UNIT 3

TOPIC 1: MONETARY POLICY

Monetary Policy: The policy adopted by the government for controlling inflationary situation
in the economy.
It is a government policy, used by the central bank of the country. Central bank is responsible
to come up with the MP of the country. MP relates to the policies which may affect the supply
of money in the economy because Central Bank is concerned with the printing of notes in the
country, and since it is concerned with printing of notes – all the policies related to the supply
of money are governed by the central bank of the country.
When we talk about MP, we are talking about the policy drafted by the central bank of the
country to control the money supply in the economy.
2 types of policy – Monetary and Fiscal.
Monetary – Policies relating to the supply of money in the economy. Comes from the central
bank.
Fiscal – Policies relating to government’s taxation, public revenue and public expenditure
Fiscal Policy comes from the side of Finance Ministry of the GOI.
Both monetary and fiscal policy of the government have these objectives of full employment,
price stability, economic growth etc., and it is said that MP and FC should move in the same
direction, only then there will be proper effect to the economy.
Whatever changes the government wants to bring in the economic variables, that can be
brought up only with the concerted efforts of both the monetary policy and the fiscal policy.

OBJECTIVES
1. Full employment: Keynesian concept of Inflation – any situation which is prior to full
employment will lead to increase in output, employment and income. So, objective of any
government would be to attain full employment because full employment means full
employment of resources, absence of any involuntary unemployment. Involuntary
unemployment means anyone who is asking for work should get employment. Anyone who
doesn’t want to work and doesn’t take up employment – won’t be considered unemployed.
Unemployed – those who are asking for work but not getting any. This is absence of
involuntary unemployment. It can be achieved by following expansionary monetary policy.
Therefore, attaining full employment is always an objective any economy and this objective
can be achieved by following expansionary monetary policy.
2. Price Stability: The objective of MP is to stabilise the fluctuation in price. It doesn’t mean
stagnation of price. Price stability must be there – too much fluctuation of prices should be
avoided. In inflationary situation, there’s too much fluctuation of prices – leads to uncertainty
– not good for economy. To avoid this, MP. It brings in stability in the fluctuation in the price
level.
3. Eco Growth: Means growth of real per capita income over a long period of time. Growth of
real per capita income is important for the growth of the economy. So, MP through the
controlling of Rate of Interest, it creates the effect of promoting the level of investment and
economic growth in the economy. MP’s tool is – controlling the ROI. This ROI is important
because it is the price which is paid for getting or giving loans. These loans are important –
they are a financial capital for the producers who want to invest money. When ROI is
governed through MP, it leads to increased level of investment. Hence, it leads to economic
growth in the country.
4. BoP Equilibrium: Any country wants to attain BoP equilibrium. BoP equilibrium is when
there is no surplus or deficit in the BoP of the country, especially the deficit. Countries wish
to avoid deficit situation in BoP. Deficit – outflow of foreign exchange > inflow of foreign
exchange. This MP again adopts various tools to attain this BoP equilibrium in the economy.
The tools of MP are also relevant for discussing the strategies to maintain equilibrium in the
BoP.

TOOLS OF MONETARY POLICY/MEASURES ADOPTED

BY CENTRAL BANK TO CONTROL CREDIT
Note: This topic is equally relevant to measures to control credit by the central bank.
Under MP 2 set of measures – quantitative and qualitative. Central Bank adopts both to
control credit. Qualitative measures affect where the credit should go and where it should be
restricted. To whom the credit is going – say, to the producers, farmers, etc. It controls that.
Quantitative Measures– control the quantity of credit going to the public, banks.
Qualitative Measures – control to what target population the credit should be going, or they
govern the type of credit, loans that is going to various segments of the economy.
In India, on a quarterly basis, the RBI gives its Monetary Policy – like what will be the bank
rate, CRR, etc.

TOOLS/MEASURES:
1. Quantitative Measures – Which tend to control the credit in quantitative terms,
that is the quantity of credit. They affect the quantity of money supply or credit in the
economy.
• Bank Rate:
Definition: The rate at which Central Bank rediscounts its first-class bills of exchange
and security.
The rate of interest at which the Central Bank gives loans to the commercial banks.
Commercial banks, in their bid to create credit and for their daily operations, need
funds. If they have a liquidity crunch and they need more funds, they can buy it from
some other bank. But when the other banks are also not able to provide funds, the
last resort is the Central Bank from whom they can get the funds. So, Bank Rate is the
rate at which Central Bank provides loans to the commercial banks at times of their
need. Normally, in most economies, Bank Rate is the anchor lending rate. That is, all
other interest rates in the economy follow the bank rate. So, if Bank Rate increases,
all other interest rates increase. Suppose the Central Bank increases the Bank Rate,
say, to control inflation, it will make the availability of funds more dearer
(contractionary monetary policy – when supply of money in the economy is reduced),
that is, the price of loans or funds which are made available by the commercial banks
will be increased too. So, when supply of money in the economy has to be reduced,
the credit creation power of commercial banks has to be curtailed. How to curtail?
 Only when the price that is paid in return for getting these funds is increased. What
is the price? RATE OF INTEREST. Since, central bank is following a contractionary
monetary policy, it wants to increase the ROI. What will it do? It will increase the Bank
Rate. Now, in most of the economies, other interest rates follow the bank rates in a
similar pattern. So that if BR increases, that means Commercial Banks are getting
funds at a higher ROI, in turn they will charge a higher interest rate with their clients,
to whom they are giving loans. Since, now the people are getting loans at a higher
rate, price is increasing – demand will decline. So, interest rates will rise and demand
for loans will decline, which will lead to decreased money supply in the economy.
Example: if I take a loan of Rs. 1 crore, then money supply worth Rs. 1 crore has
increased in the economy.
The ROI which is charged by the Central Bank in giving loans to the commercial banks.
It is just an interest rate. It is known as Marginal Standing Facility (MSF). Since 2011,
bank rate in India is called MSF. MSF is provided by the RBI (Central bank) to
commercial banks if the latter don’t have eligible securities with them.
In most of the economies, bank rate is the policy lending rate, all other interest rates
follow it. Initially in India, RBI used to use Bank Rate as a tool of Monetary Policy (or
controlling credit) frequently but now in the recent years, RBI is using other rates. It
is just used as MSF in the country. MSF is the facility provided by RBI to commercial
banks if the banks don’t have enough securities with them for getting loans from
other sources. At the time of liquidity crunch, Bank Rate is used by the commercial
banks, but not very frequently.
• Reserve Ratios: CRR &SLR. Cash Reserve Ratio. Statutory Liquidity Ratio. What is CRR?
All the commercial banks are required by law to maintain a certain percentage of its
total deposits in the form of reserve funds with the central bank. When the central
bank is following a contractionary monetary policy, that is, it wants to curtail credit
creation power of the commercial banks – central bank will increase the CRR. Reverse
happens when the Central Bank follows an expansionary monetary policy. So then,
CRR will be reduced.
SLR: All the commercial banks are required by law to maintain a certain percentage
of its total deposits in the form of gold foreign exchange and securities with them.
Ex: Say, the bank has Rs. 1000. Now, 10% of 1000 has to be kept as CRR. If SLR rate is
15%, out of the total deposits which they have – 15% of it has to be kept in form of
other liquid assets. OLA – gold, forex, approved securities, etc.
Again, if the Central Bank follows a contractionary monetary policy, it will increase
the SLR rate also. So that out of all their deposits, they have to keep a certain
percentage in the form of gold, forex, securities. That means excess funds will be
further reduced. When the excess funds are reduced, credit creation power of the
Commercial Banks is again curtailed.
During contractionary MP – CRR and SLR are increased.
During expansioary MP – CRR and SLR are reduced.
• Open Market Operations: OMO deal with the sale and purchase of government
securities in the money market. The government takes loans from public or market
in the form of government securities. GS are IOU papers/certificates on which certain
amount is written and it is written that “this much amount of money is transferred
by the public to the government at so and so rate of interest for so and so period.” It
means that much amount of money is transferring from public to the government.
 So, government takes this loan in the form of government securities (safest option to
invest in). But these government securities are in huge volumes. So, 90% of the
securities are purchased by the commercial banks, so that they can park their excess
funds in the form of government securities which is the safest option because the risk
involved in government securities is minimum. In one way, government securities
have a ready market in the form of commercial banks, because by law too commercial
banks have to purchase these securities because of SLR requirements. The sale and
purchase of securities is known as the OMO of the central bank. During the time of
contractionary monetary policy, central bank sells/floats government securities in the
market. During the time of expansionary monetary policy, central bank will purchase
the government securities from the commercial bank. Now the funds transfer from
the Central Bank to the commercial banks and the excess reserves of the commercial
bank increases and they have more funds with them to create credit. That is how
OMO is done.
• Repo & Reverse Repo Rate – Liquidity Adjustment Facility (LAF): Rate of interest
charged by the Central and Commercial banks for getting loans. Since 2000, repo and
reverse rate are covered under Liquidity Adjustment Facility (LAF). LAF is provided by
the Central Bank to provide loans to the commercial banks for just 1 day.
Commercial Banks do a lot of transactions day to day in heavy volumes. They might
be in need of funds. They can get funds from each other. During acute liquidity
crunch, they can get these funds from Central Bank. Very short loan. They can get
funds from the Central Bank overnight.
This is done at a repo rate. It is also like an interest rate. It is the rate at which the
central bank gives loans to commercial banks. Repo means repurchase auctions –
repo rate is the commercial banks getting loans from the Central Bank with the
promise that they will purchase these securities at a later date. Hence, the name repo.
The commercial banks take loans from the central bank at this repo WITH this
promise that they will repurchase these securities at a later date. Now how the
central bank gives these loans to comm banks for one day? It gives these loans in
return for the securities.
Securities is the collateral.

REPO RATE IS LOWER THAN BANK RATE.

BR IS LONG TERM RATE; RR IS SHORT TERM RATE.
RR – MOST FREQUENTLY USED.

Reverse Repo was also introduced by the RBI. It is an opposite contract. Under RRR,
banks can park their excess cash with RBI to avail a rate of interest called RRR.
When the commercial banks have excess funds, they can give away as loans too, but
also they can park these excess reserves with the central bank and get a ROI in return.
So they can park these excess reserves with the central bank at an interest rate called
RRR.
In normal terms, RRR is the ROI at which Comm Banks gives loans to Central Bank.

Repo rate and RRR are used as policy rates. They have become important tools to
control inflation these days.
RR has become an anchor rate for short term funding.
 Introduced in 2000. Both RR and RRR are known as LAF in our country.

QUALITATIVE MEASURES/SELECTIVE CREDIT CONTROL

It also has to be seen to whom the credit is flowing. Central bank also has certain measures
to govern or to control as to what credit should be flowing to what target population. There
are several economic variables/people who are in need of funds –
producers/farmers/consumers/etc. Quantitative credit control does not see as to whom the
credit is going. Qualitative measures will govern as to where the credit is going, or what
amount of credit is going in a differential pattern.
Sometimes central bank wants to govern only 1 set of credit going to a particular economic
entity, so this can be done through Selective Credit Control.

a) Regulation of Consumer Credit: This facility is used by the central bank to regulate the
credit going to the consumers. We know that the consumers can take loans from
banks to purchase cars, etc. Now, consumer credit is regulated through 2 instruments
in the form of minimum down payment and maximum period of repayment.
So, when we go to any bank to purchase a loan to buy a car. The bank will provide me
funds, but it will use 2 devices - minimum down payment and maximum period of
repayment. Minimum down payment is the amount of money which I have to give at
the time of purchase of that consumer good. So, that much amount of money has to
be given by me through my pockets.
The amount of MDP depends on the price of the good.
CONTRACTIONARY MP: Now, if the central bank wants to reduce the amount of credit
flowing to the consumers – it will increase the MDP and MPR will be reduced.
Consumer credit will go down because the method has become tedious now.
Reverse will happen in expansionary MP.
b) Regulation of margin requirements: Margin requirements means certain people are
dealing with the sale and purchase of shares or securities are in need of funds. Central
bank fixes minimum margin requirements on loans for purchasing securities. So,
commercial banks give funds for purchasing securities as well. Now, margin
requirements prevent excessive credit use for purchasing or carrying securities by
speculators.
If someone takes loan of 10,000 for purchasing securities. And the minimum margin
requirement is 10%, then he will only get 9,000 as loans for purchasing securities. 1000
will be kept by the commercial banks itself.
CONTRACTIONARY MP, AND CENTRAL BANK WANTS TO CONTROL THE AMOUNT OF
LOANS GOING TO PEOPLE TO PURCHASE THESE SECURITIES – IT WILL INCREASE THE
MINIMUM MARGIN REQUIREMENT. It only affects the sale and purchase of
government securities. Margin requirement increase – purchase of securities will decl
ine. Margin requirement decrease – purchase of securities will increase.
c) Rationing of Credit: That is, ceilings are placed on the purchase of loans. The Central
Bank rations that this much percent of loan will go to this that etc. Farmers, artisans,
etc.
d) Direct Action: Directives are given to the erring banks.
e) Moral Suasion: Request the bank to follow.
f) Publicity: Creating public awareness of the policies adopted by the commercial banks.
ROLE OF MONETARY POLICY
According to the objectives, the MP plays a role in:
1. Controlling Inflationary Pressures: in the economy, because we have seen that there are
many tools to control inflationary pressures. Hyperinflation is not good in an economy, so to
control the pressures in the economy – MP is adopted.
2. Achieving price stability: it brings proper adjustment between demand and supply of
money. It happens that there are a lot of non-monetized sectors, means initially barter system
but they became monetized later. As more and more transactions become monetized, the
demand for money increases, seeing this, Central Bank releases funds in the market in the
form of increased money supply in the economy. So, demand and supply of money
equilibrium is maintained through monetary policy.
3. Bridging BoP Deficit: Through MP, the Central Bank bridges the BoP deficit. Deficit is
created when payment paid for imports > payment received for exports. So, the Central Bank
adopts MP to control the interest rates in the economy. Through MP, if rationing is done of
funds for exports or increases the interest rate – imports will be curtailed, and deficit will be
contained. So, through a set of MP, the gap between export and import is covered by the
Central Bank.
4. Controls the Interest Rate: All the policy interest rates are governed through the MP
because there is Bank Rate, Repo Rate, Reverse Repo Rate. These are all governed through
Central Bank through its MP, and the banking habits of people are increased. If they get high
ROI, they will keep more money with banks. Banking habits increase. It can speed up the
monetization of the economy. It is advisable to follow a differential interest rate policy.
Deposit rate increasing or lending rate? Governed by Central Bank.
5. Creating banking and financial institutions: It encourages establishment of more banks;
especially rural banking is achieved.
6. Debt Management: The MP aims at proper timing and issuing of Government Securities
and Bonds, etc. So, through OMO, government securities and bills are floated at the proper
time according to the requirement of the economy. Time, availability of credit, funds, supply
of money – the Central Bank floats securities, bills keeping in mind all these things so as to
ensure proper debt management of the economy. Prices are stabilized and inflationary
situation is controlled.

This is how MP plays an important role in bringing equilibrium into the economy.

LIMITATIONS OF MONETARY POLICY

It is not necessary that the MP will definitely control the money supply, monetary situation
or the inflationary situation in the economy because the success of MP is limited by certain
constraints which are inherent in the economy. If limitations are there, MP won’t be able to
achieve its objectives to that extent.
1. Large non-monetized sector: In the underdeveloped or developing economies, large non
monetized sectors are still non monetized, especially in villages – barter system. Transactions
do take place, demand is created, supply fulfils but monetary transactions don’t take place.
Central banks focus on controlling only the money supply in the economy. If large non
monetized sector – MP will be ineffective. Government does try to bring more sectors into
the monetized sector.
2. Undeveloped money and capital market: In such underdeveloped countries, money and
capital market are not much developed. The MP has its tools in the form BR, CRR, SLR, OMO,
etc., how do they function? They function in the form of instruments of credit that are
available in the money and the capital market. What are the instruments of credit?
Instruments of credit are the ways through which, loans or credit creation takes place. They
may be in the form of bills, securities, bonds, shares, stocks, etc. When most instruments
exist, only then money supply can be effective. But in an underdeveloped economy, very few
credit instruments are available. The banking sector is also not much developed, very few
banks with few branches. Especially not there in rural areas. So, the banking habits of people
are not much developed. People don’t keep their money with banks. May keep with
themselves, or village money lender or some local people. These are called indigenous banks.
Indigenous bankers like village money lenders or the traders or the shopkeepers – they are
more prevalent in the village area to give loans to people and also to keep their money safe
in their deposits. Because of the existence of these indigenous bankers, the money supply
becomes ineffective because the MP is only meant for banks in the organized sector, that is
the institutional banks. Since MP policy is meant only for those banks which are in the
organized sector, the Central Bank has control only over them. So, MP becomes ineffective
for indigenous bankers.
3. Large NBFCs: These are large number of NBFCs (Non-Banking Financial Companies). Just
like the indigenous bankers, many NBFCs exist too. These NBFCs are the financial institutions
which are involved in accepting deposits from the public at a rate of interest and giving loans
with the same deposits to the public charging them a rate of interest. They are doing the
buying and selling of money, but they are not registered as banking companies and hence the
name NBFCs. Before the Companies Act 2013 came into operation, the NBFCs were not
regulated and they were not covered under the Companies Act. There was no precise
definition of what these NBFCs are. They were outside the purview of regulation and control.
They didn’t come under Central Bank because they were non-banking companies. They were
not corporate companies, so they were outside the control of SEBI. So, from nowhere these
companies could be control. There was no provision for them as to how they should operate.
Although Companies Act 2013 has come up with the definition of NBFCs and some regulation
has now come up with it, still large number of NBFCs are outside the purview of the Central
Bank, because they are not registered by either SEBI or RBI under the Banking Regulation Act.
Only a handful of them are registered. Hence, central bank is not aware of the existence of
these NBFCs. But these NBFCs hold a market share of a large chunk of the transactions in the
form of loans that they provide. They continue with their operation whereas the MP cannot
be applied to them because they aren’t registered, or the Central Bank is not aware of their
existence. Hence, the efforts of MP become ineffective because of the existence of these
NBFCs.
4. High amount of Liquidity: Now banking habits have developed in India – so many banks,
so many bank branches, so many private sector banks, many foreign banks which have very
huge infrastructure, strong financial existence. These foreign banks and private sector banks
have huge liquidity with them available. Even if the Central Bank follows some MP, it wants
to control money or it wants to reduce the supply of money in the economy – Central Bank
will operate through controlling or increasing the CRR, SLR. Since these banks have huge
liquidity with them, so they have huge excess reserves even after compensating for the CRR
and SLR guidelines. Efforts of the MP become ineffective.
5. Foreign Banks: It relates to the previous point. In India we have many foreign banks. They
have huge financial presence and they have liquidity, so they have huge excess money with
them.
6. Small Bank Money: Banking habits of people are not developed in underdeveloped or
developing economies, so they don’t keep much amount of savings in the form of money with
banks and the credit creation habit of banks is limited by the amount of deposits which they
have in their banks.