____________________________________________________________________________________________________

Subject Commerce

Paper No and Title 5. Business environment

Module No and 10. Government policies: monetary policy

Title
Module Tag Com_P5_M10

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

TABLE OF CONTENTS
1) Learning Outcomes

2) Understanding the concept of monetary policy and identify the objectives of Indian
monetary policy.

3) Assess the role of RBI and the role of tight and liberal monetary policy in economic
development.

4) Evaluate the different instruments of credit policy.

5) Compare the impact of Indian fiscal and monetary policy on the economic environment.

6) Summary

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you shall be able to:

 Understanding the concept of monetary policy and identify the objectives of Indian
monetary policy.

 Assess the role of RBI and the role of tight and liberal monetary policy in economic
development.

 Evaluate the different instruments of credit policy.

 Compare the impact of Indian fiscal and monetary policy on the economic environment.

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

2. Understanding the concept of monetary policy and identify the

objectives of Indian monetary policy

Monetary policy is a guiding policy by which the central bank i.e. Reserve Bank Of India (RBI)
of a country controls the supply of money, availability of bank credit and cost of money, that is,
the rate of Interest. It is one of the tools to control money supply in our economy.
Monetary policy is the macroeconomic policy laid down by the central bank. It involves
administration of money supply and interest rate. It is used by the government of a country to
achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
The RBI implements the monetary policy through open market operations, bank rate policy,
reserve system, credit control policy, moral persuasion and through many other instruments. All
this will make changes in the interest rate, or the money supply in the economy. Monetary policy
can be expansionary and contractionary in nature. Increasing money supply and reducing interest
rates indicate an expansionary policy. The reverse of this is a contractionary monetary policy.

OBJECTIVES OF MONETARY POLICY

In any economy the main objective of monetary policy is to regulate the demand and
supply of money. It aims to stabilize the prices of goods and services in an economy.
Monetary policy regulates the use of money. It also brings institutional changes in the
financial sector of the economy. Following are the main objectives of monetary policy in
India :-

1) STABLE GROWTH
Monetary policy aims to control the supply of money in such a way so that it is
enough to meet the demands for funds by peoplr.attempts are made to keep the resource
at such level so that there is stability of prices plus growth in the economy.

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

2) DEVELOPMENT OF FINANCIAL STABILITY

a stable economy is the one which is not much affected by the ups and downs of the
market.the economy which can bear the shocks of depression and recession period is a
strong one.these shocks are not good for any financial system.It is the duty of RBI to take
care of these things and always work to maintain the financial stability of the economy.

3. ATTENTION TO PRIORITY SECTORS OF THE ECONOMY

The main aim of any monetary policy is to ensure that all the people,all the sectors,all the
manufacturing and producing sector requirements of money must be met on time.RBI in
our country constantly makes efforts to provide timely and adequately credit at affordable
cost of weaker sections and low income groups. RBI, along with NABARD, is focusing
on microfinance through the promotion of Self Help groups and other institutions.

4. EMPLOYMENT GENERATION
As banks lowers the interest rates there increases the demand for money to be put in
investment activities for infrastructure development etc.this leads to increase in demand
for labour force to complete the construction and other ancilliary activities.ths it increases
the rate of employment in an economy.

5. EXTERNAL STABILITY
With the growth of imports and exports India’s linkages with global economy are getting
stronger. Earlier, RBI controlled foreign exchange market by determining eaxchange rate.
Now, RBI has only indirect control over external stability through the mechanism of
‘managed Flexibility’, where it influences exchange rate by buying and selling foreign
currencies in open market.

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

6. RISE IN SAVINGS AND INVESTMENT

RBI by offering eye-catching interest rates boosts savings in the economy. A high
rate of saving promotes investment. Thus the monetarypolicy by influencing rates of
interest can influence saving mobilization in the country.

3. Assess the role of RBI and the role of tight and liberal monetary
policy in economic development.

A Monetary policy is said to be tight if RBI increases the rate of interest thus leaving
people with less opportunity to get borrowed funds for their purchases and investments.
Similarly a monetary policy is said to be liberal if RBI decreases the rate of interest thus
leaving people with opportunity to get borrowed funds for their purchases and
investments.
RBI controls monetary policy through various ways. Some are:
The repo rate is the rate at which banks borrow short-term funds from the RBI, while the
reverse repo rate is the rate at which the RBI borrows fund from the banks. The cash
reserve ratio (CRR), which is the amount commercial banks have to keep as a deposit
with the RBI. The more the CRR, the less will be the lending capacity of banks. The RBI
uses the CRR to check liquidity in the market. If the RBI increases the CRR, the
additional deposits required by banks would reduce their lending power resulting in less
liquidity in the market. The fact the RBI did not adjust the CRR when it increased repo
rates; is a clear indicator they are anxious to maintain liquidity (money supply) to keep
stability in the market.
So we can see that whether RBI measures a tight or liberal policy has a direct impact on
the economic development of our country because it affects the availability of funds with
public.
COMMERCE PAPER No. 5: Business Environment
MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

4. Evaluate the different instruments of credit policy.

RBI has quantitative and qualitative measures to influence the money supply and
demand in the economy. The qualitative and general measures in affects the volume of
credit while qualitative measures the selective or particular use of credit.
QUANTITATIVE MEASURES

1) BANK RATE

The bank rate is the rate at which RBI rediscounts the approved bills held by commercial
banks. For controlling the credit, inflation and money supply, the RBI changes the bank
rate in the economy.

2) OPEN MARKET OPERATIONS

It refers to direct sale and purchase of securities of government in the open market to
control the volume of credit. To reduce the volume of credit these securities are sold in
the market whereas to increase the amount of money supply these securities are brought
from the market.

3) CASH RESERVE RATIO

CRR refers to that portion of total deposits that commercial banks are required to keep
with the RBI. It reduces the lending capacity of banks.

4) STATUTORY LIQUIDITY RATIO

SLR refers to that portion of total deposits that banks are required to keep with
themselves or in liquid assets. This also reduces the lending capacity of bank .

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

QUALITATIVE MEASURES
These are used by banks for selective purposes. Sometimes it could be to promote the
money supply in a particular sector or to reduce in that sector. Measures for qualitative
control are:

1) MARGIN REQUIREMENT
It refers to the difference between the securities offered and the amount borrowed by
banks. More the mar gin requirement less will be the supply of ,money.

2) MORAL SUASION
It refers to psychologically persuading the people to invest in particular sector.

3) CREDIT RATIONING
It refers to rationing the amount of credit given by banks. The RBI keeps on changing the
limits to increase or decrease the money supply in the economy.

5. Compare the impact of Indian fiscal and monetary policy on the

economic environment.

The monetary policy involves changing the interest rate and influencing the money
supply. Fiscal policy involves the government changing rates and levels of government
spending to influence aggregate demand in the economy. These are both used to pursue
policies of higher economic growth and controlling inflation. For example, the central
bank may have target of 3% inflation rate. if they feel inflation is going to increase this
targeted rate due to quick economic growth, then they can increase interest rates. Higher
interest rates increase borrowing costs and reduce consumers spending and investment,
leading to lower aggregate demand and lower inflation. If the economy goes into
recession, the RBI would cut down the interest rates.

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

Whereas fiscal policy is carried out by the government

and it involves change of level of government spending and level of taxation. To increase
demand and economic growth, the government will lower down the taxes and increase
spending, leading to higher budget deficit. On the other hand, to reduce demand and
reduce inflation, the government can increase tax rates and cut spending, thereby leading
to smaller budget deficit.
Thus, Indian fiscal and monetary policies have great impact on its economic
environment. The nature of unemployment in our country is due to lack of capital
formation. In India, fiscal policy will help us to reduce the level of unemployment. In
such a situation, government may decide to increase borrowing and spend more on
infrastructure spending. This increased government spending will inject money into the
economy and helps create jobs. The lower the rate of interest, more will the demand for
money for capital investment. Sometimes it is also suggested to keep the interest rates
high as it will limit the allocation of scarce resources in the most efficient manner. The
qualitative methods of credit control should be handled properly to ensure reasonable
control on investments and reduce the adverse effect of it. In the same way fiscal policy
directly impacts the consumption pattern of consumer. If there will be more taxes then
lesser portion of income would be left for consumption. Which ultimately bring down
demand for goods and thus the demand for money and vice-versa. On the other hand,
more spending by government would increase the demand forcing the banks to increase
interest rates. Thus we can see that fiscal and monetary policies are interrelated and have
a great impact on our economy.

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy
____________________________________________________________________________________________________

6. Summary

Monetary policy is a guiding policy by which the central bank i.e. Reserve Bank Of India
(RBI) of a country controls the supply of money, availability of bank credit and cost of
money, that is, the rate of Interest. It is one of the tools to control money supply in our
economy.
The RBI implements the monetary policy through open market operations, bank rate
policy, reserve system, credit control policy, and moral persuasion and through many
other instruments. All this will make changes in the interest rate, or the money supply in
the economy. Monetary policy can be expansionary and contractionary in nature.
Increasing money supply and reducing interest rates indicate an expansionary policy. The
reverse of this is a contractionary monetary policy.
The Indian fiscal and monetary policies have great impact on its economic environment.
The nature of unemployment in our country is due to lack of capital formation. In India,
fiscal policy will help us to reduce the level of unemployment. In such a situation,
government may decide to increase borrowing and spend more on infrastructure
spending. This increased government spending will inject money into the economy and
helps create jobs.

COMMERCE PAPER No. 5: Business Environment

MODULE No. 10: Government Policies: Monetary Policy