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Monetary Policy: An overview

24-NOV-2015 14:38

    Monetary policy refers to the credit control measures adopted by the central bank of a country. In case of Indian economy, RBI is the sole monetary authority which decides the supply of money in the economy. The Chakravarty committee has emphasized that price stability, growth, equity, social justice, promoting and nurturing the new monetary and financial institutions have been important objectives of the monetary policy in India.

    Instruments of Monetary Policy

    The instruments of monetary policy are of two types:

    1. Quantitative, general or indirect (CRR, SLR, Open market operations, bank rate, repo rate, reverse repo rate)

    2. Qualitative, selective or direct (change in the margin money, direct action, moral suasion)

    These both methods affect the level of aggregate demand through the supply of money, cost of money and availability of credit. Of the two types of instruments, the first category includes bank rate variations, open market operations and changing reserve requirements (cash reserve ratio, statutory reserve ratio). They are meant to regulate the overall level of credit in the economy through commercial banks. The selective credit controls aim at controlling specific types of credit. They include changing margin requirements and regulation of consumer credit.

    We discuss them as under:

    a. Bank Rate Policy:

    The bank rate is the minimum lending rate of the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial banks. When the central bank finds that inflation has been increasing continuously, it raises the bank rate so borrowing from the central bank becomes costly and commercial banks borrow less money from it (RBI).

    The commercial banks, in reaction, raise their lending rates to the business community and borrowers who further borrow less from the commercial banks. There is contraction of credit and prices are checked from rising further. On the contrary, when prices are depressed, the central bank lowers the bank rate.
    It is cheap to borrow from the central bank on the part of commercial banks. The latter also lower their lending rates. Businessmen are encouraged to borrow more. Investment is encouraged and followed by rise in Output, employment, income and demand and the downward movement of prices is checked.

    List of Public Sector Banks in India and their Headquarters

    b. Open Market Operations:

    Open market operations refer to sale and purchase of securities in the money market by the central bank of the country. When prices start rising and there is need to control them, the central bank sells securities. The reserves of commercial banks are reduced and they are not in a position to lend more to the business community or general public.

    Further investment is discouraged and the rise in prices is checked. Contrariwise, when recessionary forces start in the economy, the central bank buys securities. The reserves of commercial banks are raised so they lend more to business community and general public. It further raises Investment, output, employment, income and demand in the economy hence the fall in price is checked.

    c. Changes in Reserve Ratios:

    Under this method, CRR and SLR are two main deposit ratios, which reduce or increases the idle cash balance of the commercial banks. Every bank is required by law to keep a certain percentage of its total deposits in the form of a reserve fund in its vaults and also a certain percentage with the central bank.
    When prices are rising, the central bank raises the reserve ratio. Banks are required to keep more with the central bank. Their reserves are reduced and they lend less. The volume of investment, output and employment are adversely affected. In the opposite case, when the reserve ratio is lowered, the reserves of commercial banks are raised. They lend more and the economic activity is favourably affected.

    2. Selective Credit Controls:

    Selective credit controls are used to influence specific types of credit for particular purposes. They usually take the form of changing margin requirements to control speculative activities within the economy. When there is brisk speculative activity in the economy or in particular sectors in certain commodities and prices start rising, the central bank raises the margin requirement on them.

    Structure of Banking Sector in India

    a. Change in Margin Money:

    The result is that the borrowers are given less money in loans against specified securities. For instance, raising the margin requirement to 70% means that the pledger of securities of the value of Rs 10,000 will be given 30% of their value, i.e. Rs 3,000 as loan. In case of recession in a particular sector, the central bank encourages borrowing by lowering margin requirements.

    b. Moral Suasion: Under this method RBI urges to commercial banks to help in controlling the supply of money in the economy.

    Objectives of the Monetary Policy of India

    1. Price Stability: Price Stability implies promoting economic development with considerable emphasis on price stability. The centre of focus is to facilitate the environment which is favourable to the architecture that enables the developmental projects to run swiftly while also maintaining reasonable price stability.

    2. Controlled Expansion Of Bank Credit: One of the important functions of RBI is the controlled expansion of bank credit and money supply with special attention to seasonal requirement for credit without affecting the output.

    3. Promotion of Fixed Investment: The aim here is to increase the productivity of investment by restraining non essential fixed investment.

    4. Restriction of Inventories: Overfilling of stocks and products becoming outdated due to excess of stock often results is sickness of the unit. To avoid this problem the central monetary authority carries out this essential function of restricting the inventories. The main objective of this policy is to avoid over-stocking and idle money in the organization

    5. Promotion of Exports and Food Procurement Operations: Monetary policy pays special attention in order to boost exports and facilitate the trade. It is an independent objective of monetary policy.

    6. Desired Distribution of Credit: Monetary authority has control over the decisions regarding the allocation of credit to priority sector and small borrowers. This policy decides over the specified percentage of credit that is to be allocated to priority sector and small borrowers.

    7. Equitable Distribution of Credit: The policy of Reserve Bank aims equitable distribution to all sectors of the economy and all social and economic class of people

    8. To Promote Efficiency: It is another essential aspect where the central banks pay a lot of attention. It tries to increase the efficiency in the financial system and tries to incorporate structural changes such as deregulating interest rates, ease operational constraints in the credit delivery system, to introduce new money market instruments etc.

    9. Reducing the Rigidity: RBI tries to bring about the flexibilities in the operations which provide a considerable autonomy. It encourages more competitive environment and diversification. It maintains its control over financial system whenever and wherever necessary to maintain the discipline and prudence in operations of the financial system.


    So it can be conclude that the implementation of the monetary policy plays a very prominent role in the development of a country. It’s a kind of double edge sword, if money is not available in the market as the requirement of the economy, the investors will suffer (investment will decline in the economy) and on the other hand if the money is supplied more than its requirement then the poor section of the country will suffer because the prices of essential commodities will start rising.

    List of top 15 Private Sector Banks in India

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