Monetary Policy

Introduction
• Monetary policy is essentially a programme of action undertaken by the monetary authorities, generally the central bank,
to control and regulate the demand for and supply of money with the public and flow of credit with a view to achieving
predetermined macroeconomic objectives.
• Objectives :
• Economic Growth
• Employment promotion
• Economic stability and stability of the price level.
• Monetary policy measures include
• Quantitative
• Bank Rate
• Open Market Operation
• Variable Reserve ratio
• Cash Reserve ratio
• Statutory Liquidity Ratio
• Qualitative Measure
• Margin Requirement
• Moral Suasion
• Credit rationing
• Direct controls
Bank Rate
• Bank rate refers to the rate at which the central bank further discounts the bills of exchange
presented by commercial bank.
• If commercial banks are not left with adequate cash reserves, they are required to consult the
central bank for rediscounting their bills of exchange.
• For the rediscounting of bills of exchange, the central bank charges a particular amount from
commercial banks that is termed as bank rate. Also known as discount rate
• The central bank changes the bank rate depending on its purpose of increasing or decreasing the
flow of money banks.
• In case, the central bank wants to increase the credit creation capability of commercial banks, then
it decreases the bank rate and vice-versa. 
• Firstly, an increase in discount rate results in the decrease of net worth of government securities on
the basis of which commercial banks get loans and credit from the central bank
• Secondly, when the discount rate of the central bank increases, then the discount rate bank also
increases.
Open market operation
• Open Market Operations of a government involve the sales and purchase of government securities
and treasury bills by the central bank.
• If the central bank wants to increase the supply of money with the public, it purchases government
securities and treasury bills.
• On the other hand, if the central bank wants to decrease the supply of money, it sells the
government securities and treasury bills. 
• Government securities are purchased by commercial banks, financial institutions, large businesses,
and individuals having high income.
• When the customers purchase these bonds, the money is transferred from their bank accounts to the
central bank account.
• Apart from this, in case commercial banks themselves purchase government securities, their cash
reserves decrease. As a result, the credit creation capacity of commercial banks decreases.
• In case the central bank wants to increase the supply of money in economy, it purchases
government securities from commercial banks and other purchasers of government securities.
• This leads to an increase in deposits and reserves of commercial banks. Consequently, the credit
creation capacity of commercial banks increases, which raises the flow of credit to the public.
Variable Reserve Ratio
• CRR refers to the percentage of credit that needs to be maintained by commercial
banks in the form of cash reserve with the central bank.
• CRR is usually determined by the previous experience of banks related to the extent
of cash demanded by depositors
•  When there is a need of contractionary monetary policy in the economy, CRR is
increased by the central bank.
• Commercial banks need to reserve a-large amount of their total deposits with the
central bank. As a result, the credit creation capability of commercial banks
reduces, which further decreases money supply in the market. 
• In case there is a requirement of increasing supply of money in the economy, the
rate of CRR is decreased by the central bank. In such a case, the credit creation
capability of commercial banks increases.
• SLR is the amount of money that commercial banks need to keep with them in the
form of liquid assets.
Margin Requirement
• The difference between the amount of loan and total value of property is termed as lending margin.
• For example, if the value of a property is Rs. 100 million and amount of loan provided on this
property is Rs. 60 million, then the lending margin is 40%.
• The central bank has the power to make any type of changes in the lending margin on the basis of
increase or decrease in the bank credit.
Moral suasion
• Refers to a measure of assuring and influencing commercial banks to raise credit in alignment with
the directives set by the central bank.
• The moral suasion method is used when other quantitative measures of monetary policy are not
effective for monetary control.
• In this method, the central bank conducts meetings with commercial banks and writes letters to
them. The main purpose of holding meetings is to persuade commercial banks to work as per the
rules of the central bank and for the welfare of the economy.
Credit rationing
• Central bank resorts to credit rationing measures.
• They are : imposition ofupper limits on the credit available to the large industries, charging a
higher interest rate on loans beyond a certain limit, providing credit to weaker sections.
Direct controls
• Commercial banks perform their lending activities according to the instructions of the central
bank.
• One more measure that is adopted by RBI is repo rate and reverse repo rate. Repo rate refers
to the rate at which RBI charges commercial banks when they take money from it. On the
other hand, reverse repo rate refers to the rate at which RBI is ready to retain the money of
commercial banks with it.
• Repo rate helps in increasing the supply of money to reverse repo rate reduces the supply of
money. The changes are made in repo rate and reverse repo rate by RBI according to the
economic conditions
Challenges of monetary policy measures
Time Gap
• It involves time taken in formulating and implementing monetary policy in an economy.
Time gap can be classified into two categories, namely, inside time lag and outside time lag.
• Inside time lag denotes to the time gap in analyzing the type, selection, and implementation
of monetary policy as well as its results. On the other hand, outside time lag is the time
taken to receive feedback from individuals and organizations on monetary measures that are
implemented in the economy.
Difficulty in Forecasting
• Forecasting economic conditions has always been a controversial issue.
• This is because different economists have different viewpoints and they analyze the
situation differently. Forecasting based on guesses is unfruitful. Therefore, monetary policy
can be effective if it is based on evidences.
Non-banking Financial Intermediaries:
• Refers to the fact that the growth of financial market has decreased the scope of
monetary policy. With the emergence of non-banking financial intermediaries, such as
industrial development banks, insurance companies, and mutual funds, there is only a
small room for bank credit.
• This new segment of the economy is responsible in grabbing the share of commercial
banks. The non-financial intermediaries do not make credit with the help of credit
multiplier, but their share in money supply makes the monetary policy ineffective.
Less Development of Money and Credit Market:
• The effectiveness of monetary policy depends upon the efficiency of money and credit
market.
• In underdeveloped countries, the structure of money and credit market is not so
strong. Therefore, monetary policy in these countries has proved ineffective.