Academic Script

MONETARY POLICY: Instruments and Systems

“It is well enough that people of the nation do not understand our
banking and monetary system, for if they did, I believe there would be a
revolution before tomorrow morning.”

- Henry Ford

Introduction:

The success of economic stability often depends on how government

manages its credit supply in the economy. The functioning of money
market, capital market and financial sector depends on the approach of
government towards money supply and credit creation. The principal
organ of every government – to regulate, control & monitor money
supply, credit creation, process of capital formation & mobilization; is the
central bank of that country.

Central Bank therefore can be rightly called as the regulator, monitor,

promoter and architect of monetary system. In India, it is the RBI that
works as the principal regulator of money market.

Since 1930s, the role of central bank in economic management has

changed significantly. It is now recognized a basic banking regulator and
custodian of the economy. Central bank adopts different policies for
different situations and to overcome economic crises. Central bank
works as a friend philosopher and guide of the government to overcome

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the challenges of cyclical fluctuations in the economy and issues
affecting the success of certain economic policies.

The prudent economic management, stabilizing credit supply, efficient

monetary management and consistency in policy measures are the four
pillars of economic management. Central bank effectively performs these
functions by applying various systems, policies and mechanisms.

Monetary policy is one of the pioneer and principal instruments in the

hand of the central bank. As a regulator of the economy, monetary policy
becomes a very essential instrument of economic intervention in the
hands of central bank for economic management of the country. How the
monetary policy are changed and redesigned considering the
requirements of the economy is a very important issue to be studied.

The term monetary policy often is defined as ‘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.’
(http://economictimes.indiatimes.com/definition/monetary-policy)

Monetary policy is thus a very important instrument of economic

management. In this lecture, we are going to study various instruments
of monetary policy and its implications on the success of economic
management.

Instruments or techniques of Monetary Policy:

The instruments of monetary policy are tools which are used by the
monetary authority in order to attain some predetermined socio-
economic objectives.

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These instruments can be classified into two categories:

A. Quantitative Instruments or General Tools:

B. Qualitative Instruments or Selective Tools:

Let us now try to understand these tools in detail:

Quantitative Instruments or General Tools:

The Quantitative Instruments also known as the General Tools of

monetary policy are related to the quantity or volume of the money in the
economy. They are developed and designed to regulate or control the
total volume of bank credit in the economy. These tools are indirect in
nature and 61are employed for influencing the quantity of credit in the
economy.

The general tools of monetary policy and credit control have been
explained here:

1. Bank Rate Policy:

The Bank Rate Policy is a very important technique used in the monetary
policy for influencing the volume or the quantity of the credit in an
economy. The bank rate refers to rate at which the central bank
rediscounts bills of commercial banks or provides advance to commercial
banks against approved securities. In case of India, it is the standard rate
at which the banks are prepared to buy or rediscount bills of exchange or
other commercial paper eligible for purchase under the RBI Act. The
Bank Rate affects the actual availability and the cost of the credit. Any
change in the bank rate inevitably brings out a resultant change in the
interest rates of the commercial banks. An increase in the bank rate,
reduce the volume of commercial banks borrowing from the RBI. It

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restricts the banks from further credit expansion as it becomes a more
costly affair. On the other hand, in case there is a decrease in the bank
rate, borrowing for commercial banks will be easy and cheaper. This will
boost the process of credit creation.

Any change in the bank rate is normally associated with the resulting
changes in the lending rate of interest. However, the efficiency of the
bank rate as a tool of monetary policy depends on factors like existing
banking network, interest elasticity of investment demand, size and
strength of the money market, international flow of funds, etc.

2. Open market operation:

The open market operation refers to the purchase and sale of short term
and long term securities by the RBI in the open market. Open market
operation is used:

- To eliminate the situation of 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.

This is very effective and popular technique of the monetary policy. It is

important to understand the working of the OMO as an important
technique of monetary policy. If the commercial banks and private
individuals buy the securities offered by RBI in an open market, money
gets transferred from commercial banks to the RBI. This reduces the
purchasing power in the hands of public and contracts the existing
supply of money. On the other hand, when the RBI buys the securities
from commercial banks in the open market, commercial banks sell it and

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get back the money they had invested in them. This expands the supply
of money in the economy increases. In this way through open market
transactions, RBI controls the money supply in the economy.

During the inflationary phase the RBI sells securities in order to reduce
the purchasing power. During the recessionary phase RBI buys
securities and increases the supply and availability of money 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.

There are certain factors that limit the effectiveness of open market
operation like underdeveloped securities market, excess reserves with
commercial banks, indebtedness of commercial banks, etc.

3. Variation in the Reserve Ratios:

According to the RBI norms, the Commercial Banks have to keep a

certain proportion of their total deposits in the form of Cash Reserves for
the purpose of maintaining liquidity and controlling credit in an economy.
These reserve ratios are of two types viz. Cash Reserve Ratio (CRR)
and a Statutory Liquidity Ratio (SLR).

The CRR refers to some percentage of commercial bank's net demand

and time liabilities which commercial banks have to maintain with the
central bank. SLR refers to some percent of reserves to be maintained in
the form of gold or foreign securities. In case of India, the CRR remains
in between 3% to 15% percent while the SLR remains in between 25% to
40% of bank deposits.

Any change in CRR and SLR affects the lending capacity of commercial
banks. In turn, it affects the banks credit creation multiplier. RBI

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increases the percentage of CRR and SLR during the inflation to reduce
the purchasing power and credit creation. However, during the recession
it lowers the percentages of reserve ratios making more cash reserves
available for credit expansion.

Qualitative Instruments or Selective Tools ↓

The Qualitative Instruments of monetary policy are also known as the

Selective Tools of monetary policy. These tools are not used to control
and regulate the general money supply. It is used to extend and regulate
credit of certain select sectors of the economy. These instruments are
used for discriminating between different uses of credit. This method of
monetary control can have influence over the lender and borrower of the
credit.

Let us try to understand the Selective Tools of monetary policy in detail:

1. Fixing Margin Requirements:

The margin refers to the proportion of the loan amount which is not
financed by the bank. In other words, margin is that part of a loan which
a borrower has to raise in order to get finance for his purpose of taking
the loan. A change in a margin brings about a change in the size of loan
amount. This method is used to encourage credit supply for the needy
sector (like agricultural sector) by decreasing the margin. Likewise, an
increase in margin discourages the credit supply for other non-necessary
sectors (for example margin for acquiring car loans may be higher).

In case of India, RBI has the authority to change the margin for different
sectors. For this it prioritizes the credit needs of different sectors and
decides the margins accordingly. As such, this method can be employed

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for meeting the credit requirements of priority sectors like agricultural
industry.

2. Consumer Credit Regulation:

Consumer credit regulation method of selective credit control helps to

regulate consumer credit supply. Under this method the down payment,
installment amount, loan duration etc. for hire-purchase and installment
sale of consumer goods is fixed in advance. This can help in checking
the credit use and inflation in a country.

3. Publicity:

This technique of selective credit control involves the Central Bank (RBI)
making public statements regarding what is good and what is bad in the
system, through various reports published by it. This published
information helps the commercial banks to extend the credit supply in the
right direction towards the desired sectors. These publications are made
freely available in the form of weekly and monthly bulletins and can be
used for attaining goals of monetary policy.

4. Credit Rationing:

Under this method of selective tool of monetary policy, the Central Bank
fixes credit amount to be granted to the commercial banks. 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 directed to not exceed credit beyond
that limit.

5. Moral Suasion

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This method refers to the pressure exerted by the RBI on the Indian
banking system without strict enforcement of any regulation. Under this
method, the commercial banks are informed about the expectations of
RBI through a monetary policy. The central banks can issue directives,
guidelines and suggestions for commercial banks regarding reducing
credit supply for speculative purposes. It helps in restraining credit during
inflationary periods.

6. Control through Directives:

Under this technique of selective credit control the central bank issues
frequent directives to commercial banks in order to guide the commercial
banks in framing their lending policy. Through the issue of directive, the
central bank can influence credit structures, supply of credit to certain
limit for a specific purpose. The RBI may issue directives to commercial
banks for not lending loans to speculative sector such as securities, etc
beyond a certain limit especially when the economy is going through an
inflationary phase.

7. Direct Action

If certain commercial banks are not adhering to the RBI's directives, RBI
can impose an action against those banks. Some of the direct actions
imposed by RBI have been enumerated here:

- RBI may refuse to rediscount the bills and securities of commercial

banks.

- RBI may refuse credit supply to those banks whose borrowings are
in excess to their capital.

- RBI can penalize a bank by changing some rates.

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 - RBI can also put a ban on a particular bank if it does not follow its
directives and work against the objectives of the monetary policy.

The success of the selective tools of monetary supply is influenced by

factors like:

- Availability of alternative sources of credit in economy,

- Nature of functioning of the Non-Banking Financial Institutions

(NBFIs)

- Profit motive of commercial banks

But a right mix of both the general and selective tools of monetary policy
can certainly help to attain the objectives of monetary policy and give the
desired results.

Transmission Mechanism of Monetary Policy:

The monetary transmission mechanism refers to the mechanism by

which the changes in the supply of money produce the effect, which by
interacting with the economy-‘s real sector create changes in the income
and in the general price level.

This is a process that takes place with the help of two primary
mechanisms. These mechanisms are:

 Portfolio or relative price mechanism

 Wealth mechanism

1. Portfolio Mechanism:

a. According to this approach, monetary policy operates directly on

the total spectrum of spending rather than simply through

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 investment spending as often emphasized by the neo-Keynesian
approach.

b. A change in the money supply will initially affect the interest rates
associated with these assets as individual wealth holders re-adjust
their asset portfolios.

c. As a result of this operation, wealth holders exchange government

securities for central bank notes, increasing the quantity of cash
balances in their individual portfolios. This in turn creates a
temporary imbalance of excess cash in their portfolio.

d. As wealth holders try to adjust their portfolios by purchasing

interest bearing non-cash financial assets, the prices of these
assets are driven up, reducing the market rate of interest, in the
process.

e. The increase in the prices of financial assets encourages the issue

of new financial assets. The money received from the sale of these
assets, is then used to finance the purchase of the real investment.
This causes the income to expand via the investment multiplier.

2. Wealth Mechanism:

The wealth mechanism is bases on the manner in which changes in the

quantity of money affects the non-human net wealth. It also considers
the manner in which this, as a result, influences the aggregate demand.

Monetary Policy in Developing Economy:

The purpose of every economic policy is to increase the pace of

development. The universally accepted goal of the economic policy is to
maintain the pace of development of economy. This can be achieved by

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adopting a sustainable development policy. Whether an economy is in
the phase of development, or it a developed economy, the focus is
always on the pace and direction of growth.

A government has to adopt a policy that offers stability to the growth

process. Monetary policy is an instrument that offers a sound and
definite direction to the growth process.

The principal requirements of a growth driven economy are:

a. Maintenance of domestic price stability

b. Fixed realistic foreign exchange rate

In developing countries, the most disastrous effects are produced by

rising prices and frequently fluctuating foreign exchange rates. It often
retards the rate of growth as the process of capital accumulation is
discouraged due to low rate of domestic savings.

In certain cases, the inflow of foreign capital is also reduced. The scarce
economic resources cannot be properly allocated, which in turn creates
suppressed inflation.

For most of the developing countries, the key economic features

affecting the growth process are:

i. Suppressed inflationary trends

ii. Scarcity of basic economic resources
iii. Unrealistic foreign exchange rates
iv. Low rate of domestic savings
v. Transfer of funds and capital from more essential sector to less
essential sector
vi. Growing imbalance in demand and supply

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Considering these bottlenecks in the growth process, the monetary
policy in developing countries should emphasize on certain key areas.
This shall help to achieve high economic growth and face the critical
problem of various economic obstacles.

The aims of monetary policy in developing economies are:

a. To facilitate the flow of adequate volume of bank credit to industry,

agriculture and trade to finance their genuine needs.
b. To provide selective encouragement to essential sectors needing
special assistance.
c. Often the monetary policy is directed to help the weaker sections of
the community and priority sectors of the economy.
d. The sole intention of an effective monetary policy in developing
economy is to curb inflationary pressure.
e. It also aims at controlling undue expansion of credit.
f. It attempts to prevent undesirable and unproductive use of credit.
g. It promotes employment generation through productive deployment
of resources.

Merits and limitations of the monetary policy:

The central bank of every economy adopts a two way controlled

expansion of credit. On one hand, it has the responsibility to ensure the
economic growth of the nation, whereas on the other, it has to also keep
a check on economic evils such as inflation. As such, it takes steps to
expand bank credit cautiously by using certain quantitative and
qualitative methods of credit control. In other words, the central bank
aims to maintain a balance between two crucial economic activities i.e.
economic growth and economic sustainability.

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Let us try to understand the merits and limitations of monetary policy
adopted by the central bank for economic management of the country.

Merits of Monetary Policy:

Stability of The central bank develops various methods to maintain

exchange stability in interest rate and exchange rate. These
rates and methods include Liquidity Adjustment Fund, Open market
interest operation, Market Stabilization scheme and likewise.
rates

The central bank maintains financial stability with the help

Financial of various monetary policy instruments, appropriate
and macro- regulative, supervision and control mechanism. This
economic control mechanism of the central bank also helps it to face
Stability the situation of global crisis and maintain macroeconomic
stability.

The central bank creates a great impact on the economy

and society through its financial inclusion initiatives. The
Financial monetary policy of the central is designed with a view to
Inclusion support the institutions and bodies that help in growth of
microfinance. For instance: RBI has extended support to
various Self Help Groups.

The central banks usually adopt a flexible monetary policy

which is designed to incorporate the changes that occur in
Adaptability the dynamic economic environment. Owing to this
attribute of a flexible monetary policy, the central bank can
develop new methods of credit control and credit creation.

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 The monetary policy of the central bank plays a very
Increase In
important role in giving a boost to the pace of economic
the pace of
growth. Through the various monetary policy measures
economic
adopted for credit creation, the central bank helps to
growth
contribute towards the GDP of the economy.

A sound monetary policy helps to develop trust and

Increase In confidence in the minds of the general public towards the
people’s financial and banking system. This increases the bank
confidence deposits and investments in securities which help in
in banking capital accumulation and mobilization. It also helps in
sector enhancement of credit creation objective of the central
bank of an economy.

Healthy A sound and flexible monetary policy of the central bank

competitive helps in development of healthy competition among banks
spirit in the country owing to certain positive measures such as
between de-regulation of interest rates, decrease in the reserve
banks ratios etc.

Limitations of Monetary Policy:

Huge Budget The Central bank through its various monetary policy
Deficits measures tries to control inflation and balance the
money supply in the economy. However, these
monetary policy measures become more or less
ineffective if the economy faces the problem of
budget deficit. If an economy has faced budget

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 deficits perpetually, it becomes a chronic economic
problem. To curb this problem, the central bank may
resort to deficit financing solutions such as printing of
notes which artificially increases money supply. This
in long run has a disastrous effect on the economy.

Covers only the Instruments of monetary policy of the central bank

Commercial cover only the activities of the commercial banks.
Banks of the Thus inflationary pressures caused by banking
economy industry can be controlled by the central bank of the
economy through its monetary policy. However, there
are many other economic factors that cause inflation
such as artificial decrease in supply of goods,
hoarding, etc. which are not within the scope of
monetary policy. This also is a major limitation.

Corruption and The monetary policy measures of the central bank

mismanagement can prove to be effective only when there is efficient
in the banking management of banks and financial institutions. But if
and financial the officials of these institutions are corrupt and
sector inefficient, it leads to financial scams which adversely
implicate the entire economy. Thus corruption and
inefficiency are the factors that limit the effectiveness
of the central bank.

Unorganized The central bank of the country does not have any
Money Market control over the unorganized sector of the money
market. As such, presence of unorganized money
market sector in the economy is one of the main
obstacles in effective working of the monetary policy

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 of the central bank.

Lack of If the goals of monetary policy are not set out in

accountability specific terms and if there is no clarity in monetary
policy objectives, the implementation of monetary
policy instruments will not be effective. This is
because the accountability tends to be weak in such
a setting. Thus the government and regulatory bodies
like the central bank will not be able to carry on with
their responsibilities.

Black Money Every economy now-a-days is facing a very critical

situation of black money. The growing presence of
black money in the economy is like a chronic disease
which weakens the economy from within. Black
money falls beyond the purview of control of central
bank. As such, a large portion of the total money
supply in a country remains outside the purview of
central bank’s monetary management. This also is a
major factor that limits effectivity of the monetary
policy.

Lack Of Lack of transparency in the system is also one of the

Transparency very important drawbacks that limit effective
implementation of monetary policy instruments. For a
more effective monetary policy, it would be necessary
to have greater transparency in the policy formulation
and transmission process.

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Summary:

Economic stability and economic growth are two major objectives that
the central bank tries to achieve through designing and implementation
of monetary policy. The functioning of money market, capital market and
financial sector depends on how effective the central bank’s monetary
policy is. There should be right balance between the two important
functions of the central bank viz. credit creation and credit control. The
central bank can strike this balance through its various monetary policy
instruments. All these instruments are equally important. However, all the
instruments cannot be implemented simultaneously because the
monetary policy instruments are selected according to the need of the
economy.

Thus monetary policy is a very important tool of economic management

in the hands of the central bank and government.

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