central
bank in the interest of the economy as a whole.
 REPO AND REVERSE REPO RATE

In addition to all these traditional method, RBI uses Repo Rate (Repurchase
operation rate) and Reverse repo rate under its Liquidity Adjustment Facility (LAF)
programme.

REPO RATE>>> It is the rate that RBI charges the banks when they borrow
from the RBI. It is used by monetary authorities to control inflation. In the event of
inflation, Central Bank increases the RR as this acts as a disincentive for banks to
borrow from Central Bank. This ultimately reduces the money supply in the
economy and thus helps in arresting inflation.

REVERSE REPO RATE>>> It is the rate at which RBI borrows money from
the commercial banks. It is a monetary policy instrument which can be used to
control the money supply in the country. An increase in the RRR will decrease the
money supply and vice-versa, other thing remaining constant.

An increase in RRR means that commercial banks will get more incentive to park
their funds with the Central bank, thereby decreasing the supply of money in the
market.

Depending on the country needs, Central bank keeps changing these rates. In short
Repo Rate Increases Liquidity and Reverse repo rate reduces the liquidity in the
country.

Current rates in per cent as on 6 October 2018

CRR 4%
SLR 19.5%
RR 6.50%
Reverse Repo rate 6.25%
Bank rate 6.75%

Source-: rbi.org.in

CRR, SLR AND RR IMPACT ON ECONOMY IN NUTSHELL

In Last but not least we can see that change in monetary policy drastically affects
the common people and nations economy as a whole. RBI uses the monetary policy
tools periodically to infuse and drain out excess of liquidity out of the market.