Monitory policy:

Definition: Monetary policy is the macro-economic policy laid down by the central bank. It
involves the management of money supply and interest rate and is the demand side economic
policy used by the government of a country to achieve macroeconomic objectives like
inflation, consumption, growth, and liquidity.

Objectives or Goals of Monetary Policy:

The following are the principal objectives of monetary policy:

1. Full Employment:

Full employment has been ranked among the foremost objectives of monetary policy. It is an
important goal not only because unemployment leads to wastage of potential output, but also
because of the loss of social standing and self-respect.

2. Price Stability:

One of the policy objectives of monetary policy is stabilizing the price level. Both economists
and favor this policy because fluctuations in prices bring uncertainty and instability to the
economy.

3. Economic Growth:

One of the most important objectives of monetary policy in recent years has been the rapid
economic growth of an economy. Economic growth is defined as “the process whereby the
real per capita income of a country increases over a long period.”

4. Balance of Payments:

Another objective of monetary policy since the 1950s has been to maintain equilibrium in the
balance of payments.

Instruments of Monetary Policy:

The instruments of monetary policy are of two types: first, quantitative, general, or indirect;
and second, qualitative, selective, or direct. They 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. 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:

Bank Rate Policy:

The bank rate is the minimum lending rate of the central bank at which it rediscounts first-
classes bills of exchange and government securities held by the commercial banks. When the
central bank finds that inflationary pressures have started emerging within the economy, it
raises the bank rate. Borrowing from the central bank becomes costly and commercial banks
borrow less from it.

The commercial banks, in turn, raise their lending rates to the business community and
borrowers borrow less from the commercial banks. There is s 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. Output, employment, income, and demand start rising and the downward
movement of prices is checked.

Open Market Operations:

Open market operations refer to the sale and purchase of securities in the money market by
the central bank. When prices are rising and there is a 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.

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. They lend more. Investment, output, employment, income, and
demand rise and fall in price checked.

Changes in Reserve Ratios:

Cash Reserve Ratio

Definition: Cash Reserve Ratio (CRR) is a certain minimum amount of deposit that the
commercial banks have to hold as reserves with the central bank. CRR is set according to the
guidelines of the central bank of a country.

Statutory liquidity ratio

Statutory liquidity ratio (SLR) is the Indian government term for the reserve requirement that
the commercial banks in India are required to maintain in the form of cash, gold reserve
government-approved securities before providing credit to the customers.

Category # II. Qualitative or Selective Method of Credit Control:

The qualitative or the selective methods are directed towards the diversion of credit into
particular uses or channels in the economy. Their objective is mainly to control and regulate
the flow of credit into particular industries or businesses.

The following are the important methods of credit control and the selective method:

1. Rationing of Credit.

2. Direct Action.
3. Moral Persuasion.

4. Method of Publicity.

5. Regulation of Consumer’s Credit.

1. Rationing of Credit:

Under this method, the credit is rationed by limiting the amount available to each applicant.
The Central Bank puts restrictions on demands for accommodations made upon it during
times of monetary stringency.

In this, the Central Bank discourages the granting of loans to stock exchanges by refusing to
re-discount the papers of the bank which have extended liberal loans to the speculators. This
is an important method of credit control and this policy has been adopted by several countries
like Russia and Germany.

2. Direct Action:

Under this method, if the Commercial Banks do not follow the policy of the Central Bank,
then the Central Bank has the only recourse to direct action. This method can be used to
enforce both quantitatively and qualitatively credit controls by the Central Banks. This
method is not used in isolation; it is used as a supplement to other methods of credit control.

Direct action may take the form either of a refusal on the part of the Central Bank to re-
discount for banks whose credit policy is regarded as being inconsistent with the maintenance
of sound credit conditions. Even then the Commercial Banks do not fall in line, the Central
Bank has the constitutional power to order for their closure.

This method can be successful only when the Central Bank is powerful enough and has
cordial relations with the Commercial Banks. Mostly such circumstances are rare when the
Central Bank is forced to resist such measures.

3. Moral Persuasion:

This method is frequently adopted by the Central Bank to exercise control over the
Commercial Banks. Under this method, Central Bank gives advice, then request and
persuasion to the Commercial Banks to cooperate with the Central Bank in implementing its
credit policies.

If the Commercial Banks do not follow or do not abide by the advice or request of the Central
Bank no gross action is taken against them. The Central Bank merely was its moral influence
and pressure with the Commercial Banks to prevail upon them to accept and follow the
policies.

4. Method of Publicity:

In modern times, Central Bank to make their policies successful takes the course of the
medium of publicity. A policy can be effectively successful only when an effective public
opinion is created in its favor.
Its officials through newspapers, journals, conferences, and seminar’s present a correct
picture of the economic conditions of the country before the public and give a prospective
economic policy. In developed countries, Commercial Banks automatically change their
credit creation policy. But in developing countries, Commercial Banks are being lured by
regional gains. Even the Reserve Bank of India follows this policy.

5. Regulation of Consumer’s Credit:

Under this method, consumers are given credit in a little quantity and this period is fixed for
18 months; consequently, credit creation expanded within the limit. This method was
originally adopted by the U.S.A. as a protective and defensive measure, thereafter it has been
used and adopted by various other countries.