What is Monetary Policy? - India Story

Monetary Policy as it states is all about Money. Money plays an important role in the economic system we see the use of money at every step of life indeed it would be hard to imagine life without money! The main function of money in an economic system is to facilitate the exchange of goods and services.

The actions of a central bank, currency board or other regulatory committee, that determine the size and rate of growth of the money supply, which in turn affects interest rates.

In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy.

In India context central bank is referred to as RBI (Reserve bank of India)

A central bank can be said to have two main kinds of functions:
(1) macroeconomic when regulating inflation and price stability and
(2) microeconomic when functioning as a lender of last resort.

Macroeconomic Influences

As it is responsible for price stability, the central bank must regulate the level of inflation by controlling money supplies by means of monetary policy. The central bank performs open market transactions that either inject the market with liquidity or absorb extra funds, directly affecting the level of inflation. To increase the amount of money in circulation and decrease the interest rate (cost) for borrowing, the central bank can buy government bonds, bills, or other government-issued notes. This buying can, however, also lead to higher inflation. When it needs to absorb money to reduce inflation, the central bank will sell government bonds on the open market, which increases the interest rate and discourages borrowing. Open market operations are the key means by which a central bank controls inflation, money supply, and price stability.

Microeconomic Influences

The establishment of central banks as lender of last resort has pushed the need for their freedom from commercial banking. A commercial bank offers funds to clients on a first come, first serve basis. If the commercial bank does not have enough liquidity to meet its clients' demands (commercial banks typically do not hold reserves equal to the needs of the entire market), the commercial bank can turn to the central bank to borrow additional funds. This provides the system with stability in an objective way; central banks cannot favor any particular commercial bank. As such, many central banks will hold commercial-bank reserves that are based on a ratio of each commercial bank's deposits. Thus, a central bank may require all commercial banks to keep, for example, a 1:10 reserve/deposit ratio. Enforcing a policy of commercial bank reserves functions as another means to control money supply in the market.

The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate (which is set by the central bank and provides a base rate for interest rates). It has been argued that, for open market transactions to become more efficient, the discount rate should keep the banks from perpetual borrowing, which would disrupt the market's money supply and the central bank's monetary policy. By borrowing too much, the commercial bank will be circulating more money in the system. Use of the discount rate can be restricted by making it unattractive when used repeatedly.


What are elements of Monetary Policy?

As said earlier, The Central Bank controls the money supply and credit in the best interests of the economy. The bank does this by taking recourse to various instruments.

1) Bank Rate Policy
The bank rate is the rate at which the central bank lends funds to banks, against approved securities or eligible bills of exchange. The effect of a change in the bank rate is to change the cost of securing funds from the central bank. An increase in the bank rate increases the costs of securing funds and of borrowing reserves from the central bank. This will reduce the ability of banks to create credit and thus to increase the money supply. A rise in the bank rate will then cause the banks to increase the rates at which they lend. This will then discourage businessmen and others from taking loans, thus reducing the volume of credit. A decrease in the bank rate will have the opposite effect.

2) Open Market Operations
OMO is the buying and selling of government securities by the Central Bank from/to the public and banks on its own account. It does not matter whether the securities are bought from or sold to the public or banks because ultimately the amounts will be deposited in or transferred from some bank. The sale of government securities to banks will have the effect of reducing their reserves. This directly reduces the bank’s ability to give credit and therefore decrease the money supply in the economy. When the Central Bank buys securities from the banks it gives the banks a cheque drawn on itself in payment for the securities. When the cheque clears, the Central Bank increases the reserves of the bankby the particular amount. This directly increases the bank’s ability to give credit and thus increase the money supply.

3) Varying Reserve Requirements
Banks are obliged to maintain reserves with the Central Bank on two accounts. One is the Cash Reserve Ratio (CRR) and the other is the Statutory Liquidity Ratio (SLR). Under CRR the banks are required to deposit with the Central Bank a percentage of their net demand and time liabilities. Varying the CRR is a tool of monetary and credit control. An increase in the CRR has the effect of reducing the banks excess reserves and thus curtails their ability to give credit. Reducing the CRR has the effect of increasing the bank’s excess reserves, which increases its power to give credit.
The SLR requires the banks to maintain a specified percentage of their net total demand and time liabilities in the form of designated liquid assets which may be (a) excess reserves (b) unencumbered (are not acting as security for loans from the Central Bank) government and other approved securities (securities whose repayment is guaranteed by the government) and (c) current account balances with other banks. Varying the SLR affects the freedom of banks to sell government securities or borrow against them from the Central Bank. This affects their freedom to increase the quantum of credit and therefore the money supply. Increasing the SLR reduces the ability of banks to give credit and vice versa.