MONETARY POLICY ,

INSTUMENTS OF MONETARY
POLICY AND ROLE OF RBI
MEANING OF 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 achieve the predetermined macroeconomic
goals.
Objectives & Scope
• To ensure economic stability at potential level of
output.
• To achieve price stability by controlling inflation and
deflation.
• To promote and encourage economic growth
• Scope of monetary policy largely depends on two
factors : -
• Level of monetization of the economy and Level of
development of capital market.
• In the first factor , all economic transactions are
carried out with money as a medium of exchange .
• The monetary policy works by changing the general
price levels and so affects all economic activities
• In case of second factor , instruments of policy work
through the capital market.
INSTRUMENTS OF MONETARY
POLICY
• The instruments refers to the economic variable that
the central bank can change at its discretion with a
view to control and regulate the money supply and
availability of credit.
• Instruments are classified into :
a) QUANTITATIVE MEASURES
b) QUALITATIVE MEASURES.
 QUALITATIVE MEASURES
BANK RATE POLICY
• It is the minimum rate at which the central bank of a
country provides loans to the commercial bank of the
country.
• Changes in the bank rate influences in the creation of
credit by the commercial banks.
• Changes in the money supply affects the aggregate
demand and thereby output and prices.
Changes in the bank rate
INCREASE IN BANK RATE
• Used at the time of inflation
• Cost of borrowing increases
for commercial banks
• C.B’S also increase their
LENDING RATE.
• Discourages borrowing
• Results in reduction of
aggregate demand or money
expenditure.
DECREASE IN BANK RATE
• Used at the time of
depression
• Cost of borrowing decreases
• C.B’S also reduce their
lending rate
• Credits or loans from banks
become cheaper.
• Leads to increase in
aggregate demand for goods
and services
Limitations
Successful working of the bank rate is possible
only if
• All the other rates should follow the bank rate in its
movement so that bank credit should expand or
contract as desired.
• Money market must be well organised.
• The reponsiveness of businessmen to the changes in
the lending rates.
OPEN MARKET OPERATIONS
• Open market operation is sale and purchase of
government securities , treasury bills and bonds.
• The buyers and sellers are commercial banks,
financial corporations, big business corporations and
individuals with high savings.
• The sale of government bonds and securities affects
both the supply of and demand for credit.
• When people buy the government bonds & securities
through cheques drawn in commercial banks in
favour of the central bank , there is a transfer from
the buyer’s account to the central banks account
• This reduces the total deposits with the C.B’s.Results
in decrease of credit capacity and flow of bank credit.
• When the central bank decides to increase money
supply , it buys back the bonds and securities.
• As a result cash is transferred to the peoples account
with C.B’s and so deposits and cash reserves
increase.
Some of the limitations are
• When commercial banks possess excess liqiudity ,
the open market does not work.
• The Contraction and expansion of credit by
commercial banks depends on the economic and
political conditions
CASH RESERVE RATIO
• The ‘ 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.
• Normally depends on the banks’ experience
regarding the cash demand by depositors.
• When economic conditions demand monetary
expansion , the central bank cuts down the CRR
which results availability in more funds to lend
• When contractionary monetary policy is required
there is an increase in the CRR.
 STATUTORY LIQUIDITY REQUIREMENT:

• The SLR is the proportion of the total deposits which

the C.B ’s are statutorily required to maintain in the
form of liquid assets in addition to CRR.
• This is undertaken to prevent the C.B ’s from
liquidating their liquid assets when CRR is raised.
SELECTIVE CREDIT CONTROLS
CREDIT RATIONING
• It views to avail bank credit to relative weaker
business sector.
Steps for this are the
• Central banks imposes upper limits on the credit
available to large firms and industries
• Charging higher interest rate on bank loans beyond a
certain limit.
Change in lending margins
• The gap between the value of mortgaged property and
amount of loans advanced by the bank is called ‘lending
margin’.
• The Central bank changes the lending margin to regulate the
credit availability.
Moral Suasion
• Method of persuading and convincing the commercial banks
accordance to some directives for the economic welfare of
the country.
• Done by writing letters to the commercial banks.
Direct controls
• When all other methods go ineffective, the banks opt this
method. Done rarely
 WORKING OF EXPANSIONARY MONETARY POLICY

r1 r1
Rate of Interest

Rate of Interest
r2 r2

Md I

M1 M2 I1 I2
Investment demand
Quantity of Money Z

C+I2+G1
E2

C+I1+G1
C+I+G

E1

Y1 Y2
National Income
 WORKING OF CONTRACTIONARY MONETARY POLICY

r1 r1
Rate of Interest

Rate of Interest
r2 r2

Md I

M1 M2 I1 I2
Y=C+S
Investment demand
Quantity of Money Z

C+I2+G1
E2

C+I1+G1
C+I+G

E1

45’
Y1 Y2
National Income
MONETARY POLICY:
KEYNESIAN VIEW
• EASY MONETARY
POLICY
• RECESSION (problem)
• Central bank buys
securities by open mkt.
• Reduces CRR
• Lowers bank rate
• TIGHT MONETARY
POLICY
• INFLATION
• Central bank sells
securities through open
mky
• Raises CRR & SLR
• Raises Bank rate
• Raises max margin
against holding stock of
goods.
LIMITATIONS OF MONETARY
POLICY
• The time lag in planing the policy and its
implementation and working time
• Correct assessment of the problem – recession or
inflation and the magnitude of the problem is
required.
• The presence of non-banking financial
intermediairies.
• Underdevelopment of money and capital markets.
Monetary Policy In a developed country
INDIA.
• In a developed Economy - Overcome depression and
inflation situations
• In a developing economy – Promote economic growth

• OBJECTIVES OF MONETARY POLICY BY RBI:

• 1.Ensure price stability
• 2.Encourage economic growth
• 3.Encourage stability of exchange rate of rupee
 1.Price Stabilising
• Contain inflation
• Does not mean absolutely no change in price at all
• Means reasonable rate of inflation
• High degree of inflation
• Raises the cost of living of the people
• Makes exports costlier
• Makes value of money fall
• Encourages businessmen to invest
2.Economic Growth
• Ensuring adequate availability of credit
• Lowering the cost of credit
• Two types of credit requirement
• Finance working capital
• Finance investment in projects for building fixed costs

• Prior to 1991
• Tight credit policy
• Restrict credit availability to private sector
3.Exchange Rate Stability
• Before 1991-Fixed Exchange Rate System
• After 1991-Floating Exchange Rate System
• Exchange rate of rupee volatile
• Cause fluctuations in foreign exchange rate
• Need to prevent large appreciation and depreciation of money
• Exchange rate of rupee is determined by demand and supply of foreign exchange
• Mismatch – external value of rupee changes
• Depreciation of rupee caused as against US Dollars increase in
demand for Dollars from
• Corporate sector to finance imports
• FII to take out their dollars from India
• Increase in demand for Dollars by Indian Banks to finance imports
from abroad
• To arrest the fall of rupee, RBI

• Raises the bank rate

• Raises the CRR
• Cost of Credit rises, availability reduces, borrowings
discouraged, investments abroad discouraged,
demand for dollars reduced
• Release more dollars from Foreign exchange
reserves
• Increase supply of US Dollar in foreign

Exchange Market

• To prevent appreciation of rupee

• Raise prices of Indian Exports-uncompetitive

Role of Monetary policy in Economic
Growth
• Expansion of productive capacity
• Accelerate rate of savings and investment
• Steps
• Increase aggregate rate of savings
• Mobilization of savings to make it available for
investment and production
• Increase in the rate of investment
• Allocation of investment for productive purpose
and priority sectors
1.Monetary policy and Savings

 High interest policy-promote savings

 To promote economic growth-raise the rate of saving
 Real rate of interest =Nominal rate vof interest-rate of inflation

 Expand banking facility

 Surplus incomes consumed -unsaved and unproductive-induced to be saved

 To facilitate mobilisation of savings it is essential to maintain reasonable price stability

2.Monetary Policy and Investment
• Cost of credit
• Keynesian theory of Monetary Policy
• Effect of a change in money supply on the level of production and
investment operates through changes in rate of interest
• Increase in money supply - rate of interest falls - more investment
• Decrease in money supply – rate of interest rises - less investment

• Credit Availability Effect

• Increase in money supply enlarges availability of bank credit for
investment purposes - raises the level of investment
• Decrease in money supply reduces the availability of bank credit for
investment purposes - lowers the level of investment
In Public Investment
• Ensure that banking system contributes to planned
public investment
• Part of bank deposits should be invested in
government and other approved securities
• Tool to develop infrastructure and increase demand
for industrial products
• Stimulate private investments
• Technique of SLR – banks are required to keep a
part of total demand and time deposits as liquid
assets – government and other securities
In Private Investment
• Banks must provide credit to meet the working capital
requirements of agriculture and industry - large and
medium scale
• Ensure full utilisation of existing capacity and build up
more capacity
3.Allocation of Investment Funds
• Ensure proper canalisation of savings into suitable directions
• Discriminate between productive and unproductive outlays
1. Vary the reserve requirements
2.Credit Control
• Lengthening the period of repayment
• Lowering margin requirements
• Provision of special loans to banks
• Helps in 2 ways
1.Prevent savings from being wasted in unproductive channels
2.Help the economic growth to controlling inflation
Monetary Policy of RBI
1.Of Controlled Expansion 1951-1972
2.Of Pre-Reforms Period 1972-1991
3.Of Post-Reforms Period 1991-2000
Monetary policy to check Inflation and
ensure Price Stability
• In India, RBI plays both regulatory and promotional roles
• Promotes saving and investment
• Influences the cost of credit and growth of money supply
• Working of bank rate policy , open market operations function
effectively only if there is an organised bill market and
maintainence of fixed cash reserve ratios
• Method of variable cash reserve ratio is more effective
• RBI can exercise effective control over commercial banks to
restrict their credit expansion through compulsory increase in
CRR
1.Pre Reform Period
• Mixed economy with both public and private players
• RBI regulated expansion of money supply and bank
credit
• RBI was called as controlled expansion as it restricted
excessive supply of credit to private sectors
• Steps taken to control prices were
• Changes in bank rate
• Changes in CRR
• Restrict the flow of credit to particular sectors
commodities or activities
 2.Of Controlled Expansion
• Monetary policy was framed in response to the fiscal policy of
the government
• Fiscal deficits were incurred and a good part of it was financed
by borrowings from RBI
• Resulted in large increase in RBIs credit to the government
with rapid growth in money supply
• Excess liquidity in banking system was mopped up by raising
CRR and SLR to maximum
• The basic goal of the policy was to neutralise the impact of
fiscal deficit
3.Post Reform Period
• Monetary policy was framed to achieve price stability and economic
growth
• Rupee was floated to determine exchange rate
• Indian economy was opened up to private foreign investment
• Access to foreign capital market by Indian companies
• CRR and SLR were used
• Lending rates of interest were fixed at low level for priority sectors like
agriculture, small scale industries, exports
• Introduction of liquidity Adjustment Facility to adjust daily basis liquidity in
the bank system
• Increase in foreign exchange reserves – issue Indian money – liquidity in
banking system
• Capital inflows have come through exports, FIIs, FDIs
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