CHAPTER SIX

Instruments of Monetary Control

 Chapter contents

6.1. Open Market Operations (OMOs)

6.2. Variations in Reserve Requirements (RR)
6.3. Discount Rate Policy
6.4. Miscellaneous: Instruments of Monetary Policy
 6.1. Open Market Operations (OMOs)

• The term open market operations stand for the purchase and
sale of government securities by the central bank (National
Bank of Ethiopia in our country case) from/to the public and
banks on its won account.
• As we have already mentioned above, the operations of open
market can be divide into two: one is the purchase of
government securities by the central bank from the public and
banks; the other is the sale of government securities by the
central bank to the public and banks.
 Cont’d…
• From these two divisions of open market operations, we can
understand that every open market purchase by the central
bank increases the high powered money by an equal amount of
the purchase where as every sale decreases it.
• It is in either ways of these two operations of open market that
the monetary control, i.e., the central bank would use an open
market operations an instrument of monetary control.
• Because once the central bank undertakes an open market
operation, thereafter, the money multiplier process takes over
and affects the supply of money in a standard way.
 Cont’d…
• Now, let's see the conditions that must be satisfied so as to
make an open market operation power full instrument of
monetary control. There are at least three conditions that must
be satisfied:
I. The market for government securities should be well
organized and developed, that is, broad, deep and resilient,
II. The central bank should have enough capacity to buy and sell
government securities, and
III. The central bank in its conduct of these operations should not
be weighed down by weightier considerations than monetary
control.
• If those conditions are not fulfilled, the central bank has to
rely on other tools of monetary control which we are going to
discuss in the following subsequent sections.
 6.2. Variations in Reserve Requirements (RR)

• As we know, banks always keep a certain proportion of their

total assets in the form of cash, partly to meet the statutory
reserve requirement and partly to meet their own day -to-day
needs for making cash payments.
• Besides, cash is held partly in the form of 'cash on hand' and
partly in the form of 'balances with the central bank'.
• All such cash is called cash reserves of banks. They are
usually divided under two heads: required reserves and excess
reserves.
 Cont’d…

• Required reserves are cash balances which a bank is required

statutorily to hold with the central bank.
• They are calculated on average daily basis over fortnights
(formerly a week). Of course, the required reserve amount
varies from central bank of one country to another country.
• For example, according to the law enacted in India in 1956,
the reserve Bank of India (central Bank of India) is
empowered to impose statutorily 'cash reserve ratio' (CRR/ on
banks any where between 3% and 15% of the net demand and
time liability as of the last Friday of the second preceding
fortnight.
 Cont’d…

• The control measure of variable reserve ratio attempts to affect

the stock of money via the impounding or release of bank
reserves. As you can grasp it simply and clearly, there are two
different effects of variation in reserve ratio on the stock of
money. They are mentioned as follows:
 Cont’d…

I. The monetary authority may revise the average cash required

reserve (CRR) up ward, and banks are required to hold larger
reserves or balances with central bank than before for the
same amount of liabilities.
– This amounts to leaving the required reserve ratio
unchanged, but impounding of additional reserves by the
central bank.
– Since reserves are a part of the high-powered money, this
amounts to a virtual withdrawal of a part of high-powered
money form the public equal to the amount of additional
reserves impounded.
 Cont’d…

II. The second effect is in the opposite way; when the monetary
authority lowered the CRR (or the incremental CRR is
withdrawn), this amounts to releasing of reserves which
would have been otherwise impounded and so virtual
increases in high-powered money.
– When account is taken of such virtual changes in high-
powered money, what we get is called adjusted high-
powered money.
 Cont’d…

• In general, the essential function of changes in the required

reserve ratio is to bring about desired changes in the effective
(or what we call until now adjusted) amount of high-powered
money and through it in the amount of money supply (and
bank credit).
• In this sense, this method of variable reserve ratio can act as
both a supplement and as an alternative to other methods of
monetary control like an open market operations.
 Cont’d…

• From these two methods, it is commonly alleged that changes

in reserve requirement as an instrument of monetary control is
inferior to the tool of open market operations in that it makes
lumpy and discontinuous changes both in time and amount of
reserves and deposits and produces 'announcement effect'
since changes in reserve requirement are news worthy.
• Even if this is true, much should not be made of this argument.
 Cont’d…

• Because banks can be given advance notice of changes and the

changes can be introduced in stages so that banks have enough
time to adjust their portfolio accordingly.
• Then in a situation of accelerating or continuous inflation,
high-powered money and reserves would normally be growing
rapidly, and it would not bee too hard on banks to meet a
higher reserve requirement, if they want to co-operate with the
monetary authority in checking excessive expansion of money
supply.
 Cont’d…

• Variable required reserve ratio has common features with the

rest of control measures.
• Here, an attempt will be made to see the leakages which the
instrument of variable reserve ratio has as its own, just like
other control measures have.
• Some of the leakages of it are common especially with those
of open market operations.
• Before we go to the actions of banks which cause the leakage,
it is good if we know what has to be done in general for the
successful monetary management when leakages occur.
 Cont’d…

• What do you suggest for the successful monetary management

so far as leakages are concerned?
• To be successful, the monetary authority needs to understand
well the true nature and working of these leakages and the
central bank should try its best to plug or offset these leakages
as far as possible via other measures at their disposal. Let's
come back to our particular variable reserve ratio.
• When the required reserve ratio of banks is revised upward to
impound bank reserves, a part of the 'impounded' high-
powered money may leak back into the economy via the
following actions of banks.
 Cont’d…

I. Non-compliance or in complete compliance of banks to the

higher or additional reserve requirement
II. Increased or compensatory borrowing by banks from the
central bank and other sources
III. Increased or compensatory sale of government securities by
banks to the central bank.
• The occurrence of such actions of banks and the resulting
leakage shows that the variable reserve ratio by it self is not a
sufficient method of monetary control and thus it needs to be
supplemented by other measures to make it effective.
 6.3. Discount Rate Policy

• What do you remember about the function of central bank as a

lender of the last resort to commercial banks?
• In order to perform its function as a lender of the last resort to
commercial banks, it will discount first class bills or advance
loans against approved securities.
• Securities are approved if they enjoy governments guarantee
in respect of payment of principal and interest.
• The bank rate is a traditional weapon of credit control used by
a central bank.
 Cont’d…

• Before starting our discussion of the way how the bank rate is
used as a weapon of monetary control, let us see the difference
between bank rate and market rate.
• While the former (which is also called discount rat)is the rate
at which the central bank should be prepared to buy or
rediscount eligible bill of exchange or other commercial paper,
the later is lending rate charged in the money market by the
ordinary financial institutions.
• Having this difference in your mind, now we will try to see the
way of operation of the bank rate by the central bank.
 Cont’d…

• The bank rate seeks to influence both the cost and availability of the
central bank credit to members of the bank. Cost, of cource is
ermined by the discount rate charged, and the availability depends
largely on the statutory requirements of eligibility of bills for
discounting and advances, as also the maximum period for which the
credit is available.
• Accordingly, an increase in the bank rate by raising the cost of
borrowed reserves, other things remaining same, discourages bank
borrowings from the central bank. The reverse is supposed to happen
when the bank rate is lowered. T
• his varies the rate of expansion of high-powered money and so of
money supply, assuming the money multiplier to remain unchanged.
 Cont’d…

• In actual practice, however, it is extremely difficult to predict

precisely the effect of a change in the bank rate on the amount of
bank borrowings, let alone on money supply. Because this effect
will depend on several factors like:
a) The degree of banks' dependence on borrowed reserves,
b) The sensitivity of the banks' demand for borrowed reserve to the
differential between their lending rates and borrowing rates/bank
rate.
c) The extent to which the other rates of interest have already
changed or changes subsequently,
d) The state of the demand for loans and the supply of funds from
other sources, etc.
 6.4. Miscellaneous: Instruments of Monetary
Policy
6.4.1 SELECTIVE CREDIT CONTROLS (SCCs)
• Until now we have been discussing three instruments of
control: open market operation, variation in reserve
requirement, and changes in the cost and Availability of
central bank credit to banks.
• These instruments of control are commonly known as general
or quantitative method of credit controls.
• In this section, we will try to discuss the regulation of credit
for specific purposes which are known as selective or
qualitative credit controls.
 Cont’d..
• In these regards, the general credit controls relate to the total
volume of credit (via changes in high-powered money and the
cost of credit, whereas selective credit controls operate on the
distribution of the total credit.
• Selective credit control can have two opposite aspects, positive
aspect and negative aspect which are mentioned briefly below.
a) Positive aspect: Selective credit control measures can be used to
encourage greater channeling of credit into particular sector.
For example, in India, it has been done in favor of designated
priority sectors.
b) Negative aspect: Selective credit control measures can be taken
to restrict the flow of credit to particular sectors or activities.
 Cont’d…
• Just like other instruments of control, the degree of success of
selective credit controls depends on several factors. Here three
of them are mentioned.
I. The extent of effective credit restrictions:
 Since selective credit controls are generally security
oriented and non-purpose oriented, influential borrowers
can mange to escape the bite of these measures by
borrowing against the security of other collaterals and using
the funds so borrowed for indulging in the speculative
holdings of stocks.
 Therefore, the effectiveness of selective credit controls is
likely to improve if they are fully suppo9rted by general
credit controls.
 Cont’d…
II. The availability of non-bank finance: to the extent traders do
not depend up on banks for financing their inventories and
have other sources of finance (their own and of the un
regulated credit markets), they will again escape the
constraints of the selective credit controls. Obviously, this
will depend on the cost and availability of non-bank finance
to the parties concerned.
III. The degree of short fall in supply in relation to normal
demand: the greater this short fall, the more will the
speculative fever rise. In case of acute shortages, credit
controls should be imposed well in time without waiting for
the prices of sensitive commodities to rise actually.
 Cont’d…
6.4.2 STATUTORY LIQUIDITY RATIO(SLR)
• The banking system is subject not only to cash reserve
requirement (discussed previously); the banking system is also
subject to statutory liquidity requirement.
• Under the latter case, each bank is required statutorily to
maintain a prescribed minimum proportion of its daily total
demand and time liabilities in the form of designated liquid
assets.
• These liquid assets consist of (a) excess reserves (b)
unencumbered(Securities are unencumbered if loans have not
been taken against them from central bank) government and
other approved' securities, and (c) current account balances with
other banks.
 Cont’d…

•  Now we can define the statutory liquidity ratio (SLR) as

follows:
• where ER = Excess reserves
• I* = Investment in unencumbered gov't and other approved'
securities
• CB = current account balances with other banks, and
• L = Total demand and time liabilities
 Cont’d…
• What can you say about the way(s) in which the SLR operates
as an instrument of monetary control?
• There are two distinct ways in which the SLR operates as an
instrument of monetary control: one is by affecting the
borrowings of the gov't from central bank; the other is by
affecting the freedom of banks to sell gov't. Securities or
borrow against them from central bank.
• In both the ways, the creation of high powered money (H) is
affected and there by variations in the supply of money.
• A higher SLR and rapidly growing demand and time liability
of banks effect is briefly mentioned below.
 Cont’d…
• The higher SLR and rapidly growing demand and time
liabilities of banks have provided an expanding captive market
for gov't securities captive market for gov't securities and also
served as a means of allocating a growingly larger share of
banks' resources to the government and specified public sector
agencies.
 Cont’d…
6.4.3 Moral Suasion
• This is the last instrument of monetary control that we are going
to discuss it here. Those instruments which we discussed before
are used either quantitatively or qualitatively. But there is an
instrument used both quantitatively or qualitatively.
• This instrument, used by the central bank both for the
quantitative control of credit and money supply as well as for the
qualitative control of credit (i.e., control over the distribution of
bank credit) is moral suasion and it can be defined as follows.
• Moral suasion is a combination of persuasion and pressures
which a central bank is always in a position to use on banks in
general and errant banks kin particular. This is exercised via
discussions, letters, speeches, and hints thrown to banks.
 Cont’d…

• As it is mentioned above, moral suasion is used both for quantitative

and qualitative credit controls. When moral suasion is used for
quantitative credit controls, the central bank can urge banks to keep a
large proportion of their assets in the form of securities, lend their
helping hand to develop a broad and active market in treasury bills and
other government securities, and not borrow successively from the
Bank when it is engaged in fighting the forces of inflation.
• All these actions are different ways of controlling the expansion of high
powered money and so of money supply.
• But it is very difficult to say how far such advice is heeded by banks.
Nor can we measure its contribution to monetary control mechanism.
Nonetheless, it can't be denied that moral suasion measures do offer
some scope for the central bank to exercise control over money supply.