Posted by Anjali Kaur on Sep 13, 2020

Monetary Policy & Its Tools

Monetary policy refers to the central bank policy to control the money supply in the economy. In this post, I will be discussing monetary policy and its tools. Let’s study!

Monetary Policy

The Central bank controls the money supply and credit in the best interest of the economy. In order to do so, the Central bank makes the use of quantitative and qualitative credit control tools. These methods are also known as instruments to control the money supply in the economy.

Central banks applied quantitative and qualitative tools through its monetary policy.

Monetary Policy Tools

It includes quantitative and qualitative measures:

1. Quantitative Measures

The quantitative measures regulate the total quantity of credit in the economy. Such measures affect the economy as a whole and are non-discriminatory in character. It includes the following:

a. Bank rate

Bank rate or discount rate means the same in case of credit control by the central bank.

The rate at which the central bank of a country lends money to the commercial banks to meet their long term needs.

Let’s discuss the two cases to control credit in the economy:

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the bank rate is increased which further increases the lending rate of commercial banks. It makes the credit costlier, demand for credit decreases, less money will go to the economy, purchasing power is reduced, aggregate demand in the economy falls and excess demand is corrected.

If there is deflation in the economy or less money supply, it implies deficient demand for money in the economy. In such a case, the bank rate is reduced, it decreases the lending rate by commercial banks, it makes the credit cheaper, demand for credit increases. More money flows to the economy, purchasing power increases, aggregate demand increases, and deficient demand is corrected.

b. Repo rate

The rate at which the central bank of a country lends money to the commercial bank to meet their short term need.

Let’s discuss the two cases to control credit in the economy:

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the central bank will increase the repo rate which will make borrowing by commercial banks costly. So, when the repo rate is increased, banks are also forced to raise their lending rate. It made the credit costlier, demand for credit reduces, less money goes to the economy. The purchasing power is reduced, aggregate demand falls and excess demand is corrected.

If there is deflation in the economy or less money supply, it implies deficient demand for money in the economy. In such a case, the repo rate is reduced, it makes credit cheaper for commercial banks. In turn, commercial banks reduced lending rates for the borrowers, demand for credit increases. More money flows to the economy, purchasing power increases, aggregate demand increases, and deficient demand is corrected.

c. Reverse Repo Rate

The rate at which commercial banks lends money to the central bank is called the reverse repo rate.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the reverse repo rate is increased it encourages commercial banks to park their surplus funds with the central bank. This has a negative effect on the lending capacity of the commercial banks. Demand for credit will reduce, less money will go to the economy, aggregate demand falls and excess demand is corrected.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, the reverse repo rate is reduced it discourages the commercial banks to park their surplus funds with the central bank. Hence, lowering the reverse repo rate has a positive effect on the lending capacity of the commercial banks which raises the demand for borrowing from commercial banks, more money flows to the economy, purchasing power increases, aggregate demand increases, and deficient demand is corrected.

d. Open Market Operation

It refers to the purchase and sale of government securities in the open market (public and commercial banks) by the central bank.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, government securities are sold by the central bank in the open market. The central bank withdraws additional purchasing power. There will be a contraction of credit, less money flows in the economy, purchasing power in the economy reduces, aggregate demand falls and excess demand gets corrected.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, by purchasing the government securities, the central bank injects additional purchasing power in the system which expands credit. More money flows in the economy, purchasing power increases, aggregate demand rises and deficient demand is corrected.

e. Legal Reserve Ratio

LRR or variable reserve ratio is that fraction of the deposits of commercial banks, which is legally compulsory for them to maintain on account of cash reserve ratio and statutory liquidity ratio.

Cash Reserve Ratio

It is also known by the minimum reserve ratio. CRR is the minimum percentage of deposits of commercial banks (Net demand and time liabilities) which is kept in the form of cash with the central bank.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, CRR is increased to control excess demand. The central banks withdraw additional purchasing power, there will be a contraction of credit, less money will flow in the economy. The purchasing power in the economy reduces, aggregate demand falls and the excess demand is corrected.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, CRR is decreased to control the deficient demand. The central banks injects additional purchasing power in the economy which expands credit demand. Money flows in the economy, purchasing power increases, aggregate demand rises and deficient demand is corrected.

Statutory Liquidity Ratio

SLR is the minimum percentage of deposits of commercial banks (Net demand and time liabilities) which every bank is required to maintain with itself in the form of liquid assets like current account balances.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, SLR is increased to control excess demand. The central bank withdraws additional purchasing power in the economy. There will be contraction of credit, less money will flow in the economy, purchasing power in the economy falls, aggregate demand decreases and excess demand is corrected.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, SLR is decreased to control of deficient demand. The central bank injects additional purchasing power in the economy which expands the demand for credit. Money flows in the economy, purchasing power increases, aggregate demand increases, and deficient demand is corrected.

2. Qualitative measures

It refers to selective credit control that focuses on allocation of credit in the different sectors. It includes the following:

a. Margin requirement

A margin is a difference between the market value of the securities offered by the borrowers against the loan and the amount of loan granted.

Margin requirement also means the discount fixed by the central bank on the assets which are kept as securities to the commercial banks.

For example, margin requirement is 20%, then bank is allowed to give loan only upto 80% of the value of the securities.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the margin requirement is increased, to correct excess demand. The central bank withdraws additional purchasing power, there will be a contraction of credit, less money will flow in the economy. The purchasing power in the economy falls, aggregate demand decreases, and excess demand is corrected.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, the margin requirement is reduced to correct deficient demand. The central bank injects additional purchasing power in the system which expands credit, more money flows in the economy. The purchasing power in the economy increases, aggregate demand increases, and deficient demand is corrected.

b. Moral Suasion

Moral suasion implies persuasion, request, informal suggestion, advice, and appeal by the central banks to commercial banks to cooperate with the general monetary policy of the central bank.

Thank You!

You can read the related post on macroeconomics:

Introduction To Money

Central bank and its function

Process of credit creation

Precautions while calculating the national income

Real and nominal GDP

National income

National income formula list

Value-added method

Income method

Expenditure method

GDP and welfare

Domestic territory and national residents

Circular flow of income

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