Monetary Policy

>> November 13, 2009

Definition of Monetary Policy

Monetary policy is that part of economic policy in which central bank controls the cost and supply of money and credit by applying different techniques. It is also main function of central bank.
We all know, if supply and cost of money are not controlled. Then both are harmful for development of economy. In India RBI is sole institute who is taking steps to regulate money and credit by controlling its supply. Monetary policy regulates both volume and value of currency and credit.

Objective of Monetary Policy

  •      To control the supply of money.
  •     To control the cost of money and credit.
  •     Exchange stability 
  •      Full employment 

Instruments or technique of credit control / monetary policy:-

1. Bank Rate 

Bank rate is that rate which is charged by Central bank for issue loan to the member banks.  By changing it, central bank can control the credit. 

→ If Central bank increase this bank rate, all commercial banks will increase their interest rate by this loan become costly and flow of fund in the form of credit will decrease.

→ If central bank wants to expand credit, then Central bank will decrease bank rate, after this commercial bank can get advance and loan at cheap rate and by this way, they also decrease their interest rate. After this flow of cash in the form of loan will increases.

2. Open Market Operation 

Open market operation is the all action which is done by central bank for purchase and sale of member banks' security in open market. If RBI wants to contract the credit, then RBI will sell the security of member bank and member bank's flow of cash will stop. If RBI wants to expand credit in recession, then RBI will start to buy the security of member banks and member banks get cash and they can now use it for providing more loans to customers.

3. Cash Reserve Ratio / Statutory minimum reserve:-

Cash reserve ratio is the minimum percentage of the deposit to be kept as reserve by the banks with central bank. It can be used as the technique of monetary policy. By changing cash reserve ratio, RBI can contract or expand credit in Indian economy. 

→ If RBI wants to contract credit, and then RBI will increase this ratio. After this all banks have to keep more fund as reserve with RBI. So, they will decrease the amount of loan due to decrease the total fund available for enterprises. 

If RBI wants to expand credit, then RBI will decrease this ratio, after this all banks have to keep less fund as reserve with RBI. So, they will issue more credit to public. 

4. Changes in Marginal Requirement of loan:-

Marginal requirement is the difference between value of security and actual loan accepted by bank. Suppose a person wants to take loan of Rs. 80 , we has to give security of Rs. 100 then marginal requirement is Rs. 100 - Rs. 80  = Rs. 20 . 

→ If RBI wants to contract the credit , this rate will increase suppose , if RBI fixes it as 40 % , then customer can get loan of Rs. 60 after giving security of Rs. 100 . So , trend of getting loan will decrease . 

If RBI wants to expand the credit, this rate will decrease suppose, if RBI fixes it as 10% more people will take loan , if they get Rs. 90 in cash after giving security of Rs. 100 .

So , by this way RBI controls credit . 

5. Moral Persuasion / Inspiration 

RBI as central bank of country can control credit with moral persuasion. Under this persuasion, RBI can call a meeting of all commercial bank and give advice in discussion that they should not give loan for speculative purposes.

6. Rationing of Credit 

RBI has right to create ration of credit under monetary policy. It can be done by following way:-

  • To fix the amount of loan for a particular bank. 
  • To fix Quota for all banks. 
  • To fix Quota for different traders.

7. Regulation of consumer credit 

→ In case inflation, prices are increased. To control prices central bank contract credit to reduce the total amount of installment for payment. 

→ In case of deflation, prices are decreased to control prices central bank expand credit to increase the amount of installment. 


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