Monetary Policy

MEANING

Monetary policy is a set of actions taken by a country's central bank or

government to control the money supply and influence the economy. It is
a macroeconomic policy tool used by the Central Bank to influence the
money supply in the economy to achieve certain macroeconomic goals.
It involves the use of monetary instruments by the central bank to
regulate the availability of credit in the market to achieve the ultimate
objective of economic policy.

OBJECTIVE OF MONETARY POLICY

Some of the major objectives of monetary policy are as follows:

• Accelerating the growth of the economy.

• Maintaining price stability.

• Generating employment.

• Stabilizing the exchange rate

• Maintaining economic stability

TYPES OF MONETARY POLICY

Broadly, there are two types of monetary policy – Expansionary

Monetary Policy and Contractionary Monetary Policy.

1. Expansionary Monetary Policy

Expansionary monetary policy is a set of tools used by a central bank to

stimulate an economy. The goal of this policy is to increase the money
supply, which can help fight recessions and increase economic growth.
An expansionary monetary policy can help decrease unemployment and
stimulate business activities.

Some ways a central bank can implement an expansionary monetary

policy include:

• Reducing the discount rate: This is the rate at which banks can
borrow from the central bank.
• Increasing open market operations: This involves buying
government securities from banks and other institutions using
newly-minted money.
• Reducing the reserve requirement: This is the amount of money a
bank is required to keep in reserves relative to its customer
deposits.
2. Contractionary Monetary Policy

Contractionary monetary policy is an economic strategy used by central

banks to reduce the money supply in an economy to control inflation.
The goal is to slow down economic growth by increasing interest rates,
making borrowing more expensive, and reducing consumer and
business spending. However, it can also slow down economic growth
and increase unemployment in the short term.

Some ways a central bank can implement an contractionary monetary

policy include:

• Raising interest rates: This discourages borrowing and encourages

saving, leading to reduced consumption and investment.
• Selling government securities: By selling bonds, the central bank
removes cash from the economy, decreasing the money supply.
• Increasing reserve requirements: Banks are required to hold more
reserves, limiting the amount they can lend.
MONETARY POLICY TOOLS IN INDIA

Various instruments used by the RBI to control the money supply can be
categorized into two categories:

• Quantitative Tools – Quantitative tools of monetary policy

are aimed at controlling the cost and quantity of credit.

• Qualitative Tools – Qualitative tools of monetary policy are aimed

at controlling the use and direction of credit.

QUANTITATIVE TOOLS OF MONETARY POLICY

1. Cash Reserve Ratio (CRR)

Cash Reserve Ratio is a regulatory measure that requires banks to

keep a percentage of their deposits as cash reserves with the central
bank. This reserve is kept in the central bank and cannot be used for
lending or investment purposes.

The primary purpose of the CRR is to ensure that banks maintain a

certain level of liquidity to meet depositor demands. It also serves as
a tool for central banks to control money supply and inflation.

The central bank uses CRR as a monetary policy instrument to

regulate the money supply in the economy.

When the CRR is increased, banks are required to hold more cash in
reserve, leaving them with less money to lend. This reduces the
money supply in the economy, which can help control inflation.

When the CRR is decreased, banks can lend more money, increasing
the money supply and stimulating economic activity.
2. Statutory Liquidity Ratio

Statutory Liquidity Ratio or SLR is a minimum percentage of deposits

that a commercial bank has to maintain in the form of liquid cash,
gold or government-approved securities.

It is basically the reserve requirement that banks are expected to

keep before offering credit to customers. These are not reserved with
the Reserve Bank of India (RBI), but with banks themselves.

The government uses the SLR to regulate inflation and liquidity.

Increasing the SLR will control inflation in the economy while
decreasing it will cause growth in the economy.

Although, the SLR is a monetary policy instrument of RBI, it is

important for the government to make its debt management
programme successful.

SLR has helped the government to sell its securities or debt

instruments to banks. Most of the banks will be keeping their SLR in
the form of government securities as it will earn them an interest
income.

3. Bank Rate

Bank Rate refers to the rate at which the Central Bank is willing to
buy or rediscount bills of exchange or commercial papers from
commercial banks.

When commercial banks hold Bills of Exchange or Commercial

Papers, they have the option to sell or rediscount these instruments
to the central bank. In return, they receive immediate cash. This
rediscounting provides banks with liquidity when they need funds,
especially in times of liquidity crunch or rising credit demand.
The Bank Rate is a vital tool for the RBI to control the money supply
and maintain economic stability. A high bank rate results in higher
borrowing costs for commercial banks, discouraging them from
rediscounting bills and borrowing from the RBI. This leads to a
tightening of liquidity, reduced lending, and ultimately a reduction in
the money supply, helping to control inflation. Conversely, a low bank
rate encourages borrowing, increases liquidity, and stimulates
economic activity.

4. Open Market Operations

Open Market Operations (OMOs) refer to the buying and selling of

government securities by the Central Bank to regulate the short-term
money supply.

When the central bank buys government securities:

• The central bank purchases government bonds or securities from

commercial banks and financial institutions in the open market.

• In return, the central bank injects money (liquidity) into the banking
system, increasing the overall money supply.

• As banks receive more money, they have more reserves to lend,

leading to an increase in credit availability and a decrease in
interest rates.

• Lower interest rates encourage borrowing and spending by

businesses and consumers, stimulating economic activity.

When the central bank sells government securities:

• The central bank sells government bonds or securities to

commercial banks and financial institutions.
• When banks buy these securities, they pay the central bank,
reducing their reserves and tightening liquidity in the banking
system.

• With less money available, banks have less capacity to lend,

leading to a rise in interest rates.

• Higher interest rates make borrowing more expensive, which can

reduce spending and investment, helping to slow down economic
activity.

5. Repo Rate

The repo rate (short for repurchase rate) is the interest rate at which a
country's central bank, lends money to commercial banks for a short
term, in exchange for government securities.

In a repurchase agreement (repo), commercial banks borrow money

from the central bank by selling government securities to the central
bank with an agreement to repurchase them at a future date at a
predetermined price. The difference between the selling price and the
repurchase price represents the repo rate.

Impact of Repo Rate:

1. When the central bank raises the repo rate:

o Borrowing money from the central bank becomes more

expensive for commercial banks.

o To maintain profitability, banks pass on the increased cost by

raising interest rates on loans for businesses and
consumers.
 o Higher interest rates discourage borrowing, reducing the
money supply and helping to control inflation.

o This move is typically used during periods of high inflation to

curb excessive demand.

2. When the central bank lowers the repo rate:

o Borrowing from the central bank becomes cheaper for

commercial banks.

o Banks can lower the interest rates on loans, making

borrowing more attractive for businesses and consumers.

o This increases the money supply, stimulates borrowing and

spending, and helps boost economic activity.

o A reduction in the repo rate is often used to spur economic

growth, especially in times of recession or slowdown.

6. Reverse Repo Rate

The reverse repo rate is the interest rate at which a central bank
borrows money from commercial banks for a short-term period. In a
reverse repo transaction, commercial banks lend excess funds to the
central bank in exchange for government securities.

Impact of Reverse Repo Rate:

1. When the central bank raises the reverse repo rate:

o It becomes more attractive for commercial banks to lend

money to the central bank because they earn a higher
interest rate.
 o Banks are incentivized to park more of their excess funds
with the central bank rather than lend them to businesses
and consumers.

o This reduces liquidity in the economy, as less money is

available for lending, helping to control inflation.

2. When the central bank lowers the reverse repo rate:

o Commercial banks earn a lower interest rate on their excess

funds parked with the central bank.

o Banks are less inclined to lend to the central bank and are
more likely to lend to businesses and consumers.

o This increases liquidity in the economy, promoting lending,

investment, and economic growth.

QUALITATIVE TOOLS OF MONETARY POLICY

1. Margin Requirements

Margin requirements under monetary policy refer to the minimum

amount of collateral that borrowers must provide when taking loans,
particularly for buying securities or other assets. Central bank can set
margin requirements as part of their monetary policy tools to regulate
credit flow and control financial stability. Margin requirements are
primarily used to control speculative borrowing. They also help
manage the money supply by influencing how much credit is available
in the financial system.

How It Works:

• When margin requirements are raised, borrowers need to provide

more collateral or equity to secure a loan. This reduces their ability
 to borrow, which in turn slows down the creation of credit in the
economy.

• When margin requirements are lowered, borrowers can secure

loans with less collateral, which increases their borrowing capacity
and boosts credit availability.

2. Rationing of Credit

Rationing of credit is a monetary policy tool used by central bank to

control and limit the amount of credit available in the economy. It
involves setting limits on the amount of loans that banks can offer to
businesses or consumers, particularly during times of excessive
credit growth, inflation, or economic instability. Its purpose is to
ensure the credit is directed towards priority sectors (e.g., agriculture,
infrastructure, etc.) rather than speculative or non-essential areas.

How It Works:

• The central bank imposes quantitative limits on the amount of

credit banks can extend.

• It may also place restrictions on certain types of loans (e.g., luxury

housing, speculative investments).

• Credit may be rationed for sectors deemed non-essential or risky,

while priority sectors may still have access to credit.

3. Regulation of Consumer Credit

Regulation of consumer credit refers to the guidelines and restrictions

imposed by a central bank or government to control the terms and
conditions under which consumer loans (such as personal loans, auto
loans, and credit card debt) are extended by financial institutions. This
regulation is a tool of monetary policy used to manage the availability
and cost of credit to consumers. It helps to control inflation by
regulating consumer demand for goods and services as consumer
credit can increase purchasing power.

Tighter regulations can reduce consumer spending by making loans

less accessible or more expensive, helping to control inflation.

Looser regulations can encourage borrowing, boosting consumer

spending and stimulating economic growth, especially during a
slowdown.

4. Moral Suasion

Moral suasion refers to the use of persuasion, influence, and non-

binding requests by a central bank or government to encourage
financial institutions, particularly commercial banks, to adopt certain
policies or behaviours, without the use of formal regulations or legal
requirements. It is a softer tool of monetary policy, relying on dialogue
and influence rather than mandates. Its purpose is to guide financial
institutions in a desired direction for the greater economic good. Moral
suasion can influence banks’ decisions on credit allocation, interest
rates, or lending policies without resorting to formal tools that may
have larger economic impacts. While not legally binding, financial
institutions often comply because of their reliance on the central bank
for liquidity and regulatory relationships.

5. Issue of Directives

The issue of directives refers to the formal instructions or guidelines

issued by a central bank to commercial banks and financial
institutions. These directives are mandatory and serve as a tool of
monetary policy to regulate the activities of banks and control various
aspects of the financial system. The issue of directives is a formal and
binding method through which central banks instruct financial
institutions to align their operations with broader monetary policy
goals, ensuring stability and proper functioning of the financial
system.

How It Works:

• The central bank may issue directives that instruct banks to follow
certain policies, such as:

o Setting limits on the volume of credit to certain sectors (e.g.,

real estate or consumer loans).

o Changing interest rates or lending margins to align with

monetary policy goals.

o Adjusting reserve requirements or the types of assets banks

can hold.

• Directives are often backed by legal authority, meaning non-

compliance can result in penalties or sanctions for the institutions
involved.

6. Direct Action

Direct action refers to the measures taken by a central bank or

regulatory authority to enforce compliance and achieve specific
monetary policy or regulatory objectives through immediate and
tangible interventions. Unlike indirect tools such as moral suasion or
open market operations, direct action involves concrete steps that
have immediate and binding effects on financial institutions.
 How It Works:

• Penalties and Sanctions: Imposing fines or other penalties on

banks that fail to adhere to regulations or directives.

• Restrictions: Placing limitations on specific activities of banks,

such as restricting their ability to lend or requiring them to maintain
higher reserves.

• Intervention: Directly intervening in the operations of a financial

institution, such as restructuring or taking control if the institution is
facing severe financial distress.

CREDIT CREATION BY COMMERCIAL BANKS

• Commercial banks create credit primarily through the process of

lending.
• Deposits are the main source of funds for a bank. When customers
deposit money, this is recorded as a liability for the bank because the
bank owes this money to depositors.
• Banks are only required to keep a fraction of the deposits as
reserves, either in cash or in accounts with the central bank. This
fraction is regulated by the reserve requirement set by central banks
• The remaining portion of the deposits can be loaned out to
borrowers, which allows the bank to generate credit.
• The loan is credited to the borrower's bank account. This creates a
new deposit in the borrower’s bank.
• That bank can then lend out a portion of the deposit, and the cycle
continues. This is called the money multiplier effect.
• Each time money is lent and deposited, new credit is created,
amplifying the money supply beyond the initial deposit.
CROWDING OUT

The diagram illustrates the crowding

out effect, a macroeconomic
phenomenon where increased
government spending reduces private
investment. This occurs when the
government borrows funds to finance
its spending, leading to higher interest
rates. As a result, the cost of borrowing
becomes more expensive for private businesses, discouraging
investment.

IS Curves: These represent the equilibrium in the goods market. IS is

the initial equilibrium, and IS1 is the new equilibrium after government
spending increases.

LM Curve: This represents the equilibrium in the money market. It is

assumed to be upward sloping, indicating that higher interest rates lead
to lower money demand.

Equilibrium: The intersection of the IS and LM curves determines the

equilibrium level of income (Y) and the interest rate (r).

Crowding Out: The shift of the IS curve from IS to IS1 represents the
crowding out effect. The increase in government spending leads to a
higher demand for loanable funds, which drives up interest rates. This
higher interest rate reduces private investment, leading to a smaller
increase in income (Y1) compared to the expected increase (Y2).