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Meaning of monetary policy

It is defined as the central bank’s policy pertaining to the control of the availability, cost and use of money and credit with the help of monetary measures in order to achieve specific goals.
The objectives of monetary policy in India are:
  • To regulate monetary growth so as to maintain price stability
  • To ensure adequate expansion in credit, thereby, assisting in the economic growth of the country
  • To encourage flow of credit to priority and other neglected sectors
  • To fill the credit gaps by creating institutions and to introduce measures for strengthening the banking system
There are two types of instruments used to control credit, namely quantitative and qualitative methods.
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Quantitative or general measures

These measures are used for controlling the total volume of credit in the banking system without the regard to the use to which it is put. The quantitative measures consist of:
Bank rate policy
Bank rate is the rate at which the central bank discounts the bills of commercial bank. When the central bank wishes to control credit, it raises the bank rate. This makes the price of credit higher as it increases the cost of borrowings of commercial banks, which in turn, charge a higher rate of interest from their borrowers. Thus, the business community feels discouraged to borrow. This reduces the demand for credit to go down. As a result, the investment activities would slow down and will adversely affect production and employment and hence the economic growth as a whole. When the central bank wishes to enhance the production and investment in an economy, it will reduce the bank rate. This will have a reverse effect as of the above case on the economy and hence would assist in the economy to flourish.


Note: Bank rate in India was 10% in 1981, 12% in 1991, 11% in 1997 which was reduced in stages to 6.5% in April 2001. In April 2003, it was further reduced to 6%. However, it was increased to 9% in 2012 (in stages). During April 2014 it was 9%.

Open market operations
It refers to Central banks initiative to deliberately sell or purchase securities and bills in the market in order to control the volume of credit. If securities are sold in the open market, the cash reserves of the commercial banks reduce due to the purchase of these securities. This leads to lowering the credit-creating base of the commercial banks and hence credit contracts. Decrease in money supply through open market operations increases the interest rates making credit costlier. When the securities are bought in the open market, it leads to an expansion of credit which is made possible by strengthening the cash reserves of the banks. An increase in the money supply through open market operations decreases the interest rates making credit cheaper.
Variable reserve requirements
There are two types of reserves which the commercial banks are required to maintain with the central bank. They are:
  • Cash Reserve Ratio (CRR): It refers to that portion of total deposits which a commercial bank has to keep with the central bank in the form of cash reserves.
  • Statutory Liquidity Ratio (SLR): It refers to that portion of total deposits which a commercial bank has to keep with itself in the form of liquid assets like cash, gold or approved Government securities.
When the central bank wishes to reduce credit in the economy, it increases these ratios. Raising the reserve rates will reduce the surplus cash reserves of the bank which can be offered for credit. This will contract credit in the system. When the central bank wishes to encourage credit in the economy, it decreases these ratios. Reducing the reserve rates will increase the surplus cash reserves of the bank which can be offered for credit. This will expand credit in the system.


Note: CRR was quite low at 4.5% in March 2004. Due to inflationary conditions in the economy, it was raised in stages to 9% in August 2008. But when conditions eased, it was again reduced in stages to 5% in January 2009 and is at 4.5% as on September 2012. It was further reduced to 4% April 2014. As on September 2012, the SLR is 24%. As on April 2014 SLR was 23%.


Repo rate and reverse repo rate
Repo rate is the rate at which commercial banks borrow money from the RBI. RBI lends money to bankers against approved securities for meeting their daily requirements or to fill short term gap.
A low repo rate will help banks to get money at a cheaper rate. When repo rate increases, borrowings from RBI becomes expensive. As on September 2012, it was 8%. As on April 2014 it was 8%.
Reverse repo rate is the rate at which the RBI borrows money from banks. An increase in this rate can cause the banks to transfer more funds to RBI due to attractive interest rates. As on September 2012, it was 7%. As on April 2014 it was 7%.

Qualitative or selective measures

Unlike quantitative, these instruments of credit control are directed towards the particular use of credit and not its total volume. The qualitative measures consist of:
Securing loan regulation by fixation of margin requirements
The central bank has the authority to fix the maximum amount that the purchaser of securities may borrow against those securities. Raising of margin reduces the borrowing capacity of the security holder and vice-versa.
Consumer credit regulation
It lays down rules regarding down payments and maximum maturities of instalment credit for the purchase of specified durable consumer goods. Raising the down payment limits and shortening of maximum period tend to reduce the demand of loans and thus, check consumer credit and vice-versa.
Issue of directives
The central bank issues directives to commercial banks which are in the form of oral or written statements, appeals or warnings to control individual credit structure and to restrain the aggregate volume of loans.
Rationing of credit
This method is adopted by the central bank for controlling and regulating the purpose for which credit is granted or allocated by commercial banks.
Moral suasion
It is a psychological means of controlling credit by the way of persuasion and request made by the central bank to the commercial banks to co-operate with the general monetary policy.
Direct action
The central bank may refuse to rediscount papers, give excess credit or it may charge a penal rate of interest above the bank rate against the commercial banks that erringly demand credit beyond a prescribed limit. This is known as direct action.

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