List of Contents

What is Monetary policy? History of Monetary policy Goals/Objectives of Monetary Policy Types of Monetary Policy Instruments/Tools Of Monetary Policy Quantitative & Qualitative Measures Highlights of Monetary Policy 2010-2011 Limitations Of Monetary Policy Effects of Monetary policy Conclusion

What is Monetary Policy?

Monetary policy is essentially a programme of action undertaken by the monetary authorities generally the central bank, to control and regulate the supply of money with the public and the flow of credit with a view to achieving the objectives of general economic policy
Shaw defines monetary policy as Any conscious action undertaken by the monetary authorities to change the quantity, availability or cost.., of money.

History of monetary policy

Monetary policy is associated with the interest rates and availability of credit. Instruments of monetary policy have included short-term interest and bank reserves For many centuries there were only two forms of monetary policy: 1.Decisions about coin age, 2.Decisions to print paper money to create credit

Objectives Of Monetary Policy

Maintain price Stability. Flow of credit to the productive sectors of the economy.

Stability for the national currency.

Growth in employment and income.

To promote and encourage economic growth in the country.

TYPES OF MONETARY POLICY

Expansionary Policy: In an expansionary policy the government increases the total money supply in the economy rapidly. The expansionary policy is adopted to reduce unemployment in recession by lowering the interest rates ,In an expansionary policy. Example: If the Central Government pursues expansionary monetary policy by increasing the supply of money then the nominal interest rate will fall, investment will rise, consumption will rise. 2. CONTRACTIONARY POLICY: In contractionary policy the government raises the interest rates to fight inflation. The contractionary policy leads to Decrease in the money supply. Contractionary policy can be implemented by requiring banks to hold a higher Proportion of their total assets in reserve by requiring a higher proportion of total assets to be held as liquid cash, the Central bank reduces the availability of loan able funds. This acts as a reduction in the money supply.
1.

Cont..
Example: if the Fed pursues contractionary monetary policy by decreasing the supply of money, the nominal interest rate will rise, investment will fall, and consumption will fall. Interest sensitive purchases are expensive People save more and consume less Because the supply of money decreases, people buy lesser goods and services.

Instruments of Monetary Policy

SLR SLR
QUALITATIVE

Bank rate

Open market operations

QUANTITATIVE

Credit Rationing

Change in Lending margins

Moral Suasion

Cash Reserve Ratio

Direct Controls

Quatitative Instruments

Open Market Operations (OMO): It means the purchase and sale of securities by the central bank of the country. The OMO is the most powerful and widely used tool of monetary control.

Bank Rate: Bank rate is the rate at which the central bank rediscounts the bills of exchange presented by the commercial banks. For practical purposes bank rate is the rate which the central bank charges on the loans and advances to the commercial banks.

Qualitative Instruments
Credit Rationing: Under this two measures are adopted: Imposition of upper limits on the credit available to large industries and firms. Charging a higher interest rate on bank loans beyond a certain limit.

Change In Lending Margins: The banks provide loans only upto a certain percentage of the value of the mortgaged property. The gap between the value of the mortgaged property and amount advanced is called lending margin.

The Cash Reserve Ratio (CRR): Cash Reserve Ratio is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank.

Statutory Liquidity Requirement (SLR): The SLR Is that proportion of the total deposits which commercial banks are required to maintain with them in the form of liquid assets (cash reserve, gold and govt. bonds) in addition to CRR.

 Moral Suasion:

The moral suasion is a method of persuading and convincing the commercial banks to advance credit in accordance with the directive of the central bank in the economic interest of the country.

Direct controls: Where all other methods prove ineffective, the monetary, authorities resort to direct control measures with clear directive to the banks carry out their lending activity in a specified manner.

Highlights of Monetary Policy 2010-2011

The Reserve Bank announces the following policy measures: The Bank Rate has been retained at 6.0 percent. It has been decided to increase the repo rate from 5.0 per cent to 5.25 per cent The reverse repo rate is increased from 3.5 per cent to 3.75 per cent. It has been decided to increase the cash reserve ratio (CRR) of scheduled banks by 25 basis points from 5.75 per cent to 6.0 per cent. The SLR is announced 25%.

Limitations Of Monetary Policy

The time lag : The first and the most important limitation in the effective working of monetary policy is the time lag. i.e. time taken in chalking out the policy action, its implementation and working time.

Problem in forecasting : The formulation of an appropriate monetary policy requires a reliable assessment of the magnitude of the problem-recession or inflation- as it helps in determining the appropriate policy measures.

Non-banking Financial Intermediaries: The structural change in the financial market has also reduced the scope of effectiveness of monetary policy.

Under Development of money and capital markets : The effectiveness of monetary policy in less developed countries is reduced considerably because of the underdeveloped character of their capital and money

markets.

The Monetary Policy Effect

The expenditures that are most likely to be affected by monetary policy are those financed to a substantial extent by the use of credit. It includes business investment , inventory investment, residential construction, consumer purchases , electrical appliances, furniture and capital outlays by state and local governments. The paper by Michael J. Hamburger surveys a number of econometric studies that have been made of each of these categories of expenditures. Residential construction and business investment in plant and equipment are significantly affected by monetary policy also significant effects on consumer purchases on state and local government expenditures. A number of investigators have been unsuccessful in isolating any monetary influences. We can conclude with two main polices they are :The extent that monetary influences affect the various types of expenditures primarily through interest rates. There are substantial time lags between changes in interest rates and the resulting changes in expenditures, although the lags seem to vary somewhat from one category of expenditures to another.

Contd.

The results of this kind of investigation thus far can hardly be characterized as conclusive. In some cases, such as business investment in plant and equipment, in which a number of independent investigations have been carried out, the different investigators have used somewhat different models. While all of the recent studies indicate that monetary policy has significant effects on investment which operate with substantial lags, both the magnitude of the effect and the length of the lag vary considerably from one study to another. Clearly, much further study will be needed before we can predict the effects of monetary policy with very much confidence. The survey in the Hamburger paper, discussed above, relates to the initial impacts on investment-defined broadly to include not only business investment but investment by households in new homes and durable goods and capital outlays by state and local governments. In a concluding section, Hamburger discusses briefly some results obtained by computer simulations using two large econometric models of the U.S. economy. These simulations provide estimates of the total effects on the economy of certain changes in monetary policy, including not only the initial impacts but also the secondary multiplier and accelerator effects. These simulations suggest that monetary policy has important effects but that the bulk of these effects are felt only after a considerable amount of time has elapsed following the initiation of a change in policy.

conclusion
Thus, the Government through its Monetary Policy can affect the levels of money supply in the market. When the inflation in any economy rises it raises the interest rates to suck excess liquidity in the system thereby reducing the purchasing power by making the credits available costlier whereas when unemployment rises the government increases the money supply by lowering the interest rates which ultimately leads to cheaper loans being available which in turn generates employment opportunities in an economy.