MBA 1st Year Monetary Policy Study Material Notes

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Monetary Policy

Monetary policy refers to the case of techniques of monetary control at the disposal of the Central Bank of the country. A development-oriented economy like India needs a sound monetary policy, which is not only helpful in the economic development of a country but is also able to bring out stability in the country. (MBA 1st Year Monetary Policy Study Material Notes)

Some of its definitions are:

“Monetary policy is a policy employing the Central Bank’s control of the supply of money as an instrument of achieving the objectives of general economic policy”.

“Monetary policy is a conscious action undertaken by the monetary authorities to change the quantity, availability, and cost of money”.

“Monetary policy is the attitude of the political authority towards the monetary system of the community under its control”

Generally, it is said that monetary policy is a programme undertaken by the monetary authorities generally the Central Bank, to control and regulate the supply of money to the public and the flow of credit with a view to achieving pre-determined macroeconomic goals.

The objectives of monetary policy are growth, employment, stability of price and foreign change, and balance of payment equilibrium. Monetary policy is the use of instruments under the control of RBI to influence the demand for goods and services of the trends in certain sectors of the economy. It is said to be operating through varying cost and availability of credit and helps to show changes in the pattern of assets of credit institutions, especially banks. (MBA 1st Year Monetary Policy Study Material Notes)

Nature of Monetary Policy

Reserve Bank of India with the help of monetary policy targets a key set of indicators to ensure that there exists price stability in the country’s economy. The factors induced are as follows:

1. The money supply is commonly referred to as Mą.
2. Interest rate.
3. Inflation.

The monetary policy gives a platform or a base to announce the rules am wended bodies such as banks, Flies, non-banking finance companies, residue base to announce the rules and regulations or norms for s primary dealers in monking finance companies, residual non-banking companies, the policy is said to be announced two kets and authorized dealers in foreign exchange markets. One for the slack season year in accordance with the agricultural cycles. (MBA 1st Year Monetary Policy Study Material Notes)

1. One for the slack season [April-September.]
2. One for the busy season (October-March).

Objectives  of Monetary Policy

In the present day economy, the objectives of monetary policy are:

1. The neutrality of money is only a technical device.
2. Price stability prevents changes in the general price level.
3. Exchange rate stability by using an interest rate mechanism.
4. Promotion of economic growth, by raising financial resources.
5. Maintenance of a high level of employment, by raising the level of investment.
6. Achieving a balance of payments equilibrium.

Scope of Monetary Policy

The area of economic transactions and the macro-economic variables that monetary authorities influence is said to be the scope of monetary policy. The scope of monetary policy by and large depends upon two factors:

1. The level of the monetary economy.
2. The level of development of the capital market.

The entire economic activities are covered by the monetary policy in an economy. All the economic transactions in such an economy are carried out with money as the main medium of exchange. Suppose if the monetary policy works by simply changing the price level, it can affect all the economic activities, such as production, consumption, savings and investment, and foreign trade. Employment, general price level, GDP, and foreign exchange are said to influence monetary policy.

A developing capital market is one that has the following features:

1. A large number of financially strong commercial banks, financial institutions, credit organizations, and short-term bill markets.
2. A major part of financial transactions is routed through the capital markets.
3. The working capital of various sub-markets is inter-linked and inter-dependent.
4. The commodity sector is highly sensitive to changes in the capital market.

It is important that the bank rates and cash reserve ratio work through the commercial banks. Therefore for a widespread impact of monetary policy on the economy, it is essential that the capital sub-markets have strong financial links with the commercial banks.

Limitations of Monetary Policy

Various limitations of monetary policy can be described as:

1. The Time Lag: Time lag means time taken in chalking out the policy action, its implementation, and working time. It has two parts:

(a) Inside Lag: It is the time lost in identifying the:

(i) Nature of the problem.

(ii) Sources of the problem.

(iii) Assuming the magnitude of the problem.

(iv) Choice of appropriate policy action.

(v) Implementation of policy actions.

(b) Outside Lag: The outside lag is the time taken by the households and the firms to react in response to the policy action that is taken by monetary authorities. If operational lags are the long magnitude of the problem, they may change rendering the policy ineffective. (MBA 1st Year Monetary Policy Study Material Notes)

The time lag of monetary policy particularly the response lag is found to be much longer than the time lag of fiscal policy. According to Friedman and Schwartz, an average time lag is of 18 months between peaks (or troughs ) of money supply and peaks or (troughs) of business cycles. 

2. The problem in Forecasting: To formulate problems must be assessed. More important is to the problem must be assessed. More important is to forecast the effects of monetary action. Prediction difficult tasks. An appropriate policy has An appropriate policy based on guesswork is found to be unsatisfactory.
3. Non-banking Financial Intermediaries: The structural change in the financial reduced the scope of the effectiveness of monetary policy intermediaries including industrial finance corporations, corporations, industrial development banks, etc. have reduced the share of the commercial banks, in the total credit.
4. Under Development of Money and Capital Market: In underdeveloped countries, the character of their money and capital markets is also underdeveloped. Their money and capital DE are fragmented while effective working of monetary policy has Lucy has a requirement that money makes the sub-market of the capital market work independently. So the effects of change in money sun in the interest rates remained confined to the banking sector only.

Instruments/Working of Monetary Policy

Instruments of monetary policy refer to the economic variables that the central bank can with a view to control and regulate the money supply and the available play and the availability of credits. This instrument of monetary policy is also known as a weapon of monetary control. (MBA 1st Year Monetary Policy Study Material Notes)

The measures of monetary policy are generally clarified under two categories:

1. Quantitative measures                            2. Qualitative or selective credit controls.

1. Quantitative Measures                   

Traditional or quantitative measures of monetary control are as follows:

(a) Open Market Operations: Sale and purchase of government securities and treasury bills the central bank of the country makes an open market operation. To increase the supply of money to the public, the central bank purchases government securities, i.e. bills and bonds. Similarly, when it decides to reduce the money it sells government bonds and securities. The open market operation has not proved a powerful tool in the hands of RBI. (MBA 1st Year Monetary Policy Study Material Notes)

Effectiveness of Open Market Operations: 

(i) When commercial banks possess excess liquidity, the open market operations do not work effectively.

(ii) In a very buoyant market situation, the effective control of demand for credit through opal market operation is doubtful. During the depression period, open market operations are not effective for a lack of demand for credit.

(iii) In underdeveloped countries where the banking system is not well-developed, securities and capital markets are not interdependent.

(iv) The popularity of government bonds and securities with the public also matters a lot. The government debt instruments are not popular because of the low rate of return. A central bank in such a case has to use coercive power measures and force the commercial banks to buy the government bonds as in the case in India. (MBA 1st Year Monetary Policy Study Material Notes)

(b) Bank Rate Policy: Bank rate is the rate at which the central bank rediscount the first class De of exchange presented by commercial banks.

The RBL Act defines, ‘Bank rate’ as the standard rate at which the bank is prepared to buy bills exchange, or other commercial papers, eligible to purchase under this act.

The central bank can change this rate-increase or decrease depending on what it wants to do i.e expand or contract the flow of credit from the commercial bank. The bank rate policy was adopted by the Bank of England in 1839.

The working of the discount rate policy is simple. When the central bank changes its own discount rate, commercial banks raise their discount rates too and vice-versa. For example, during inflation RBI increases the bank rate and during deflation, RBI decreases the bank rate. (MBA 1st Year Monetary Policy Study Material Notes)

Cash Reserve Ratio or Statutory Res Reserve Ratio: It is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank.

The main objective is to prevent a shortage of cash in meeting the demand of Cash depositors.

By changing the CRR, the central bank can change the money supply overnight. Cen Lege of cash in meeting the demand of cash depositors. Op when conditions have the demand of contraction in monetary conditions and get the money supply overnight. The central bank raises when conditions have the demand for expansion of money.

Limitations of CRR: These are as follows:

(i) Its effectiveness is limited by the existence of an unorganized banking sector

(ii) It proves handier where open market operation and bank rate policy prove less effective.

(iii)Its effectiveness depends upon the share of the banking credit in the credit market.

(iv) CRR is relatively more effective in advanced countries with advanced banking systems accounting for a major share in the capital market. (MBA 1st Year Monetary Policy Study Material Notes)

2. Qualitative or Selective Credit Controls

The qualitative or selective credit control measures are resorted to when RBI intends to control the use of credit. Its impact is uniform in all sectors of the economy.

The monetary policy is often faced with the problems of:

(a) Rationing the credit.

(b) Diverting the flow of credit from the non-priority sectors to the priority ones.

(c) Curbing speculative tendency based on the availability of bank credit. Measures of SCC (Selective Credit Control) are as follows:

(a) Direct Controls: When all methods are ineffective, the monetary authorities resort to direct control measures. The measures are resorted to when the commercial banks do not follow the Instructions issued by the central bank.

(b) Moral Suasion: It is a method of persuading and convincing commercial banks to advance credit in accordance with the central bank in the economic interest of the country. Under this, the central bank writes a letter to and holds meetings with banks on money and credit matters and pursues them to follow the credit policy.

(c) Credit Rationing: When there is a shortage of institutional credit for the business sector, the strong sector captures a major portion of the total institutional credit. Hence, weaker sectors are starved of necessary funds. In this method, the central bank can fix the quota of credit for banks. (MBA 1st Year Monetary Policy Study Material Notes)

(d) Change in Lending Margins: ‘Lending margin’ is the difference between the values of the mortgaged property and the amount advanced.

The banks provide loans only up to a certain percentage of the value of the mortgaged property. RBI, by increasing the lending margin, can control the expansion of credit. (MBA 1st Year Monetary Policy Study Material Notes)

Structural Adjustments and Monetary Policy

The structural adjustment program has re-defined the objectives and instruments of monetary policy. The major considerations which underline the monetary policy in recent years are:

1. Bringing about a deceleration in the monetary expansion.
2. Reducing the monetary deficit, ie printing of new currency consistent with the government objective of bringing down fiscal deficit. (MBA 1st Year Monetary Policy Study Material Notes)
3. Boosting exports in order to alleviate the problem of external payments deficit.