Monetary Policy

Importance of Monetary Policy

• Gross National Product (GNP) = C + I + G + X

Where: C = Private Consumption expenditure

I = Private Investment Expenditure
G = Government Expenditure
X = Net Exports

C, I, X can be influenced by the monetary policy which can also influence

the private consumption and investment spending and exports and
imports.

• The Government and the Central Bank(i.e., RBI) make use of various
fiscal and monetary weapons respectively to achieve stability and growth
by influencing and regulating the behavior of the various classes of
spenders as savers, consumers and investors.

• These policies can influence the aggregate supply and demand and the
associated level of employment, wages, interest, rent, price and profit.

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 Monetary Policy
 Monetary Policy refers to the use of instrument within the control of the
Central Bank to the influence the level of aggregate demand for the goods and
services or to influence in certain sector of the economy.

 Monetary policy operates through varying the cost and availability of credit.

 The modern economy is regarded as a credit economy in sense that

credit forms the basis of most of the economic activities in such an economy.

The level and nature of economic activities such an economy are influenced
by the cost and availability of the credit.

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Monetary Policy and Money Supply
• The capacity of banks to provide credit depends on their cash
reserves (comprising cash in hand and balances with the Reserve
Bank), a substantial portion of the reserves being generally held
in the form of balances with the Reserve Bank.
• Cash Reserves increase through a rise in the deposit resources of
banks, or by their borrowing from the Reserve Bank, or by sale
of their investments.
• If the Bank desires to bring about an expansion in credit, it
adopts measures to increase the banks reserves. If credit is to be
restricted, it attempts to shorten the reserves.

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 Measures of Money Stock
Reserve Bank of India employs FOUR measures of money stock, namely M1,
M2, M3, M4

M1 : The measure of money stock designed by M1 is usually described as the

money supply. The components of money supply are currency with the
public(i.e., notes n circulation, circulation of rupee coins and circulation of
small coins) and deposits(demand deposits with banks and other deposits
with the RBI).

M2 : M2 is M1 + Post Office Savings Bank Deposits.

M3 : M3 is M1 + Time Deposits with the banks. In other words, M3 is money

supply plus fixed deposits with the banks. M3 is usually referred to as
aggregate monetary resources.

M4 : M4 is M3 plus the total Post Office Deposits.

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Instruments of Monetary Policy

Instruments of monetary policy are

divided into :
1.General Methods
2.Selective Methods

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 General Credit Control
• The general methods affect the total quantity of credit and
affect the economy generally.
• There are three general or quantitative instruments of credit
control.
1. The Bank Rate
2. Open Market Operations
3. Variable Reserve Requirements
• The use of one instrument rather than another at any point of
time is determined by the nature of the situation and the
range of influence.

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 Bank Rate Policy
• The Bank rate, also known as the Discount Rate.
• The Bank Rate Policy seeks to affect both the cost and
availability of credit.
• The importance of the Bank Rate lies in the fact that it acts as
pace-setter to all the other rates of interests.
• An increase in the Bank Rate implies an increase in the cost of
credit and vice-versa. The demand for credit usually varies
with the variation in the cost of credit.
• The central bank has control to bring a contraction in the
money supply by raising Bank Rate and an expansion in the
money supply by lowering it.

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 Bank Rate Policy(Contd…)
• The Theory of Bank Rate states, an increase in the Bank Rate
reduces the extent of borrowings. Reduction in the Discount
rate has the opposite effects.
• Ex: High inflation leads to increase in Bank Rate and reduce
the inflation.

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 Open Market Operations.
• Its refer broadly to the purchase and sale by the
Central Bank of a variety of assets, such as foreign
exchange, gold, government securities and even
company shares. In India, they are confined to the
purchase and sale of Government securities.
• To increase the money supply, the central bank buys
securities from commercial banks and public.

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 Variable Reserve Ratios
• Commercial banks in every country maintain, either by the
requirement of law by or custom, a certain percentage of
their deposits in the form of balances with the central bank.
• The central bank has the power to vary this reserve
requirement and the variation in the reserve requirements
affect the credit creating capacity of commercial banks.
• Ex: If the reserve requirement is 10%, the maximum amount
the bank can lend is equivalent to 90% of the total reserves. If
the reserve ratio is raised to 20%, the bank cannot lend more
than 80% of the total reserves.

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Statutory Liquidity Requirement
• All banks to maintain a minimum amount of
assets/need to have threshold limit of assets
which is not less than specified demand.

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 Selective Credit Regulation
• Selective or Qualitative credit control refers to regulation of
credit for specific purpose or branches of economic activity.
• The aim of selective controls is to discourage such forms of
activity as are considered to be relatively inessential or less
desirable.
• In India, such controls have been used to prevent speculative
hoarding of commodities like food grains and essential raw
material to check an under rise in their prices.
• Credit controls are considered to be useful supplement to
general credit regulation.s

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Thank You!
Monetary Policy and Money Supply
• The budgetary operations of the Government, considerably
affect the money supply. If the Government meets its
budgetary deficits by borrowing from the Reserve Bank, there
will be an increase in money supply, both in currency and bank
deposits. The RBI has no control over budgetary operations.
• RBI’s influence is restricted in the countries international
payments position.
• Central banking instruments of control operate by varying the
cost and availability of credit and these produce desired
changes in the assets pattern of credit institutions, principally
commercial banks

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