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1.1 INTRODUCTION
The liquidity or the money supply in the economy is controlled by the RBI. The RBI
decides on this policy after taking into consideration the current economic scenario
and the what the future economic scenario of the country should be. This is very
important considering the fact that, the money supply in the economy has far reaching
consequences than what a normal man thinks it has.
The amount of money supply in the economy has its direct effect on the prices of the
goods which are sold/bought in the economy. This is because of a very simple reason
the money supply is actually the amount of money a person has. So if a person has a
lot more money than his demands for goods and services will increase. Which is very
essential for the economy to function but excess demand lead to rise in prices or in
technical terms, inflation. If the money market transactions continue to feed the
inflation, in the long run its very harmful for the economy as it results in very high
prices, reduction in demand, fall in the value of money which in turn leads to more
money supply which results in hyper-inflation and complete rundown of the economy.
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.
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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.
For instance, liquidity is important for an economy to spur growth. To maintain
liquidity, the RBI is dependent on the monetary policy. By purchasing bonds through
open market operations, the RBI introduces money in the system and reduces the
interest rate.
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An easy or expansionary monetary policy is implemented by reducing statutory bank
reserves or lowering key interest rates and improving market liquidity to encourage
economic activity. A contractionary or tight monetary policy reduces liquidity and
increases interest rates which has a negative impact on both production and
consumption and therefore, economic growth.
The Reserve Bank of India Act, 1934 (RBI Act) has been amended by the Finance
Act, 2016, to provide for a statutory and institutionalized framework for a Monetary
Policy Committee, for maintaining price stability, while keeping in mind the objective
of growth. The Monetary Policy Committee would be entrusted with the task of fixing
the benchmark policy rate (repo rate) required to contain inflation within the specified
target level. A Committee-based approach for determining the Monetary Policy will
add lot of value and transparency to monetary policy decisions.
The meetings of the Monetary Policy Committee shall be held at least 4 times a year
and it shall publish its decisions after each such meeting.
The provisions of the RBI Act relating to Monetary Policy have been brought into
force through a Notification in the Gazette of India Extraordinary on 27.6.2016. The
factors constituting failure to meet inflation target under the Monetary Policy
Committee Framework have also been notified in the Gazette on 27.6.2016. The
Government, in consultation with RBI, has notified the inflation target in the Gazette
of India Extraordinary dated 5th August 2016 for the period beginning from the date
of publication of this notification and ending on the March 31, 2021, as under:-
As per the provisions of the RBI Act, out of the six Members of Monetary Policy
Committee, three Members will be from the RBI and the other three Members of
MPC will be appointed by the Central Government. In exercise of the powers
conferred by section 45ZB of the Reserve Bank of India Act, 1934, the Central
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Government has accordingly constituted, through a Gazette Notification dated
29thSept 2016, the Monetary Policy Committee of RBI, with the following
composition, namely:-
(d) Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) —Member
(e) Professor Pami Dua, Director, Delhi School of Economics (DSE) — Member
The instrument of monetary policy are tools or devise which are used by the
monetary authority in order to attain some predetermined objectives. There are
two types of instruments of the monetary policy as shown below.
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
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economy. These tools are indirect in nature and are employed for influencing the
quantity of credit in the country. The general tool of credit control comprises of
following instruments.
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".
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 reduce the volume of
commercial banks borrowing from the RBI.
It deters banks from further credit expansion as it becomes a more costly 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.
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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. However there
are certain limitations that affect OMO viz; underdeveloped securities market, excess
reserves with commercial banks, indebtedness of commercial banks, etc.
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(B) Qualitative Instruments or Selective Tools:
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 favouring export over import or essential over non-essential credit
supply. This method can have influence over the lender and borrower of the credit.
The Selective Tools of credit control comprises of following instruments.
1. Fixing Margin Requirements:
The margin refers to the "proportion of the loan amount which is not financed by the bank".
Or in other words, it is that part of a loan which a borrower has to raise in order to get finance
for his purpose. 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.
Under this method, consumer credit supply is regulated through hire-purchase and
instalment sale of consumer goods. Under this method the down payment, instalment
amount, loan duration, etc is fixed in advance. This can help in checking the credit use
and then inflation in a country.
3. Publicity:
This is yet another method of selective credit control. Through it Central Bank (RBI)
publishes various reports stating what is good and what is bad in the system. This
published information can help commercial banks to direct credit supply in the
desired sectors. Through its weekly and monthly bulletins, the information is made
public and banks can use it for attaining goals of monetary policy.
4. 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
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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 expoursure to
unwanted sectors.
5. Moral Suasion:
It implies to pressure exerted by the RBI on the Indian banking system without any
strict action for compliance of the rules. It is a suggestion to banks. It helps in
restraining credit during inflationary periods. Commercial banks are informed about
the expectations of the central bank through a monetary policy. Under moral suasion
central banks can issue directives, guidelines and suggestions for commercial banks
regarding reducing credit supply for speculative purposes.
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.
7. 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.
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securities) at the disposal of the community and by making borrowing conditions
easier through lower rates of interest.
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CHAPTER: 2
RESEARCH METHODOLOGY
aggregate demand and economic growth in the economy. It involves increasing the
money supply and lowering the interest rates. The lower interest rate encourages the
borrowers to buy more which increases the economic activity. The increased
economic activity leads to more employment opportunities thus decreasing
unemployment. It also increases the inflation as more money is available to buy goods
and services.
It is also known as central banks seeks to increase the money supply by lowering the
interest rates.
Contraction monetary policy is the monetary policy which is used to fight the
inflation in economy. It involves decreasing the money supply and increasing the
interest rates. As reduction in money supply increases the interest rates, the borrowers
will be reluctant to borrow the money due to higher borrowing cost which ultimately
reduces the economic activity. It leads to decrease in inflation, increase in
unemployment and slowdown in economy.
It is also known as tight money policy as central banks seeks to reduce the money
supply by restricting credit by increasing interest rates.
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unconventional monetary policy was employed us United States after the financial
crisis of 2007 in the form Quantitative Easing (QE).
The Reserve Bank of India employs various instruments of monetary policy in India
to achieve the objectives of price stability and higher economic growth. Some of the
important instrument or tools of monetary policy in India are:
It refers to the cash which banks have to maintain with the Reserve Bank of India as
percentage of Net Demand and Time Liabilities (NDTL). An increase in CRR makes
it mandatory for banks to hold large portion of their deposits with the RBI. Therefore
it reduces their deposit available for credit and they lend less which affect their
profitability and also reduces the money supply in economy.
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Statutory Liquidity Ratio (SLR):
Apart from CRR, the banks in India are required to maintain liquid assets in the form
of gold, cash and approved securities. The increase/decrease in SLR affects the
availability of money for credit with banks.
Under Liquidity Adjustment Facility (LAF) the banks purchase money from RBI on
repurchase agreements.
Repo Rate: It is the interest rate at which the Reserve Bank provides
overnight liquidity to banks against the collateral of government and other
approved securities under the liquidity adjustment facility (LAF)
Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank
absorbs liquidity, on an overnight basis, from banks against the collateral of
eligible government securities under the LAF.
Marginal Standing Facility
Under SF, the scheduled commercial banks can borrow additional amount of
overnight money from the Reserve Bank by dipping into their Statutory Liquidity
Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety
valve against unanticipated liquidity shocks to the banking system.
Bank Rate:
It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange
or other commercial papers.
Under this method, the central influence the credit growth in country through
following techniques:
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Moral Suasion:
The central persuades the commercial banks to regulate the credit growth through oral
and verbal communication.
There are many reasons for monetary policy not able to achieve its intended
objectives. Some of the reasons are:
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2.1 THE FOLLOWING POINTS HIGHLIGHT THE SIX MAIN OBJECTIVES
OF MONETARY POLICY IN INDIA.
1. High employment
2. Economic growth
3. Price stability
4. Interest-rate stability
1. High employment:
Any modern government is committed to promote high employment.
High employment is a desirable goal of monetary policy for two main reasons:
(1) high unemployment causes much human misery, with families suffering financial
distress and loss of personal self- respect,
(2) secondly, when unemployment is high, the economy has not only idle workers but
also idle resources (closed factories and unused equipment), resulting in a loss output
At first, it might seem that full employment is the point at which no worker is’ out of
a job, that is, when unemployment is zero. But, this definition ignores the fact that
some unemployment, called fractional unemployment, is beneficial to the economy.
For example, a worker who decides to look for a better job might be unemployed for a
while during the job search Workers often voluntarily decide to leave work
temporarily to pursue other activities (raising a family, travel, returning to school),
and when they decide to re-enter the job market, it again takes some time for them to
find the right job.
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The goal for high employment should, therefore, not seek an unemployment level of
zero, but rather a level above zero consistent with full employment at which the
demand for labour equals the supply of labour. Economists call this the natural rate of
unemployment.
2. Price stability:
Over the past two decades, macroeconomists have become more aware of the social
and economic costs of inflation and more concerned with a stable price level as a goal
of economic policy. Price stability is desirable in a developing country like India,
because a rising price level (inflation) creates considerable uncertainty in the
economy.
For example the information conveyed by the prices of goods and services is harder to
interpret when the overall level of prices is changing, which complicates decision
making for consumers, businesses and governments at different levels.
Inflation also makes it difficult to plan for the future. For example it is more difficult
to decide how much funds should be put aside to provide for one’s children’s college
education in an inflationary environment.
Furthermore inflation may strain a country’s social fabric. Conflict may result because
each group in the society may compete with other groups to make sure that its wages
keep up with the rising level of prices.
3. Interest-rate stability:
Interest-rate stability is desirable because fluctuations in interest rates can create
uncertainty in the economy and make it more and more difficult to plan for the future.
Fluctuations in interest rates also affect consumers’ willingness to buy durable goods,
such as houses, motor cars, refrigerators, washing machines or even personal
computers.
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A major reason for the creation of the central bank is that it can promote a more stable
financial system. One way in which the central bank promotes stability is helping
prevent financial panics (particularly bank failure) through its role as lender of last
resort. The central bank is the ultimate source of funds in the moneymarket.
With the increasing importance of international trade to the Indian economy, the value
of the rupee relative to other currencies has become a major consideration for the
RBI. A rise in the value of the rupee makes Indian industries less competitive with
those abroad, and declines in the value of the rupee stimulate inflation in India.
In addition, preventing large changes in the value of the rupee makes it easier for
firms and individuals purchasing or selling goods abroad to plan ahead.
Stabilising extreme movements in the value of the rupee in foreign exchange markets
is thus viewed as a worthy goal of monetary policy.
6. Economic growth:
The goal of steady economic growth is closely related to the high employment goal,
because businesses are more likely to invest in capital equipment to increase
productivity and economic growth when unemployment is low. Conversely, if
unemployment is high and factories are idle, it does not pay for a firm to invest in
additional plants and equipment.
Although the two goals are closely related, policies can be specifically aimed at
promoting economic growth by directly encouraging firms to invest or by
encouraging people to save, which provides more funds for firms to invest.
Monetary policy tools are used by currency boards, central banks, or even
governments to control currency supplies. Consumer access to cash, along with the
interest rates charged by lending institutions, create economic foundations for
businesses to build upon. The tools used to regulate those base needs dictate how
much stability is found in the financial markets. There are numerous ways for
monetary policy tools to be used as a benefit to society. They maintain a balance of
value with currency exchanges, stabilize economies, and can even address debt or
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unemployment issues. The Federal Reserve is tasked with the implementation of
monetary policy tools that promote expansion or limit recession at the national level.
Based on the rates they set, local banks and credit unions create offers for their
customers which encourage an expansion of borrowing. People then purchase homes
and vehicles, or use their credit cards, to generate economic activities. The advantages
and disadvantages of monetary policy tools look at how these artificial structures
compare to what a natural free-market system would dictate for each person.
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4. They promote lower inflation rates:
One of the most significant advantages that monetary policy tools offer is price
stability. When consumers know how much their preferred goods or services cost,
then they are more likely to initiate a transaction. That process keeps pricing
structures stable because the value of the money used is also consistent. These tools
make it possible to keep the value of money close to what it tends to be. Between
2009-2018, the inflation rate in the United States was under 10%. That means $1 in
2009 was worth $1.09 in 2018, maintaining the wealth earned by households.
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2.3 List of the Disadvantages of Monetary Policy Tools
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barriers to access for the average person. Venezuela experienced devastating
hyperinflation in 2018 to the tune of 1.29 million percent.
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reached the installation rates seen in the 1990s yet because of how the monetary
policy tools were used before the global recession took place.
The advantages and disadvantages of monetary policy tools promote economic
stability, which then encourages growth. There aren’t guarantees with any tools like
this, however, because individuals are unpredictable. People can choose to do the
opposite of what the tool anticipates, creating unexpected outcomes which are
sometimes damaging to society. There are those who benefit and those who do not,
but the goal of the tools is the same: to help the most people possible with what they
do.
Monetary policy refers to the policy of the central bank with regard to the use
of monetary instruments under its control to achieve the goals specified in the
Act.
Section 45ZB of the amended RBI Act, 1934 also provides for an empowered
six-member monetary policy committee (MPC) to be constituted by the
Central Government by notification in the Official Gazette. Accordingly, the
Central Government in September 2016 constituted the MPC as under:
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6. Dr. Raindrop H. Dholakia, Professor, Indian Institute of Management,
Ahmadabad – Member.
(Members referred to at 4 to 6 above, will hold office for a period of four years or
until further orders, whichever is earlier.)
The MPC determines the policy interest rate required to achieve the inflation
target. The first meeting of the MPC was held on October 3 and 4, 2016 in the
run up to the Fourth Bi-monthly Monetary Policy Statement, 2016-17.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in
formulating the monetary policy. Views of key stakeholders in the economy,
and analytical work of the Reserve Bank contribute to the process for arriving at
the decision on the policy repo rate.
Read this article to learn about Monetary Policy of a Country – explained with
Diagram)!
Several economists have defined monetary policies differently.
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According to Shaw, monetary policy can be referred as,
“any conscious action undertaken by the monetary authorities to change the quantity,
availability or cost… of money.”
The main objective of the monetary policy is to achieve economic growth, maximize
employment, maintain price stability, and attain balance of payment equilibrium. The
monetary policy can be maintained by changing the rates of interests, such as Cash
Reserve Ratio (CRR) and bank rate.
The effectiveness of monetary policy can be influenced by two factors, namely, level
of monetized economy and level of capital market development. In monetized
economy, the monetary policy covers all economic activities. Moreover, in this type
of economy, money serves as the medium of exchange for all economic transactions.
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The other important factor that influences the effectiveness of monetary policy is the
development of capital market. A capital market can be defined as a market in which
both, public and private sectors, sell financial securities to raise funds. Some of the
instruments of monetary’ policy, such as CRR and bank rate, work through the capital
market.
Monetary policy influences the economic activities by making certain changes in the
capital market. Therefore, for effective monetary policy, it is necessary that the capital
market should be well developed.
Quantitative Measures:
Quantitative measures are the measures that can be used for controlling and regulating
the demand and supply of money. In addition to the quantitative measures of
monetary policy, the nations can also adopt some direct measures for regulating the
demand and supply of money. For example, in India, all the major banks are
nationalized; therefore, the central bank (Reserve Bank of India) uses direct measures
to cope with various economic problems, such as inflation.
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The different quantitative measures (as shown in Figure-3) are explained in detail.
These operations are performed by the central bank with the help of commercial
banks. The central bank is not involved in the direct dealing with the public.
Government securities are purchased by commercial banks, financial institutions,
large businesses, and individuals having high income. All these customers of
government bonds have their accounts in commercial banks.
When the customers purchase these bonds, the money is transferred from their bank
accounts to the central bank account. In this way, when the central bank conducts
operations in the open market, the bank deposits and reserves of commercial banks
and their potential to generate credit get affected.
For example, to reduce the chances of inflation, the central bank decrease the supply
of money in the market. In such a case, commercial banks sell government securities
in the market. This operation can be made easier when the commercial banks are
under the direct control of government.
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However the supply of money can be adversely affected in certain situations. For
example,, when customers purchase government securities they draw checks from
their commercial bank accounts in favour of the central bank. In this way the money
is transferred from commercial banks to the central bank account.
This results in the reduction of deposits and reserves held by commercial banks which
further decreases their credit creation capacity. As a consequence to this, the flow of
credit from commercial banks to general public decreases.
However, in case the central bank wants to increase the supply of money in economy,
it purchases government securities from commercial banks and other purchasers of
government securities. In such a case, money moves from the central bank account to
individuals’ accounts.
(b) Growth of capital market: Refers to one of the most important limitation of the
bank rate policy. Over the years, the capital market has expanded rapidly with the
growth of financial institutions and credit organizations.
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This has reduced the scope of bank credit. Therefore, variations made by the central
bank in the discount rate, particularly in case of increase in the discount rate, have
very less impact on credit market.
Implies that fluctuation in the discount rate effective only when the demand of money
is interest elastic. Generally, in less developed or underdeveloped countries, the
interest rates in the credit market are sticky. Therefore, in these countries, the changes
in discount rate have not been proved very effective.
CRR is usually determined by the previous experience of banks related to the extent
of cash demanded by depositors. Commercial banks always retain their reserves
beneath the safe limits. This is because of the reason that cash reserves are non-
interest bearing in nature.
This situation may result in financial crunch in banking sector. Therefore, CRR has
been made obligatory by the central bank for commercial banks. In addition, it has
become an important measure for the central bank to control the supply of money.
CRR IS also termed as Statutory Reserve Ratio (SRR).
The central bank possesses the power of changing the rate of CRR depending on
economic situations. When there is a need of contractionary monetary policy in the
economy, CRR is increased by the central bank. In this case, commercial banks need
to reserve a-large amount of their total deposits with the central bank.
As a result, the credit creation capability of commercial banks reduces, which further
decreases money supply in the market. On the other hand, in case there is a
requirement of increasing supply of money in the economy, the rate of CRR is
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decreased by the central bank. In such a case, the credit creation capability of
commercial banks increases.
This implies that the bank can provide loans on the remaining amount, which is
Rs.160 million. On the other hand if the rate of CRR increases to 25%, then the bank
would be able to provide loans on the amount Rs.150 million.
CRR is the most effective tool then the other tools of quantitative measures of
monetary policy. It is the most popular instrument in developed countries where
banking system is highly developed and had a greater stake in the capital market.
However, CRR is restricted by its dependency on the bank credit system in the credit
market.
The liquid assets can include cash reserve, gold, and government securities. In India,
SLR was proposed by RBI to prevent the selling of government securities by
commercial banks in case of increase in CRR. Before SLR was introduced,
commercial banks were involved in the practice of selling government securities, in
case of increase in CRR, to overcome a fall in their loanable funds.
In India, RBI has continuously increased SLR from 25% in 1970s to 38.5% in 1991.
However, SLR has been reduced to 30% on additional deposits in 1992. Now, the rate
of SLR is 25% for commercial banks. However, it keeps on changing depending on
the economic conditions.
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Selective Credit Controls:
The quantitative measures of monetary control have uniform effect on the whole
credit market. In simple terms, these measures have an even effect on all the sectors
of an economy. However, this situation may not always wanted by policymakers for
the formulation of policies.
This is because of the reason that policymakers need to allocate the money in different
sectors of the society and move the flow of money from most important sectors to
least important sectors of the economy. In addition, the policymaker’s nave to reduce
the risk factors associated with the availability of bank credit.
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CHAPTER 3
REVIEW OF LITERATURE
Examining the impact of monetary policy on bank loans in the context of the US,
Bernanke and Blinder suggested that open market sales by the Federal Reserve,
draining reserves and hence deposits from the banking system, would limit the supply
of bank loans by reducing banks' access to loan able funds.
However, Roomer and Roomer concluded that credit channel was ineffective. The
debate on monetary policy transmission was extended further in a Symposium on
‘The Monetary Policy Transmission’ in the Journal of Economic Perspectives.
Under the financial market view, Taylor found the traditional interest rate channel to
be important for monetary policy transmission to the real economy. Roof and
Obstfeld emphasized the importance of exchange rate channel of monetary policy
transmission. Meltzer .
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CHAPTER 4
DATA ANALYSIS AND INTERPRETATION
Inside time lag denotes to the time gap in analyzing the type, selection, and
implementation of monetary policy as well as its results. On the other hand, outside
time lag is the time taken to receive feedback from individuals and organizations on
monetary measures that are implemented in the economy.
In case, both the time lag increase, result in new types of economic problems, but
make the whole monetary policy ineffective. Fiscal policy has a shorter time lag as
compared to monetary policy. The time lag in monetary policy can be 12 to 16
months.
This is because different economists have different viewpoints and they analyze the
situation differently. Forecasting based on guesses is unfruitful. Therefore, monetary
policy can be effective if it is based on evidences.
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This new segment of the economy is responsible in grabbing the share of commercial
banks. The non-financial intermediaries do not make credit with the help of credit
multiplier, but their share in money supply makes the monetary policy ineffective.
4. High Liquidity:
The majority of commercial banks possess high liquidity so that they are not
influenced by the credit policy of the central bank. This also makes monetary policy
less effective.
5. Foreign Banks:
In almost every underdeveloped country foreign owned commercial banks exist. They
also render monetary policy less effective by selling foreign assets and drawing
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money from their head officers when the central bank of the country is following a
tight monetary policy.
So the principal objectives of monetary policy in such a country are to control credit
for controlling inflation and to stabilise the price level, to stabilise the exchange rate,
to achieve equilibrium in the balance of payments and to promote economic
development.
Commercial banks keep an elastic cash-deposit ratio because the central bank’s
control over them is not complete. They are also reluctant to invest in government
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securities due to their relatively low interest rates. Moreover, instead of investing in
government securities, they prefer to keep their reserves in liquid form such as gold,
foreign exchange and cash. Commercial banks are also not in the habit of redics
counting or borrowing from the central bank.
The bank rate policy is also not so effective in such countries due to: (i) the lack of
bills of discount; (ii) the narrow size of the bill market; (iii) a large non-monetised
sector where barter transactions take place; (iv) the existence of indigenous banks
which do not discount bills with the central bank; (v) the habit of the commercial
banks to keep large cash reserves; and (vi) the existence of a large unorganised money
market.
The use of variable reserve ratio as an instrument of monetary policy is more effective
than open market operations and bank rate policy in LDCs. Since the market for
securities is very small, open market operations are not successful. But a rise or fall in
the variable reserve ratio by the central bank reduces or increases the cash available
with the commercial banks without affecting adversely the prices of securities.
Again, the commercial banks keep large cash reserves which cannot be reduced by an
increase in bank rate or sale of securities by the central bank. But raising the cash
reserve ratio reduces liquidity with the banks. The use of variable reserve ratio has
certain limitations in LDCs.
The non-banking financial intermediaries do not keep deposits with the central bank
so they are not affected by it. Second, banks which do not maintain excess liquidity
are more affected than those who maintain it.
The qualitative credit control measures are, however, more effective than the
quantitative measures in influencing the allocation of credit, and thereby the pattern of
investment. In LDCs, there is a strong tendency to invest in gold, jewellery,
inventories, real estate, etc., instead of in alternative productive changes available in
agriculture, mining, plantations and industry. The selective credit controls are more
appropriate for controlling and limiting credit facilities for such unproductive
purposes. They are beneficial in controlling speculative activities in food-grains and
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raw materials. They prove more useful in controlling ‘sectional inflations’ in the
economy.
They curtail the demand for imports by making it obligatory on importers to deposit
in advance an amount equal to the value of foreign currency. This has also the effect
of reducing the reserves of the banks in so far as their deposits are transferred to the
central bank in the process. The selective credit control measures may take the form
of changing the margin requirements against certain types of collateral the regulation
of consumer credit and the rationing of credit.
Monetary policy in the form of interest rate policy plays an important role in bridging
the balance of payments deficit. Underdeveloped countries develop serious balance of
payments difficulties to fulfil the planned targets of development. To establish
infrastructure like power, irrigation, transport, etc. and directly productive activities
like iron and steel, chemicals, electrical, fertilisers, etc., underdeveloped countries
have to import capital equipment, machinery, raw materials, spares and components
thereby raising their imports. But exports are almost stagnant. They are high-price due
to inflation. As a result, an imbalance is created between imports and exports which
lead to disequilibrium in the balance in payments. Monetary policy can help in
narrowing the balance of payments deficit through high rate of interest. A high
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interest rate attracts the inflow of foreign investments and helps in bridging the
balance of payments gap.
to follow a policy of discriminatory interest rate-charging high interest rates for non-
essential and unproductive uses and low interest rates for productive uses.
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Debt Management:
Debt management is one of the important functions of monetary policy in an
underdeveloped country. It aims at proper timing and issuing of government bonds,
stabilising their prices and minimising the cost of servicing the public debt.
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production capacity. This enables the economy to produce more goods and services
every year.
In truth, faster economic growth can be attained by an economy largely if not entirely,
by increasing the rate of saving and investment
How this can be achieved by using monetary policy may now be discussed:
If monetary policy is to promote economic growth, it has to raise the rate of saving. In
a developing country like India, the central bank should raise the rate of interest to a
reasonable level to induce people to save more. So larger and larger volume of
resources will be available for investment (particularly in fixed assets).
In times of inflation the nominal rate of interest has to be raised so that the real rate of
interest remains constant. In fact in order to mobilise more and more saving through
the banking system for investment purposes, it is absolutely essential to maintain
reasonable price stability so that people have less incentive to buy gold, real estate or
goods for hoarding and speculation. If due to excessive rise in price the real rate of
interest becomes negative, people will have less incentive to save.
However, the rate of interest affects only people’s desire to save. But their capacity to
save depends, apart from income, on the existence of banks and other financial
institutions. So the governments of developing countries should build a strong
financial infrastructure by setting up banks, post offices, insurance companies, stock
exchanges, mutual funds, and pension funds mainly in rural areas where the majority
of the people live.
Even if the rate of interest is very low, private enterprises may not be willing to make
new investment in time of depression due to lack of profitable business opportunities.
This, of course, is Keynes’s view. But in normal times an increase in the supply of
money due to an increase in bank credit leads to an increased investment. In addition
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in a developing country public (government) investment plays an important role in
economic development. So monetary policy should also make adequate funds
available for public investment.
The monetary policy of a developing country like India has to be such as to ensure
that a large portion of deposits mobilised by banks is invested in government and
other approved securities so as to enable the government to finance its planned
investment. Infrastructure building is so important for economic development.
So public investment has to be made to set up power plants, build roads, highways
and ports. Such investment promotes industrial development directly and indirectly
(by establishing backward and forward linkages). As a result there is a tremendous
increase in demand for industrial products.
Each industry purchases inputs from other industries and sells its products to both
households and other businesses. The operation of multiplier stimulates private
investment further. Thus public investment on social overhead capital will crowd in,
rather than crowd out, private investment. Moreover, construction of irrigation dams
promotes agricultural growth by raising both production and productivity.
In India, a new tool of monetary control has been introduced for taking out large
resources from the banking sector for financing public investment, viz., statutory
liquidity ratio (SLR). Now in addition to keeping cash reserves commercial banks are
to keep a minimum portion of their total demand and time deposits in some specified
liquid assets, mainly in government and other approved securities’.
Since both large-scale and medium-size industries require funds for investment in
fixed capital, working capital as also for holding inventories (of both finished goods
and raw materials) monetary policy has also to ensure that the need for bank credit for
investment and production in the private sector is fully satisfied.
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Adequate bank credit is necessary for two purposes:
(i) To utilise the existing production capacities in the private sector and
Banks must also provide adequate credit to meet the minimum working capital needs
of agriculture and industry.
The mobilisation of savings is not enough. Savings are to be utilised for productive
investment. So monetary policy should be discriminatory in nature. It should restrict
the flow of credit in unproductive sectors and wasteful activities which are inimical to
economic growth. At the same time it should direct the flow of credit in productive
channels.
So there is need for much stricter application of selecting credit control (SCC) mainly
with a view to influencing the pattern of investment. SCC also helps the process of
development indirectly by checking price rise and thus avoiding the distortion created
by double digit inflation. However, it has to be supported by proper credit rationing.
In order to become a good target for monetary policy a variable should satisfy the
following conditions:
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1. Measurability: The target variable should be easily measurable with little or no
time lag. To meet this condition, accurate and reliable data must be available. The
data should also conform to the theoretical definitions of the target variables.
2. Attainability:
The monetary authority should be able to attain its targeted goals, otherwise, setting
the targets will be an exercise in futility. The targets which are unattainable are not
practical. A target will be attainable when- (a) it is rapidly affected by policy
instruments; and (b) there are no or very little non-policy influences on it.
The target variable should be closely related to the higher level goal variables and this
relation should be well understood and reliably estimable. For example, even if the
monetary authority is able to attain the interest rates target, all is in vain if the interest
rates do not affect the ultimate goals of employment. The price level, the rate of
economic growth, and the balance of payments.
There are three main variables used as monetary targets. They are- money supply,
bank credit and interest rates. Which of these variables is superior and chosen as
target variable depends upon how far it satisfies the three criteria of measurability,
attainability and relatedness to ultimate goals.
All the interest rates in the market do not change together and equi-proportionately.
Interest rates are also not affected by the policy instruments as rapidly as other target
variables are. Moreover, non-policy factors greatly influence the interest rates.
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As regards the fulfilment of the criterion of relatedness to goal variables, the
economists differ sharply. The Keynesians recommend interest rate as appropriate
target variable, while the monetarists prescribe money supply. Practical central
bankers, on the other side, consider bank credit as a better target variable.
(i) On the basis of the criteria of measurability and attainability, both money supply
and bank credit are better target variables than interest rates.
(ii) As between money supply and bank credit, money supply is definitely superior
because there exists weak theoretical and empirical evidence in support of close
causal link between credit and higher goals variables.
(iii) Money supply is much more easily influenced by policy instruments than interest
rates and the weight of policy factors is heavier than non- policy factors on money
supply variable.
(iv) Empirically also, the relation between money supply and the level of economic
activity (and thus other goal variables) is stable and calculable. The same cannot be
said about interest rates.
Recently, Benjamin Friedman, a Harvard economist, has suggested that the best
intermediate target would be a combination of a credit variable target and a monetary
growth target. Such a system, according to him, would draw on a more diverse and
hence more reliable information base for the signals that govern the systematic
response of monetary policy to emerging developments.
Under such a system, the central bank would select one monetary aggregate and total
net credit, specify growth rate together for both and carry out open market operations
aimed at achieving both targets. A deviation in either target from its respective target
range would require a change in open market operations.
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It is to be carefully noted that the targets of money supply and interest rate pose a
problem of mutually exclusivity. The monetary authority can select an interest rate or
a money supply target, but not both. In Figure-5, for example, the monetary authority
cannot choose both Oi interest rate, and OM1 money supply. If it chooses Oi interest
rate, it must accept OM money supply and if it chooses OM1 money supply, it must
allow the interest rate to fall to Oi1..
Actual practice, whether the monetary authority should choose interest rate target or
money supply target depends upon the source of instability in the economy. If the
source of instability is in the commodity market, i.e., variations in private and public
spending or variations in the is curve, then money supply target should be set and
pursued.
On the contrary, if the source of instability in the economy is in the money market,
i.e., unstable demand or supply of money, or variations in the LM curve, then the
interest rate target will be selected.
1. Instability of IS Curve:
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Instability in the IS curve can arise- (a) because of destabilising fiscal policy adopted
by the government (i.e., changes in public spending), or (b) because of variations in
consumption function or investment function (i.e., changes in the private spending).
Given the money market conditions (i.e., given the LM0 curve in Figure-6), a fall in
spending will cause the IS curve to shift to the left from IS0 to IS1.
This will reduce the rate of interest from Oi0 to Oi1 and the income level from OY0
to OY1. Using the strategy of stabilizing the money supply, the monetary authority is
induced to increase the money supply, thus shifting the LM curve to the right.
This will cause income to rise above OY1 back towards the target level OY0,
although the interest rate is further reduced. Thus, if the LM curve is stable, then an
unstable IS curve causes the level of income to fluctuate between OY1 and OY0,
when a money supply target is followed.
This implies that money supply targeting will be stabilising or counter-cyclical; that
is, increasing money supply during recession will increase income and reduce rate of
interest, and reducing money supply during inflation will reduce income and raise rate
of interest.
On the other hand, using the strategy of setting the interest- rate target means keeping
the desired rate of interest at a particular level, say Oi0. In this case, the LM curve
becomes horizontal at i0 (i.e., LM1 curve in Figure-6). The money supply must be
adjusted to maintain Oi0 level of interest rate. In this process, the national income will
fluctuate between Y2 and Y0. Since Y2 Y0 > Y1 Y0, a money stock
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implies that changes in the money supply to maintain a constant interest rate will be
pro-cyclical when the IS curve is unstable. During recession, when IS curve shifts
from IS0 to IS1, the interest rate falls from i0 to i1 and income level falls from Y0 to
Y1. The monetary authority would be prompted to decrease money supply to achieve
the equilibrium level where LM curve intersects IS curve and the interest rate is raised
to the desired Oi0 level. This will, however, further reduce the income level from
OY1- to OY2. Thus, when IS curve is unstable, setting the interest rate target by
changing money supply will be destabilising and inappropriate. The monetary
authority would be prompted to decrease money supply during recession to restrict
interest rate from falling and to increase money supply during inflation to keep
interest rate down.
2. Instability of LM Curve:
Instability in the LM curve arises mainly due to unstable demand for money in the
money market which causes shifts in the LM curve. In a situation of stable IS curve
and unstable LM curve, the strategy of constant money supply will cause the With the
increase in demand for money, the LM curve will shift from LM0 to LM1.The effect
of this shift is to reduce income from OY0 to OY1 and raise the rate of interest from
Oi0 to Oi1. Moreover, pursuing constant money supply target will be pro-cyclical.
Increase in the rate of interest induces an increase in money supply. In such condition,
constant money stock-policy will require that the monetary authority should reduce
money supply.
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This will cause the lm carve to shift further from lm1 to the left, rate of interest to rise
further above oi1, and the income level to fall further below oy1. Thus, in a situation
of unstable lm curve and stable is curve, setting a constant money supply target will
be destabilizing and inappropriate.
It will require decrease in money supply, causing interest rate to rise and income level
to fall, every time the demand for money rises during recession, and increase in
money supply, causing interest rate to fall and income level to rise, every time the
demand for money falls during inflation.
In contrast, the policy of targeting interest rate at Oi0 means that the LM curve
becomes horizontal at i0 (i. e., LM2 curve in Figure-7). This will leave the level of
income unaltered at OY0 which corresponds to the point of intersection of IS0 and
LM2. The interest rate target will be stabilizing and counter- cyclical. It will induce
the monetary authority to increase the money supply when the demand for money
increases during recession, and to decrease the money supply when the demand for
money falls during inflation.
Thus, the general conclusion is that the question as to which target is better is an
empirical question. If is more stable than LM, setting an interest rate target is
appropriate. If, on the other hand, LM is more stable than IS, setting a monetary
aggregate target is appropriate.
Recently, the need for pursuing monetary target has been widely recognised and
seriously discussed in India. In 1982, the Reserve Bank of India appointed a
committee, with Prof. Sukhumi Chakra arty as its chairman, with the objective of
reviewing the working of monetary system in the country.
In its report, submitted in 1985, the Committee, among other things, laid stress on the
desirability of developing monetary targets at the aggregate level for securing an
acceptable and orderly pattern of monetary growth.
The Committee has emphasised the need to pursue price stability as the broad
objective of the monetary policy consistent with the other socio-economic goals
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embodied in the Five Year Plans. For achieving this objective, money supply (M3)
should be regulated in the framework of monetary targeting in terms of a range, with
feedback and necessary support from an appropriate interest rate policy.
Monetary policy is a way for the RBI to control the supply of money in the economy.
So these credit policies help control the inflation and in turn help with the economic
growth and development of the country. So now let us take a look at the various
instruments of monetary policy that the RBI has at its disposal.
Open Market Operations is when the RBI involves itself directly and buys or sells
short-term securities in the open market. This is a direct and effective way to increase
or decrease the supply of money in the market. It also has a direct effect on the
ongoing rate of interest in the market.
Let us say the market is in equilibrium. Then the RBI decides to sell short-term
securities in the market. The supply of money in the market will reduce. And
subsequently, the demand for credit facilities would increase. And so correspondingly
the rate of interest would also see a boost.
On the other hand, if RBI was purchasing securities from the open market it would
have the opposite effect. The supply of money to the market would increase. And so,
in turn, the rate of interest would go down since the demand for credit would fall.
2] Bank Rate:
One of the most effective instruments of monetary policy is the bank rate. A bank rate
is essentially the rate at which the RBI lends money to commercial banks without any
security or collateral. It is also the standard rate at which the RBI will buy or discount
bills of exchange and other such commercial instruments. So now if the RBI were to
increase the bank rate, the commercial banks would also have to increase their lending
rates. And this will help control the supply of money in the market. And the reverse
will obviously increase the supply of money in the market.
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3] Variable Reserve Requirement:
There are two components to this instrument of monetary policy, namely – The Cash
Reserve Ratio (CLR) and the Statutory Liquidity Ratio (SLR). Let us understand them
both.
Cash Reserve Ratio (CRR) is the portion of deposits with the commercial banks that it
has to deposit to the RBI. So CRR is the percent of deposits the commercial banks
have to keep with the RBI. The RBI will adjust the said percentage to control the
supply of money available with the bank. And accordingly, the loans given by the
bank will either become cheaper or more expensive. The CRR is a great tool to
control inflation.
The Statutory Liquidity Ratio (SLR) is the percent of total deposits that the
commercial banks have to keep with themselves in form of cash reserves or gold. So
increasing the SLR will mean the banks have fewer funds to give as loans thus
controlling the supply of money in the economy. And the opposite is true as well.
And the reverse repo rate is the rate at which the RBI parks its funds with the
commercial banks for short time periods. So the RBI constantly changes these rates to
control the flow of money in the market according to the economic situations
5] Moral Suasion:
This is an informal method of monetary control. The RBI is the Central Bank of the
country and thus enjoys a supervisory position in the banking system. If there is a
need it can urge the banks to exercise credit control at times to maintain the balance of
funds in the market. This method is actually quite effective since banks tend to follow
the policies set by the RBI.
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CHAPTER 5
CONCLUSION
While monetary policy has been primarily acting through availability of credit, the
cost of credit has also been adjusted upward, sometimes very sharply to meet
effectively the inflationary situations.
The areas of operation of monetary policy did not remain confined to those related to
the regulation of monetary supply and keeping prices in check. Role of RBI as a
Regulator and Supervisor of the financial system which have gone under various
strategic shifts and RBI has made significant improvements in the quality of
performance of its regulatory and supervisory function, and as a result our standards
are comparable to the worlds. From the data collected and analyzed the impact of
credit policy on nationalised bank .
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5.1 SUGGESTION
The monetary policy statement should focus on a single policy interest rate (in India's
case, the reverse repo rate). By giving importance of a potential monetary signal in the
repo rate and the bank rate, the RBI only causes confusion's
The RBI deserves credit for more frequent communication with financial markets.
The move toward quarterly economic assessments and policy announcements are
steps toward the right direction. However, the art of written central bank
communication is a new experience for the RBI, so it is understandable if there is a bit
of learning by doing. A few suggestions to improve the communication:
The clarity in communication that came across in the media comments by the
governor and deputy governor was conspicuous by its absence in the policy statement.
Separately, there appears to be a mismatch between the concern about the inflation
outlook expressed in recent statements, the guidance offered, and the actual monetary
action.
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5.2 REFERENCE
https://www.google.com/amp/s/m.economictimes.com/definition/monetary-
policy/amp?espv=1
https://www.investopedia.com/terms/r/rbi.asp
http://www.economicsdiscussion.net/trade-cycle/control-trade-cycle/monetary-policy-
concept-instruments-and-objectives-trade-cycle-control/14665
https://businessjargons.com/types-of-monetary-policy.html
https://vittana.org/15-advantages-and-disadvantages-of-monetary-policy-tools
http://www.economicsdiscussion.net/monetary-policy/objectives-of-monetary-policy-
6-objectives-india/26107
http://www.economicsdiscussion.net/monetary-policy/monetary-policy-meaning-
objectives-scope-role-and-targets-economics/31314
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