Amity School of Business

Module VI Monetary and Fiscal Policy

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What is Monetary Policy?

The term monetary policy refers to actions taken by central banks to affect monetary magnitudes or other financial conditions. Monetary Policy operates on monetary magnitudes or variables such as money supply, interest rates and availability of credit. Monetary Policy ultimately operates through its influence on expenditure flows in the economy. In other words affects liquidity and by affecting liquidity, and thus credit, it affects total demand in the economy.

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INSTRUMENTS OF CREDIT CONTROL

Quantitative Measures Qualitative Measures

Quantitative Measures
Legal Reserve Ratio Bank Rate Policy Open Market Operations

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Open Market Operations (OMOs) OMOs involve buying (outright or temporary) and selling of govt securities by the central bank, from or to the public and banks. RBI when purchases securities, pays the amount of money by crediting the reserve deposit account of the sellers bank, which in turn credits the sellers deposit account in that bank.

Bank Rate

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Standard rate at which bank is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase The rate of interest charged by central bank on their loans to commercial banks is called bank rate(Discount rate). An increase in bank rate makes it more expensive for commercial banks to borrow . This exerts pressure to bring about the rise in interest rates (lending rates) charged by commercial banks on their lending to public. This leads to a general tightening in economy. Whereas decrease in bank rate has the opposite effect and leads to general easing of credit in the economy.

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RESERVE REQUIREMENTS The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault(vault cash), or with a central bank.

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RESERVE REQUIREMENTS

Thus central bank makes it legally obligatory for commercial banks to keep a certain minimum percentage of deposits in reserve. These are of 2 types: Cash reserves Liquidity reserves

CRR

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Banks are required to maintain a certain percentage of their deposits in the form of reserves or balances with the RBI It is called Cash Reserve Ratio or CRR Since reserves are high-powered money or base money, by varying CRR, RBI can reduce or add to the banks required reserves and thus affect banks ability to lend.

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STATUTORY LIQUIDITY RATIO

Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is the amount which a bank has to maintain in the form: Cash Gold valued at a price not exceeding the current market price, Unencumbered approved securities (G Secs or Gilts come under this) valued at a price as specified by the RBI from time to time.

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STATUTORY LIQUIDITY RATIO

The quantum is specified as some percentage of the total demand and time liabilities of a bank. This percentage is fixed by the Reserve Bank of India. The maximum and minimum limits for the SLR are 40% and 25% respectively. The objectives of SLR are: To restrict the expansion of bank credit. To augment the investment of the banks in Government securities. To ensure solvency of banks. A reduction of SLR rates looks eminent to support the credit growth in India.

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QUALITATIVE MEASURES
Credit rationing Moral suasion Changing lending margin Direct controls

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CREDIT RATIONING
More popular techniques in developing countries because financial infrastructure is not fully developed. A credit ceiling is allotted to each sector and to each bank Because of its non interest nature, suitable for controlling Islamic banks. Issue of Penalty

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MORAL SUASION
Informal contacts, consultations, meetings, to explain position of central bank on various issues. It implies the central bank exerting pressure on banks by using oral and written appeals to expand or restrict credit in line with its credit policy.

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CHANGING LENDING MARGIN

The difference between the value of mortgaged property and the amount advanced as loan is lending margin. The central bank is empowered to change the lending margin with a view to change the credit with the banks.

DIRECT CONTROLS Amity School of Business

When all other methods prove ineffective, the central bank imposes direct controls with a clear directive to banks to carry out their lending activity in a specified manner.