Monetary Policy

Importance of Monetary Policy Gross National Product (GNP) = C + I + G + X Where: C = Private Consumption expenditure I = Private Investment Expenditure G = Government Expenditure X = Net Exports C, I, X can be influenced by the monetary policy which can also influence the private consumption and investment spending and exports and imports. The Government and the Central Bank(i.e., RBI) make use of various fiscal and monetary weapons respectively to achieve stability and growth by influencing and regulating the behavior of the various classes of spenders as savers, consumers and investors. These policies can influence the aggregate supply and demand and the associated level of employment, wages, interest, rent, price and profit.

Monetary Policy Monetary Policy refers to the use of instrument within the control of the Central Bank to the influence the level of aggregate demand for the goods and services or to influence in certain sector of the economy. Monetary policy operates through varying the cost and availability of credit. The modern economy is regarded as a credit economy in sense that credit forms the basis of most of the economic activities in such an economy. The level and nature of economic activities such an economy are influenced by the cost and availability of the credit.

Monetary Policy and Money Supply The capacity of banks to provide credit depends on their cash reserves (comprising cash in hand and balances with the Reserve Bank), a substantial portion of the reserves being generally held in the form of balances with the Reserve Bank. Cash Reserves increase through a rise in the deposit resources of banks, or by their borrowing from the Reserve Bank, or by sale of their investments. If the Bank desires to bring about an expansion in credit, it adopts measures to increase the banks reserves. If credit is to be restricted, it attempts to shorten the reserves.

Measures of Money Stock Reserve Bank of India employs FOUR measures of money stock, namely M1, M2, M3, M4 M1 : The measure of money stock designed by M1 is usually described as the money supply. The components of money supply are currency with the public(i.e., notes n circulation, circulation of rupee coins and circulation of small coins) and deposits(demand deposits with banks and other deposits with the RBI). M2 : M2 is M1 + Post Office Savings Bank Deposits. M3 : M3 is M1 + Time Deposits with the banks. In other words, M3 is money supply plus fixed deposits with the banks. M3 is usually referred to as aggregate monetary resources. M4 : M4 is M3 plus the total Post Office Deposits.

Instruments of Monetary Policy Instruments of monetary policy are divided into : General Methods Selective Methods

General Credit Control The general methods affect the total quantity of credit and affect the economy generally. There are three general or quantitative instruments of credit control. 1. The Bank Rate 2. Open Market Operations 3. Variable Reserve Requirements The use of one instrument rather than another at any point of time is determined by the nature of the situation and the range of influence.

Bank Rate Policy The Bank rate, also known as the Discount Rate. The Bank Rate Policy seeks to affect both the cost and availability of credit. The importance of the Bank Rate lies in the fact that it acts as pace-setter to all the other rates of interests. An increase in the Bank Rate implies an increase in the cost of credit and vice-versa. The demand for credit usually varies with the variation in the cost of credit. The central bank has control to bring a contraction in the money supply by raising Bank Rate and an expansion in the money supply by lowering it.

Bank Rate Policy(Contd…) The Theory of Bank Rate states, an increase in the Bank Rate reduces the extent of borrowings. Reduction in the Discount rate has the opposite effects. Ex: High inflation leads to increase in Bank Rate and reduce the inflation.

Open Market Operations. Its refer broadly to the purchase and sale by the Central Bank of a variety of assets, such as foreign exchange, gold, government securities and even company shares. In India, they are confined to the purchase and sale of Government securities. To increase the money supply, the central bank buys securities from commercial banks and public.

Variable Reserve Ratios Commercial banks in every country maintain, either by the requirement of law by or custom, a certain percentage of their deposits in the form of balances with the central bank. The central bank has the power to vary this reserve requirement and the variation in the reserve requirements affect the credit creating capacity of commercial banks. Ex: If the reserve requirement is 10%, the maximum amount the bank can lend is equivalent to 90% of the total reserves. If the reserve ratio is raised to 20%, the bank cannot lend more than 80% of the total reserves.

Statutory Liquidity Requirement All banks to maintain a minimum amount of assets/need to have threshold limit of assets which is not less than specified demand.

Selective Credit Regulation Selective or Qualitative credit control refers to regulation of credit for specific purpose or branches of economic activity. The aim of selective controls is to discourage such forms of activity as are considered to be relatively inessential or less desirable. In India, such controls have been used to prevent speculative hoarding of commodities like food grains and essential raw material to check an under rise in their prices. Credit controls are considered to be useful supplement to general credit regulation.s

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Monetary Policy and Money Supply The budgetary operations of the Government, considerably affect the money supply. If the Government meets its budgetary deficits by borrowing from the Reserve Bank, there will be an increase in money supply, both in currency and bank deposits. The RBI has no control over budgetary operations. RBI’s influence is restricted in the countries international payments position. Central banking instruments of control operate by varying the cost and availability of credit and these produce desired changes in the assets pattern of credit institutions, principally commercial banks