INTRODUCTION
The emergence of monetary policy is a powerful tool of economic control and management.
MEANING OF MONETARY POLICY
Monetary policy is essentially a program of action undertaken by the monetary authorities, generally the central bank, to control and regulate the supply of money with the public and the flow of credit with a view achieving predetermined macroeconomic goals.
The objectives of monetary policy are the same as the objective of macroeconomic policy, viz. growth. employment, stability of price and foreign exchange, and the balance -of- payment equilibrium. The macroeconomic goals are determined on the basis of the economic needs of the country. Once macro goals are determined. the basic policy question arises as to whether to increase or decrease the supply of money. The next - step is to make the choice of instruments that can effectively increase or decrease money supply with the public.
Scope of Monetary Policy
The scope of monetary policy spans the entire area of economic transactions and the macroeconomic variables that monetary authorities can influence and alter by making changes in the monetary policy instruments. The scope of monetary policy depends, by and large. on two factors.
(i) The level of monetization of the economy, and
(ii) The level of development of the capital market.
In a fully monetized economy, the scope of monetary policy encompasses the entire economic activities. In such an economy, all economic transactions are carried out with money as a medium of exchange. In that case, monetary policy works by changing the supply of and demand for money and the general price level. It is therefore capable of affecting all economic activities production, consumption, savings, investment and foreign trade. The monetary policy can influence all major macro variables--GDP, savings and investment, employment, the general price level, foreign trade and balance of payments.
Another factor that matters in determining the scope and the effectiveness of the monetary policy is how it developed and integrated the capital market . Some instruments of monetary control (bank rate and cash reserve ratio) work through the capital market. Where the capital market is fairly developed, monetary policy affects the level of economic activities through the changes in the capital market. It works faster and more effectively in an economy with a fully developed capital market. Incidentally, a developed capital market Is one which has the following features:
(i) a large number of financially strong commercial banks, financial institutions, credit Organizations, and short-term bill market,
(ii) a major part of financial transactions are routed through the capital markets,
(iii) the working of capital sub-markets is inter linked and interdependent, and
(iv) commodity sector is highly sensitive to the Changes in the capital market.
Monetary weapons like bank rate and cash reserves ratio work through the commercial banks. Therefore, for the monetary policy to have a widespread impact on the economy, other capital sub-markets must have a strong financial link with the commercial banks.
INSTRUMENTS OF MONETARY POLICY
The instruments of monetary policy refer to the economic variables that the central bank can change at its discretion with a view to controlling and regulating the supply of and demand for money and the availability of credit. The instruments are also called 'weapons of monetary control. Samuelson and Nordhaus call them The Nuts and Bolts of Monetary Policy. Monetary instruments are generally classified under two categories:
(i) quantitative measures, and
(ii) qualitative or selective credit controls.
Quantitative Measures of Monetary Control
quantitative measures, also called as traditional measures of monetary control are following.
(i) Open market operations,
(ii) Discount rate or bank rate, and
(iii) Cash reserve ratio (CRR).
(i) Open Market Operations
The open market operation' is the sale and purchase of government securities and Treasury Bills by the central bank of the country. When the central bank decides to pump money into circulation, it buys back the government securities, bills and bonds, and when it decides to reduce money in circulation, it sells the government bonds and securities. The open market operation is the most powerful and widely used tool of monetary control. First used, in the US by the Federal Reserve System in 1922 has ever since been used as a major weapon of credit control in most developed countries.
The central bank carries out its open market operations through the commercial banks it does not deal directly with the public. The buyers of the government bonds include commercial banks, financial corporations, big business corporations and individuals with high savings. These customers of government bonds hold their accounts with the banks.
(ii) Discount Rate or Bank Rate Policy
'Discount rate' or Bank rate' is the rate at which the central bank rediscounts the bills of exchange presented by the commercial banks. The RBI Act 1935 defines 'bank rate' as the "standard rate at which (the bank) is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under this Act." The RBI rediscounts only the government securities, approved bills and the 'first class bills of exchange.' When commercial banks are faced with short- age of cash reserves, they approach the central bank to get their bills of exchange rediscounted. It is a general method of borrowing by the commercial banks from the central bank, the 'lender of the last resort'. The central bank rediscounts the bills presented by the commercial bank at a discount rate. This rate is traditionally called bank rate. A more appropriate name in usage now is the discount rate. However, for all practical purposes, the bank rate is the rate at which the central bank charges on the loans and advances to the commercial banks.
The central bank can change this rate-increase or decrease-depending on whether it wants to expand or reduce the flow of credit from the commercial bank. When it wants to increase the credit creation capacity of the commercial banks, it reduces the discount rate and when it decides to decrease the credit creation capacity of the banks, it increases the bank rate. This policy action by the central bank is called the bank rate policy or more appropriately, the discount rate policy. The bank rate policy was first adopted by the Bank of England in 1839. it was the only and the most widely used weapon of credit control until the open market operation, first used in 1922 in the Us, emerged as a more powerful instrument of monetary control.
In India, the RBI has been using, though infrequently, the bank rate since its inception in 1935. The bank rate remained constant at 3%. In 1951, it was increased to 3.5% and to 4% in 1956 and remained in force till 1962. In the subsequent year, the bank was increased more frequently and it rose to 12% in 1992. with growing need for credit facility with economy growing at 5-6% and also decreasing rate of inflation, the bank rate was reduced gradually to 6.5% in 2001. which is lowest since 1973.
(iii) The Cash Reserve Ratio or Statutory Reserve Ratio
The 'cash reserve ratio" is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank. The objective of the cash reserve is to prevent shortage of cash for meeting the cash demand by the depositors. The cash reserve ratio (CRR) depends, normally, on the banks' experience regarding the cash demand by the depositors. But, "If there were no government rules, banks would probably keep only a very small fraction of their deposits in the form of re- serves." Since the cash reserves are non-interest bearing, commercial banks often keep their cash reserves below the safe limits. This situation might lead to a financial crisis in the banking sector and collapse of the banking system. In order to prevent this eventuality. the central bank imposes a CRR on the banks. This has come as a handy tool for the central bank to control money Supply. The central bank enjoys the legal powers to change the cash reserve ratio of the banks. The cash reserves under this provision is therefore a legal requirement. Therefore, the cash reserve ratio is also called a statutory reserve ratio (SRR).
By changing the CRR the central bank can change the money supply overnight. When economic conditions demand a contractionary monetary policy, the central bank raises the CRR And, when economic conditions demand monetary expansion, the central bank cuts down the CRR.
The Statutory Liquidity Requirement (SLR). In India, the RBI has imposed another reserve requirement in addition to CRR. It is called Statutory Liquidity Requirement (SLR). The SLR was first imposed in 1949 and was fixed at 20%. The SLR is the proportion of time Total Deposits which commercial banks are statutorily required to maintain in the form of liquid assets (cash reserve, gold and government bonds) in addition to cash reserve ratio. This measure was undertaken to prevent the commercial banks from liquidating their liquid assets when CRR is raised. What commercial banks used to do, before SLR was imposed , was to convert their liquid assets into cash to replenish the fall in their loanable funds due to rise in the CRR.
Qualitative or Selective Credit Controls
The quantitative methods of monetary controls affect, when they are affective, the entire credit market in the same direction. They lead either to expansion or to contraction of the total credit. In other words, their impact on all the sector of the economy is uniform. This may not be always desirable or intended by the policy-makers.
The monetary authorities are often faced with the problems of
(a) rationing of credit,
(b) diverting the flow of credit of from the non-priority sectors to the priority sectors, and
(c) curbing speculative tendency based on the availability of bank credit.
These objective of credit control are not well served by the quantitative measures of credit control. The monetary authorities resort, therefore, to qualitative or selective credit controls.
Credit rationing -
Change in Lending Margins -
Moral suasion-
Direct Controls-
-Transmission mechanism of monetary policy-
-Portfolio Adjustment-
-The Keynesian Approach -
-The Monetarist Approach -
-The Limitations and Effectiveness of Monetary Policy-
(i) The Time Lag
(ii) Problems in Forecasting
(iii) Non - banking Financial Intermediaries
(iv) Underdeveloped Money and Capital Markets
Monetary Policy of India :
The Core Issue
The RBI, the central monetary authority of India, has not clearly stated - surprising though--its monetary policy in its published documents. The RBI has, in fact, managed monetary affairs of the country, especially the control, regulation and allocation of bank credit as and when required by the needs of the country. The reason was that the RBI was severely constrained by the growing deficit financing by the Government of India. However, an idea of India's recent monetary policy can be had from the Chakravarty Committee Report' and the writings of C. Rangarajan, a former Governor of RBI.
Policy Objectives
The three major objectives of India's overall economic policy have been
(i) economic growth.
(ii) social justice, i.e., an equitable Distribution of income, and
(iii) price stability.
These objectives have in general been the objective of India's monetary policy. Of the various objectives, however , Chakravarty Committee considered promoting price stability as 'the dominant objective of the monetary policy'. For, in the Committee's opinion. "II is price stability which provides the appropriate environment under which growth can occur and social justice can be ensured, It is important to note here that, in RBI's perception, price stability implies stability of the general price level with four - percent inflation.
Targets
In order to achieve the objectives of its monetary policy, the RBI adopted a reconciliatory approach that incorporates the various kinds of interactions between the real and monetary sectors. On the monetary side, the RBI targeted to control the money supply (M) to ensure price stability with 4- Percent inflation. For this purpose, an annual 14- percent growth in money supply was recommended by the Chakravarty Committee. This was undoubtedly a very high growth rate of money supply but it was justified by the RBI in view of the growing demand for money. In the Committee's opinion this might help to keep inflation rate up to four percent. Is 14 percent annual Increase in money supply justified ? There is no unanimous answer to this question. In the opinion of Prof. S. B. Gupta, a five percent annual increase in money supply is the desirable rate for the Indian economy. The Chakravarty Committee finds a 10 percent growth in money supply for a zero annual rate of inflation. During the 1990s, however, money supply increased at an annual average of 13%, be it due to RBI targeting or spontaneous, but inflation continues to be around 5% per annum.
Monetary Measures
To control money supply, the RBI has been using all the three traditional measures, viz., open market operation, cash reserve ratio (CRR) and bank rate. open market operation and bank rate policy have not been very effective. Increasing CRR, as an instrument of monetary control, has been relatively more effective: it was intermittently increased from 4 percent in 1962 to 12 percent in !992, though it was decreased to 6.5 percent in 2001.
