Monetary Policy

Topics: Monetary policy, Central bank, Inflation Pages: 6 (1158 words) Published: March 19, 2013
Monetary Policy

(Economic Stabilization Policies)
Stabilization policies are policies by the government to maintain full employment and reasonably stable price level The objectives of the macroeconomic policies are mainly two:  Sustain economic growth (maintain full employment)

Macroeconomic Policies

 Control inflation (stabilize general price level)

Types of Macroeconomic Policies
 Fiscal Policies  Monetary Policies

Monetary Policy
How does a monetary authority decide on when to expand or contract credit and by how much?

Decision based on the overall objectives of the monetary policy

Meaning of Monetary Policy
“Monetary policy is essentially a programme 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 to achieving predetermined macroeconomic goals” The objectives of monetary policy are the same as of macroeconomic policy – price stability, currency stability, financial stability, growth in employment and income

Monetary Policy and Money Supply
 The money supply is controlled by the RBI through:
 Changing

the reserve requirements

 Changing

the policy rates (bank rate, repo rate and reverse repo rate) operations

 Open-market 

Thus the quantity of money supplied does not depend on the interest rate and is vertical

Instruments of Monetary Policy
Credit Control by the Central Bank
Instruments of credit control
Broadly categorized into two:

– General instruments are intended to regulate the total volume of credit (quantitative) Include (1) policy rates, (2) open market operations, (3) power to vary the reserve requirements – Selective instruments to regulate the purpose for which commercial banks generated credit (qualitative)

Variable Reserve Ratios
Banks are required to maintain a percentage of their deposits in the form of balances with the RBI, known as legal reserve requirement (statutory reserve requirement) RBI has the power to vary this ratio and used as an instrument of credit control An increase in reserve requirement ratio will reduce the reserves for lending by the banks

A lowering of the reserve ratio will enable the banks to expand credit The most easiest way to control credit

Bank Rate
The minimum rate at which the central bank of a country provided financial assistance to commercial banks By raising or lowering bank rate, the central bank can reduce or expand credit granted by banks Currently bank rate in India is 6.0%

Bank Rate
How bank rate works?
↑ bank rate → ↑ cost of borrowing by commercial banks from the central bank → ↑ in lending rate of commercial banks → less borrowing Adverse effect on the level of production and prices Usually used during inflationary situation

Similarly, a fall in bank rate lower the lending rates of CBs and lead to expansion of bank credit and may raise income and output

Conditions for successful working of bank rate
A well organized money market in order to have impact on other rates in the market Reactions of borrowers to change in the lending rates

A fall in output may coexist with a rise in price
Customers’ assessment of the economic situation. If the business conditions are not favorable lowering of lending rate may not attract much borrowers

Bank Rate in India

Policy Rates
(, 27/01/2012)

Bank rate Repo rate

6% 8.5 %

Reverse repo rate

7.5 %

Repo (from the perspective of the seller of a security) or Reverse repo (from the perspective of the buyer of a security) is a Repurchase agreement in which two parties agree to sell and repurchase a security on an agreed date at a predetermined price. When banks sell securities, repo rate is applicable; when banks buy securities to park surplus funds, reverse repo rate is applicable.

Reserve Ratios
(, 27/01/2012)

Cash Reserve ratio Statutory Liquidity ratio...

References: 1. Chapters 12 & 13,‘Principles of Economics’, 8th edn., by Michael Melvin and William Boyes.
2. Chapters 2 & 5, ‘Macroeconomic Policy Environment’ by Shymal Roy.
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