Monetary Policy

The term monetary policy is also known as the 'credit policy' or called 'RBI's money
management policy' in India. Monetary policy is regarded as necessary tool of economic
management. Monetary policy refers to the use of official instruments under the control of the
Central Bank to regulate the availability, cost and use of money and credit. It influences the
economic trends.

Definition of Monetary Policy

According to A.G. Hart,

"A policy which influences the public stock of money substitute of public demand for such assets
of both that is policy which influences public liquidity position is known as a monetary policy."

The Central Bank of a nation keeps control on the supply of money to attain the objectives of its
monetary policy.

Objectives of Monetary Policy

The objectives of a monetary policy in India are similar to the objectives of its five year plans. In
a nutshell planning in India aims at growth, stability and social justice. After the Keynesian
revolution in economics, many people accepted significance of monetary policy in attaining
following objectives.

1. Rapid Economic Growth

2. Price Stability
3. Exchange Rate Stability
4. Balance of Payments (BOP) Equilibrium
5. Full Employment
6. Neutrality of Money
7. Equal Income Distribution

The efficacy of monetary policy depends on the prevailing economic situation and structural
factors like,

(i) The proportion of currency in money supply.

(ii) Size of public debt.

(iii) Non-monetized sector in the economy.

(iv) Pre sence of active sub-markets.

(v) The degree of imbalance in the overall supply, demand situation

(vi) Trends in agricultural and industrial production.

(vii) General Price level, and

(viii) The balance of payment situation.

Monetary Policy Techniques/Tools/Instruments

instruments or techniques or Tools of monetary policy can be divided into two categories:

(A) Quantitative or General Methods.

(B) Qualitative or Selective Methods.

A. Quantitative or General Methods:

1. Bank Rate or Discount Rate:

Bank rate refers to that rate at which a central bank is ready to lend money to commercial banks
or to discount bills of specified types.

2. Open Market Operations:

By open market operations, we mean the sale or purchase of securities. As is known that the
credit creating capacity of the commercial banks depend on the cash reserves of the

3. Variable Reserve Ratio:

The commercial banks have to keep given percentage as cash-reserve with the central bank. In
lieu of that cash ratio, it allows commercial banks to contract or expand its credit facility. If the
central bank wants to contract credit (during inflation period) it raises the cash reserve ratio.

4. Change of Liquidity:

According to this method, every bank is required to keep a certain proportion of its deposits as
cash with it. When the central bank wants to contract credit, it raises its liquidity ratio and vice
versa.

B. Qualitative or Selective Methods:

1. Change in Marginal Requirements:

Under this method, the central bank effects a change in the marginal requirement to control and
release funds. When the central bank feels that prices are rising on account of stock-piling of
some commodities by the traders, then the central bank controls credit by raising the marginal
requirements. (Marginal requirement is the difference between the market value of the assets and
its maximum loan value). Let us suppose, a borrower pledged goods worth Rs. 1000 as security
with a bank and gets a loan amounting to Rs. 800.

2. Regulation of consumer credit:

During inflation, this method is followed to control excess spending of the consumers. Generally
the hire purchase facilities or installment methods are used to reduce to the minimum to curb the
expenditure on consumption. On the contrary, during depression period, more credit facilities are
allowed so that consumer may spend more and more to pull the economy out of depression.

3. Direct Action:

This method is adopted when some commercial banks do not co-operate with the central bank in
controlling the credit. Thus, central bank takes direct action against the defaulter. The central
bank may take direct action in a number of ways as under.

(i) It may refuse rediscount facilities to those banks who are not following its directions.

(ii) It may follow similar policy with the bank seeking accommodation in excess of its capital
and reserves.

(iii) It may change rates over and above the bank rate.

(iv) Any other strict restrictions on the defaulter institution.

4. Rationing of the credit:

Under this method, the central bank fixes a limit for the credit facilities to commercial banks.
Being the lender of the last resort, central bank rations the available credit among the applicants.

6. Publicity:

Publicity is also another qualitative technique. It means to force them to follow only that credit
policy which is in the interest of the economy. The publicity generally takes the form of
periodicals and journals. The banks are not kept informed about the type of monetary policy, the
central bank regards goods for the economy. Therefore, the main aim of this method is to bring
the banking community under the pressure of public opinion.