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Aman Economics Monetary Policy
Aman Economics Monetary Policy
INFLATION
Monetary policies can target inflation levels. The low level of inflation is
considered to be healthy for the economy. However, if the inflation is high, the
monetary policy can address this issue.
UNEMPLOYMENT
Monetary policies can influence the level of unemployment in the economy. For
example, an expansionary monetary policy generally decreases unemployment
because the higher money supply stimulates business activities that lead to the
expansion of the job market.
Using its fiscal authority, a central bank can regulate the exchange rates between
domestic and foreign currencies. For example, the central bank may increase the
money supply by issuing more currency. In such a case, the domestic currency
becomes cheaper relative to its foreign counterparts.
TOOLS OF MONETARY POLICY
Central banks use various tools to implement monetary policies. The widely
utilized monetary policy tools include:
A central bank can influence the interest rates by changing the discount rate. The
discount rate (base rate) is an interest rate charged by a central bank to banks for
short-term loans. For example, if a central bank increases the discount rate, the cost
of borrowing for the banks increases. Subsequently, the banks will increase the
interest rate they charge their customers. Thus, the cost of borrowing in the
economy will increase, and the money supply will decrease.
Central banks usually set up the minimum amount of reserves that must be held by
a commercial bank. By changing the required amount, the central bank can
influence the money supply in the economy. If monetary authorities increase the
required reserve amount, commercial banks find less money available to lend to its
clients and thus, money supply decreases.
The central bank can either purchase or sell securities issued by the government to
affect the money supply. For example, central banks can purchase government
bonds. As a result, banks will obtain more money to increase the lending and
money supply in the economy.
EXPANSIONARY VS CONTRACTIONARY MONETARY POLICY
It is a monetary policy that aims to increase the money supply in the economy by
decreasing interest rates, purchasing government securities by central banks, and
lowering the reserve requirements for banks. An expansionary policy lowers
unemployment and stimulates business activities and consumer spending. The
overall goal of the expansionary monetary policy is to fuel economic growth.
However, it can also possibly lead to higher inflation.
The RBI is the central bank of India. It was established on 1ST April 1935 under a
special act of the parliament. The RBI is the main authority for the monetary policy
of the country. The main functions of the RBI are to maintain financial stability and
the required level of liquidity in the economy.
The RBI also controls and regulates the currency system of our economy. It is the
sole issuer of currency notes in India. The RBI is the central banks that control all the
other commercial banks, financial institutes, finance firms etc. It supervises the entire
financial sector of the country.
OBJECTIVES
Promotion of saving and investment: Since the monetary policy controls the rate
of interest and inflation within the country, it can impact the savings and
investment of the people. A higher rate of interest translates to a greater chance
of investment and savings, thereby, maintaining a healthy cash flow within the
economy.
Controlling the imports and exports: By helping industries secure a loan at a
reduced rate of interest, monetary policy helps export-oriented units to substitute
imports and increase exports. This, in turn, helps improve the condition of the
balance of payments.
Managing business cycles: The two main stages of a business cycle are boom
and depression. Monetary policy is the greatest tool using which boom and
depression of business cycles can be controlled by managing the credit to control
the supply of money. The inflation in the market can be controlled by reducing
the supply of money. On the other hand, when the money supply increases, the
demand in the economy will also witness a rise.
Regulation of aggregate demand: Since monetary policy can control the demand
in an economy, it can be used by monetary authorities to maintain a balance
between demand and supply of goods and services. When credit is expanded and
the rate of interest is reduced, it allows more people to secure loans for the
purchase of goods and services. This leads to the rise in demand. On the other
hand, when the authorities wish to reduce demand, they can reduce credit and
raise the interest rates.
Generation of employment: As monetary policy can reduce the interest rate,
small and medium enterprises (SMEs) can easily secure a loan for business
expansion. This can lead to greater employment opportunities.
Helping with the development of infrastructure: The monetary policy allows
concessional funding for the development of infrastructure within the country.
Allocating more credit for the priority segments: Under the monetary policy,
additional funds are allocated at lower rates of interest for the development of the
priority sectors such as small-scale industries, agriculture, underdeveloped
sections of the society, etc.
Managing and developing the banking sector: The entire banking industry is
managed by the Reserve Bank of India (RBI). While RBI aims to make banking
facilities available far and wide across the nation, it also instructs other banks
using the monetary policy to establish rural branches wherever necessary for
agricultural development. Additionally, the government has also set up regional
rural banks and cooperative banks to help farmers receive the financial aid they
require in no time
INSTRUMENTS
Monetary policy is a way for the RBI to control the supply of money in the economy.
So these credit policies help control the inflation and in turn help with the economic
growth and development of the country. So now let us take a look at the various
instruments of monetary policy that the RBI has at its disposal.
1. Open Market Operations Open Market Operations is when the RBI involves
itself directly and buys or sells short-term securities in the open market. This is
a direct and effective way to increase or decrease the supply of money in the
market. It also has a direct effect on the ongoing rate of interest in the market.
Let us say the market is in equilibrium. Then the RBI decides to sell short-term
securities in the market. The supply of money in the market will reduce. And
subsequently, the demand for credit facilities would increase. And so
correspondingly the rate of interest would also see a boost. On the other hand,
if RBI was purchasing securities from the open market it would have the
opposite effect. The supply of money to the market would increase. And so, in
turn, the rate of interest would go down since the demand for credit would fall.
2. Bank Rate One of the most effective instruments of monetary policy is the
bank rate. A bank rate is essentially the rate at which the RBI lends money to
commercial banks without any security or collateral. It is also the standard rate
at which the RBI will buy or discount bills of exchange and other such
commercial instruments. So now if the RBI were to increase the bank rate, the
commercial banks would also have to increase their lending rates. And this
will help control the supply of money in the market. And the reverse will
obviously increase the supply of money in the market.
6. Repo Rate: The (fixed) interest rate at which the Reserve Bank provides
overnight liquidity to banks against the collateral of government and other
approved securities under the liquidity adjustment facility (LAF).
7. Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank
absorbs liquidity, on an overnight basis, from banks against the collateral of
eligible government securities under the LAF.
8. Liquidity Adjustment Facility (LAF): The LAF consists of overnight as
well as term repo auctions. Progressively, the Reserve Bank has increased
the proportion of liquidity injected under fine-tuning variable rate repo
auctions of range of tenors. The aim of term repo is to help develop the
inter-bank term money market, which in turn can set market based
benchmarks for pricing of loans and deposits, and hence improve
transmission of monetary policy. The Reserve Bank also conducts variable
interest rate reverse repo auctions, as necessitated under the market
conditions.
10.Corridor: The MSF rate and reverse repo rate determine the corridor for the
daily movement in the weighted average call money rate.
11.Bank Rate: It is the rate at which the Reserve Bank is ready to buy or
rediscount bills of exchange or other commercial papers. The Bank Rate is
published under Section 49 of the Reserve Bank of India Act, 1934. This
rate has been aligned to the MSF rate and, therefore, changes automatically
as and when the MSF rate changes alongside policy repo rate changes.
12.Cash Reserve Ratio (CRR): The average daily balance that a bank is
required to maintain with the Reserve Bank as a share of such per cent of its
Net demand and time liabilities (NDTL) that the Reserve Bank may notify
from time to time in the Gazette of India.
13.Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required
to maintain in safe and liquid assets, such as, unencumbered government
securities, cash and gold. Changes in SLR often influence the availability of
resources in the banking system for lending to the private sector.
Monetary policy refers to the use of monetary instruments under the control of
the central bank to regulate magnitudes such as interest rates, money supply and
availability of credit with a view to achieving the ultimate objective of economic
policy.
For an effective anti-cyclical monetary policy, bank rate, open market operations,
reserve ratio and selective control measures are required to be adopted
simultaneously. But it has been accepted by all monetary theorists that
(i) the success of monetary policy is nil in a depression when business
confidence is at its lowest ebb
(ii) (ii) it is successful against inflation. The monetarists contend that as
against fiscal policy, monetary policy possesses greater flexibility and it
can be implemented rapidly.
BIBLOGRAPHY