Monetary economics, role of monetary policy, instruments of monetary policy

1. MONETARY POLICY
Prof. Prabha Panth,
Osmania University,
Hyderabad

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What is Monetary Policy
• Monetary policy is the policy of the Central Bank of
the country.
• Harry G. Johnson, "It is the policy of the central bank
of an economy, to control the supply of money with
the aim of achieving macroeconomic stability".
• The Central Bank is the Apex Bank, and controls
commercial banks, non-banking institutions, and
Money market.
• It formulates policies based on Govt decisions.
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Functions of Central Bank
1. Bank of issue: Monopoly of Note issue
2. Banker to the Govt
3. Banker’s Bank
4. Custodian of foreign exchange reserves, and
controls rates of exchange rates,
5. Lender of the last resort.
6. Bank of central clearance, settlement and
transfer, and
7. Controller of credit.
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Objectives of Credit Control
1. To maintain stability in the economy through
monetary policy, during inflation and
deflationary situations
2. To provide credit to the Govt and commercial
banks
3. To ensure economic growth.
4. To promote full employment
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Instruments of Credit Control
The Central Bank has two main instruments of
credit control:
1) Quantitative methods,
2) Qualitative methods
In the Quantitative methods, the total amount
of credit is controlled.
In the second case, the type of credit, the
particular sector receiving credit is controlled.
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1. Quantitative Controls
1. Bank Rate or Discount Rate:
The Bank Rate is the rate of interest at which the
Central Bank gives loans to commercial banks
against govt and other approved securities.
 Inflation, it increases Bank rate, making credit
costlier. Commercial banks also increase their
interest rates.
 Recession, reduces Bank rate, so credit is cheaper.
Commercial banks also reduce their own rates of
interest.
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• The Bank Rate can be effective only if:
– Commercial banks borrow money from CB
– Commercial banks also increase or decrease their own
rates of interest.
– Borrowers do not mind paying higher interest during
inflation, if they expect higher profits.
– The entire economy is monetised. If there is huge
unorganised money market, then it will not work,
– Keynes showed that during recession, low rate of interest
only leads to Liquidity trap
– High interest rates are passed down and affect production
of necessaries.
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2. Changes in Reserve Ratio:
Each commercial bank should keep a percentage
of its reserves with the Central Bank.
• Banker’s Bank.
• In times of inflation, the Central Bank
increases this reserve ratio to reduce the
supply of money with commercial banks.
• During recession, it decreases the reserve
ratio, so commercial banks have more funds to
give as loans.
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• Limitations:
– RR is effective only if commercial banks do not
have other sources of reserves.
– They can borrow from other banks or from other
financial institutions.
– The investors can also borrow from other sources,
and not only from commercial banks
– During recession, when there is no demand for
funds, increasing the funds with commercial banks
will not lead to recovery.
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3. Open Market Operations (OMO):
The Central Bank can buy and sell securities in
the Open Market (i.e. Stock exchange).
During Inflation, sells its stocks, removes excess
money from the hands of public.
To reduce demand and prices
During recession it buys stocks from the public,
and increases the supply of money.
This is expected to increase demand and prices.
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• Limitations:
– The OMO will work only if the Stock Exchange is
well developed.
– Public is ready to buy or sell the stocks/shares.
– Even if they buy, they can again sell them and get
access to more cash.
– During recession, more supply of funds will not
start the recovery.
– In less developed countries people may not buy
stocks, and the stock market is not well developed.
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II. Qualitative or Selective Methods
1. Regulation of Consumer Credit: first introduced
by Federal Bank of America 1941.
To reduce consumer demand for durables – cars, TV, or
even for housing loans,
This will reduce demand and reduce prices.
To ration the scarce consumer goods needed for defence
not civilian uses.
But in less developed countries, banks don’t lend for
consumer durables purchase.
All consumers may not borrow from banks
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2. Margin Requirements:
―When commercial banks give loans, to keep a certain
amount with themselves called margin requirements.
― Used by US Federal banks since 1934
― For certain types of loans, the Margin requirements
may be increased to reduce cash with the public.
But it is effective only if:
a)Consumers approach banks for loans
b)Cannot resell their securities to others in the market
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3. Moral Suasion:
• The Central Bank advises or requests the
commercial banks about its credit policy, without
any orders or penalties.
• Since commercial banks respect the CB, they will
carry out the requests.
• Successful in UK, Sweden, France, Holland.
BUT:
Not successful in USA, where there are too many
unitary banks.
Where commercial banks carry large reserves.
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4. Direct Action:
• The CB can refuse to give loans to commercial banks
for the sectors which create inflation.
• If commercial banks do not follow the instructions of
the central bank, it will refuse to lend commercial
banks
5.Publicity:
• CB publishes its monetary policy to get public
reaction.
• It can blacklist banks that are not following its orders.
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Evaluation of Monetary Policy
1. Effective only in a highly monetised economy.
2. Commercial banks and non banking institutions
should follow CB policy.
3. High rates of interest may stop loans to weaker
sections and priority sectors.
4. Affects growth and distribution
5. Monetary Policy is not effective in recession.
6. Based on Demand Pull inflation, not cost push or
structuralist inflation
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