Monetary Policy - Its Meaning, Definitions Objectives

Meaning of Monetary Policy

The term monetary policy is also known as the 'credit policy' or called 'RBI'smoney management policy' in
India. How much should be the supply of money in the economy? How much should be the ratio of interest?
How much should be the viability of money? etc. uch !uestions are considered in the monetary policy. "rom
the name itself it is understood that it is related to the demand and the supply of money.
Definition of Monetary Policy
#any economists have given various definitions of monetary policy. ome prominent definitions are as follows.
$ccording to Prof. Harry Johnson% &$ policy employing the central banks control of the supply of money as
an instrument for achieving the ob'ectives of general economic policy is a monetary policy.&
$ccording to A.. Hart% &$ policy which influences the public stock of money substitute of public demand for
such assets of both that is policy which influences public li!uidity position is known as a monetary policy.&
"rom both these definitions( 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 ob'ectives. The )entral Bank of a nation keeps control on
the supply of money to attain the ob'ectives of its monetary policy.
Objectives of Monetary Policy
The ob'ectives of a monetary policy in India are similar to the ob'ectives of its five year plans. In a nutshell
planning in India aims at growth( stability and social 'ustice. $fter the !eynesian revol"tion in economics(
many people accepted significance of monetary policy in attaining following ob'ectives.
*. Rapid +conomic ,rowth
-. .rice tability
/. +0change Rate tability
1. Balance of .ayments 2B3.4 +!uilibrium
5. "ull +mployment
6. 7eutrality of #oney
8. +!ual Income 9istribution
These are the general ob'ectives which every central bank of a nation tries to attain by employing
certain tools 2Instruments4 of a monetary policy. In India( the RBI has always aimed at the controlled e0pansion
of bank credit and money supply( with special attention to the seasonal needs of a credit.
:et us now see ob'ectives of monetary policy in detail %;
*. #a$id %conomic ro&th % It is the most important ob'ective of a monetary policy. The monetary policy
can influence economic growth by controlling real interest rate and its resultant impact on the investment. If
the RBI opts for a cheap or easy credit policy by reducing interest rates( the investment level in the economy
can be encouraged. This increased investment can speed up economic growth. "aster economic growth is
possible if the monetary policy succeeds in maintaining income and price stability.
-. Price 'tability % $ll the economics suffer from inflation and deflation. It can also be called as .rice
Instability. Both inflation are harmful to the economy. Thus( the monetary policy having an ob'ective of price
stability tries to keep the value of money stable. It helps in reducing the income and wealth ine!ualities.
<hen the economy suffers from recession the monetary policy should be an 'easy money policy' but when
there is inflationary situation there should be a 'dear money policy'.
/. %(change #ate 'tability % +0change rate is the price of a home currency e0pressed in terms of any
foreign currency. If this e0change rate is very volatile leading to fre!uent ups and downs in the e0change rate(
the international community might lose confidence in our economy. The monetary policy aims at maintaining
the relative stability in the e0change rate. The RBI by altering the foreign e(change reserves tries to
influence the demand for foreign e0change and tries to maintain the e0change rate stability.
1. )alance of Payments *)OP+ %,"ilibri"m % #any developing countries like India suffers from the
9ise!uilibrium in the B3.. The Reserve Bank of India through its monetary policy tries to maintain
e!uilibrium in the balance of payments. The B3. has two aspects i.e. the 'B3. urplus' and the 'B3. 9eficit'.
The former reflects an e0cess money supply in the domestic economy( while the later stands for stringency of
money. If the monetary policy succeeds in maintaining monetary e!uilibrium( then the B3. e!uilibrium can
be achieved.
5. -"ll %m$loyment % The concept of full employment was much discussed after =eynes's publication of
the &,eneral Theory& in *>/6. It refers to absence of involuntary unemployment. In simple words '"ull
+mployment' stands for a situation in which everybody who wants jobs get 'obs. However it does not mean
that there is a ?ero unemployment. In that senses the full employment is never full. #onetary policy can be
used for achieving full employment. If the monetary policy is e0pansionary then credit supply can be
encouraged. It could help in creating more 'obs in different sector of the economy.
6. .e"trality of Money % +conomist such as /ic0sted( #obertson have always considered money as a
passive factor. $ccording to them( money should play only a role of medium of e0change and not more than
that. Therefore( the monetary policy should regulate the supply of money. The change in money supply
creates monetary dise!uilibrium. Thus monetary policy has to regulate the supply of money and neutrali@e the
effect of money e0pansion. However this ob'ective of a monetary policy is always critici@ed on the ground
that if money supply is kept constant then it would be difficult to attain price stability.
8. %,"al Income Distrib"tion % #any economists used to 'ustify the role of the fiscal policy is
maintaining economic e!uality. However in resent years economists have given the opinion that the monetary
policy can help and play a supplementary role in attainting an economic e!uality. monetary policy can make
special provisions for the neglect supply such as agriculture( small;scale industries( village industries( etc. and
provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in
recent period( monetary policy can help in reducing economic ine!ualities among different sections of
society.
Instr"ments of Monetary Policy - 1"antitative 2 1"alitative 3ools
The instrument of monetary policy are tools or devise which are used by the monetary authority in order to
attain some predetermined ob'ectives. There are two types of instruments of the monetary policy as shown
below.
*A+ 1"antitative Instr"ments or eneral 3ools 4
The Auantitative Instruments are also known as the ,eneral Tools of monetary policy. These tools are related to
the Auantity or Bolume of the money. The Auantitative Tools of credit control are also called as ,eneral 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 !uantity of credit in the country. The
general tool of credit control comprises of following instruments.
5. )an0 #ate Policy *)#P+
The Bank Rate .olicy 2BR.4 is a very important techni!ue used in the monetary policy for influencing the
volume or the !uantity of the credit in a country. The bank rate refers to rate at which the central bank 2i.e RBI4
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 e0change or other
commercial paper eligible for purchase under the RBI $ct&. The Bank Rate affects the actual availability and
the cost of the credit. $ny change in the bank rate necessarily brings out a resultant change in the cost of credit
available to commercial banks. If the RBI increases the bank rate than it reduce the volume of commercial
banks borrowing from the RBI. It deters banks from further credit e0pansion as it becomes a more costly affair.
+ven with increased bank rate the actual interest rates for a short term lending go up checking the credit
e0pansion. 3n the other hand( if the RBI reduces the bank rate( borrowing for commercial banks will be easy
and cheaper. This will boost the credit creation. Thus any change in the bank rate is normally associated with
the resulting changes in the lending rate and in the market rate of interest. However( the efficiency of the bank
rate as a tool of monetary policy depends on e0isting banking network( interest elasticity of investment demand(
si@e and strength of the money market( international flow of funds( etc.
6. O$en Mar0et O$eration *OMO+
The open market operation refers to the purchase andCor sale of short term and long term securities by the RBI
in the open market. This is very effective and popular instrument of the monetary policy. The 3#3 is used to
wipe out shortage of money in the money market( to influence the term and structure of the interest rate and to
stabili@e the market for government securities( etc. It is important to understand the working of the 3#3. If the
RBI sells securities in an open market( commercial banks and private individuals buy it. This reduces the
e0isting money supply as money gets transferred from commercial banks to the RBI. )ontrary 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. 3bviously the stock of money in the economy increases. This way when the
RBI enters in the 3#3 transactions( the actual stock of money gets changed. 7ormally 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 ban0ing system. Thus
under 3#3 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 3#3 vi@D underdeveloped securities market( e0cess reserves
with commercial banks( indebtedness of commercial banks( etc.
7. 8ariation in the #eserve #atios *8##+
The )ommercial Banks have to keep a certain proportion of their total assets in the form of )ash Reserves.
ome part of these cash reserves are their total assets in the form of cash. $part of these cash reserves are also
to be kept with the RBI for the purpose of maintaining li!uidity and controlling credit in an economy. These
reserve ratios are named as )ash Reserve Ratio 2)RR4 and a tatutory :i!uidity Ratio 2:R4. The )RR refers
to some percentage of commercial bank's net demand and time liabilities which commercial banks have to
maintain with the central bank and :R refers to some percent of reserves to be maintained in the form of gold
or foreign securities. In India the )RR by law remains in between /;*5 percent while the :R remains in
between -5;1E percent of bank reserves. $ny change in the BRR 2i.e. )RR F :R4 brings out a change in
commercial banks reserves positions. Thus by varying BRR commercial banks lending capacity can be affected.
)hanges in the BRR helps in bringing changes in the cash reserves of commercial banks and thus it can affect
the banks credit creation multiplier. RBI increases BRR during the inflation to reduce the purchasing power and
credit creation. But during the recession or depression it lowers the BRR making more cash reserves available
for credit e0pansion.
*)+ 1"alitative Instr"ments or 'elective 3ools 4
The Aualitative Instruments are also known as the elective Tools of monetary policy. These tools are not
directed towards the !uality of credit or the use of the credit. They are used for discriminating between different
uses of credit. It can be discrimination favoring e0port over import or essential over non;essential credit supply.
This method can have influence over the lender and borrower of the credit. The elective Tools of credit control
comprises of following instruments.
5. -i(ing Margin #e,"irements
The margin refers to the &proportion of the loan amount which is not financed by the bank&. 3r in other words(
it is that part of a loan which a borrower has to raise in order to get finance for his purpose. $ change in a
margin implies a change in the loan si@e. 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. +0ample%; If the RBI feels that more credit supply should be
allocated to agriculture sector( then it will reduce the margin and even G5;>E percent loan can be given.
6. 9ons"mer 9redit #eg"lation
Hnder this method( consumer credit supply is regulated through hire;purchase and installment sale of consumer
goods. Hnder this method the down payment( installment amount( loan duration( etc is fi0ed in advance. This
can help in checking the credit use and then inflation in a country.
7. P"blicity
This is yet another method of selective credit control. Through it )entral Bank 2RBI4 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.
:. 9redit #ationing
)entral Bank fi0es credit amount to be granted. )redit is rationed by limiting the amount available for each
commercial bank. This method controls even bill rediscounting. "or certain purpose( upper limit of credit can be
fi0ed and banks are told to stick to this limit. This can help in lowering banks credit e0poursure to unwanted
sectors.
;. Moral '"asion
It implies to pressure e0erted 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. )ommercial
banks are informed about the e0pectations of the central bank through a monetary policy. Hnder moral suasion
central banks can issue directives( guidelines and suggestions for commercial banks regarding reducing credit
supply for speculative purposes.
<. 9ontrol 3hro"gh Directives
Hnder this method the central bank issue fre!uent 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.
=. Direct Action
Hnder 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. econdly( RBI may refuse credit supply to
those banks whose borrowings are in e0cess to their capital. )entral bank can penali@e a bank by changing some
rates. $t last it can even put a ban on a particular bank if it dose not follow its directives and work against the
ob'ectives of the monetary policy.
These are various selective instruments of the monetary policy. However the success of these tools is limited by
the availability of alternative sources of credit in economy( working of the 7on;Banking "inancial Institutions
27B"Is4( profit motive of commercial banks and undemocratic nature off these tools. But a right mi0 of both the
general and selective tools of monetary policy can give the desired results.
>imitations #)I?s Monetary Policy - India Money Management
Obstacles In Im$lementation of Monetary Policy 4
Through the monetary policy is useful in attaining many goals of economic policy( it is not free from certain
limitations. Its scope is limited by certain peculiarities( in developing countries such as India. ome of the
important limitations of the monetary policy are given below.
5. 3here e(ist a .on-Moneti@ed 'ector
In many developing countries( there is an e0istence of non;moneti@ed economy in large e0tent. .eople live in
rural areas where many of the transactions are of the barter type and not monetary type. imilarly( due to non;
moneti@ed sector the progress of commercial banks is not up to the mark. This creates a ma'or bottleneck in the
implementation of the monetary policy.
6. %(cess .on-)an0ing -inancial Instit"tions *.)-I+
$s the economy launch itself into a higher orbit of economic growth and development( the financial sector
comes up with great speed. $s a result many 7on;Banking -inancial Instit"tions 27B"Is4 come up. These
7B"Is also provide credit in the economy. However( the 7B"Is do not come under the purview of a monetary
policy and thus nullify the effect of a monetary policy.
7. %(istence of Anorgani@ed -inancial Mar0ets
The financial markets help in implementing the monetary policy. In many developing countries the financial
markets especially the money markets are of an unorgani@ed nature and in backward conditions. In many places
people like money lenders( traders( and businessman actively take part in money lending. But unfortunately they
do not come under the purview of a monetary policy and creates hurdle in the success of a monetary policy.
:. Higher >i,"idity Hinders Monetary Policy
In rapidly growing economy the deposit base of many commercial banks is e0panded. This creates e0cess
li!uidity in the system. Hnder this circumstances even if the monetary policy increases the )RR or :R( it dose
not deter commercial banks from credit creation. o the e0istence of e0cess li!uidity due to high deposit base is
a hindrance in the way of successful monetary policy.
;. Money .ot A$$earing in an %conomy
:arge percentage of money never come in the mainstream economy. Rich people( traders( businessmen and
other people prefer to spend rather than to deposit money in the bank. This shadow money is used for
buying $recio"s metals like gold( silver( ornaments( land and in speculation. This type of lavish spending give
rise to inflationary trend in mainstream economy and the monetary policy fails to control it.
<. 3ime >ag Affects '"ccess of Monetary Policy
The success of the monetary policy depends on timely implementation of it. However( in many cases
unnecessary delay is found in implementation of the monetary policy. 3r many times timely directives are not
issued by the central bank( then the impact of the monetary policy is wiped out.
=. Monetary 2 -iscal Policy >ac0s 9oordination
In order to attain a ma0imum of the above ob'ectives it is unnecessary that both the fiscal and monetary policies
should go hand in hand. $s both these policies are prepared and implemented by two different authorities( there
is a possibility of non;coordination between these two policies. This can harm the interest of the overall
economic policy.
These are ma'or obstacles in implementation of monetary policy. If these factors are controlled or kept within
limit( then the monetary policy can give e0pected results. Thus though the monetary policy suffers from these
limitations( still it has an immense significance in influencing the process of economic growth and
development.
#eforms in the Indian Monetary Policy D"ring 5BBCs
The #onetary policy of the RBI has undergone massive changes during the economic reform period. $fter *>>*
the #onetary policy is disassociated from the fiscal policy. Hnder the reform period an emphasis was given to
the stable macro economic situation and low inflation policy.
The ma'or changes in the Indian #onetary policy during the decade of *>>E.
*. #ed"ced #eserve #e,"irements % 9uring *>>Es both the )ash Reserve Ratio 2)RR4 and the tatutory
:i!uidity Ratio 2:R4 were reduced to considerable e0tent. The )RR was at its highest *5I plus and
additional )RR of *EI was levied( however it is now reduced by 1I. The :R is reduced form /G.5I to a
minimum of -5I.
-. Increased Micro -inance % In order to strengthen the rural finance the RBI has focused more on the
elf Help ,roup 2H,4. It comprises small and marginal farmers( agriculture and non;agriculture labour(
artisans and rural sections of the society. However still only /EI of the target population has been benefited.
/. -iscal Monetary 'e$aration % In *>>1( the ,overnment and the RBI signed an agreement through
which the RBI has stopped financing the deficit in the government budget. Thus it has seperated the
#onetary policy from the fiscal policy.
1. 9hanged Interest #ate 'tr"ct"re % 9uring the *>>Es( the interest rate structure was changed from its
earlier administrated rates to the market oriented or liberal rate of interest. Interest rate slabs are now reduced
up to - and minimum lending rates are abolished. imilarly( lending rates above Rs. Two lakh are freed.
5. 9hanges in Accordance to the %(ternal #eforms % 9uring the *>>E( the e0ternal sector has undergone
ma'or changes. It comprises lifting various controls on imports( reduced tariffs( etc. The #onetary policy has
shown the impact of liberal inflow of the foreign capital and its implication on domesticmoney supply.
6. Higher Mar0et Orientation for )an0ing % The banking sector got more autonomy and operational
fle0ibility. #ore freedom to banks for methods of assessing working funds and other functioning has
empowered and assured market orientation.
%val"ation of the Monetary Policy in India
9uring the reforms though the #onetary policy has achieved higher success in the #onetary policy( it is not
free from limitation or demerits. It needs to be evaluated on a proper scale.
1. -ailed in 3ac0ling )"dgetary Deficit % The higher level of the budget deficit has made the #onetary
policy ineffective. The automatic moneti@ation of the deficit has led to high #onetary e0pansion.
2. >imited 9overage % The #onetary policy covers only commercial banking system leaving other non;
bank institutions untouched. It limits the effectiveness of the monitor policy in India.
3. Anorgani@ed Money Mar0et % In our country there is a huge si@e of the unorgani@ed money market. It
dose not come under the control of the RBI. Thus any tools of the #onetary policy dose not affect the
unorgani@ed money market making #onetary policy less affective.
4. Predominance of 9ash 3ransaction % In India still there is huge dominance of the cash in total money
supply. It is one of the main obstacles in the effective implementation of the #onetary policy. Because
#onetary policy operates on the bank credit rather on cash.
5. Increase 8olatility % $s the #onetary policy has adopted changes in accordance to the changes in the
e0ternal sector in India( it could lead to a high amount of the volatility.