Monetary Policy Is How Central Bank Manages Money Supply to Attain the Objective of Its Monetary Policy
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Monetary policy is how central bank manages money supply to attain the objective of its monetary policy.Objectives or Goals of Monetary Policy:Price StabilityOne of the policy objectives of monetary policy is to stabilize the price level. Stable prices improve public confidence, promote business activity and ensure equal distribution of income & wealth. Therefore, it will enhance the prosperity and welfare in the community. Both economists and laymen favor this policy because fluctuations in prices bring uncertainty and instability to the economy. But it is hard to determine the satisfactory price. Full EmploymentTo attain this objective, it is necessary to increase production and demand. During depression period, there is low production because of low demand and wide unemployment. Thus, the objective of monetary policy is to check rising unemployment during a depression.Exchange rate StabilityMonetary policy uses to balance of payments create fluctuation in the foreign exchange rates. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy.Economic Growth:Economic growth is defined as “the process whereby the real per capita income of a country increases over a long period of time.”Central bank imply monetary policy to achieve economic development which give you the proper utilization of natural and human resources, more capital formation, more employment, increase in national and per capital income, and increase in income along with an increase in the standard of living.Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability.”How Central Banks Create Money Out of Thin Air.” About.com News & Issues. Web. 24 Oct. 2015.”Objectives of Monetary Policy.” Objectives of Monetary Policy. Web. 24 Oct. 2015.”Monetary Policy – Its Meaning, Definitions Objectives Articles.” Monetary Policy – Its Meaning, Definitions Objectives Articles. Web. 24 Oct. 2015.Monetary Policy Instruments1. Quantitative Instruments or General Tools The Quantitative Instruments are also known as the General Tools of monetary policy. These tools are related to the Quantity or Volume of the money. The Quantitative Tools of credit control are also called as General Tools for credit control. They are designed to regulate or control the total volume of bank credit in the economy. These tools are indirect in nature and are employed for influencing the quantity of credit in the country. The general tool of credit control consists of
– Bank Rate Policy (BRP)The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for influencing the volume or the quantity of the credit in a country. The Bank Rate affects the actual availability and the cost of the credit. Any change in the bank rate necessarily brings out a resultant change in the cost of credit available to commercial banks. If the central bank increases the bank rate than it reduce the volume of commercial banks borrowing from the central bank. It deters banks from further credit expansion as it becomes a more costly affair. Even with increased bank rate the actual interest rates for a short term lending go up checking the credit expansion. On the other hand, if the central bank reduces the bank rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit creation. Thus any change in the bank rate is normally associated with the resulting changes in the lending rate and in the market rate of interest. However, the efficiency of the bank rate as a tool of monetary policy depends on existing banking network, interest elasticity of investment demand, size and strength of the money market, international flow of funds, etc. – Open Market Operation (OMO)The open market operation refers to the sale of short-term and long-term securities by the central bank in the open market. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. If the central bank sells securities in an open market, commercial banks and private individuals buy it. This reduces the existing money supply as money gets transferred from commercial banks to the central bank. On the other hands, when the central bank buys the securities from commercial banks in the open market, commercial banks sell it and get back the money they had invested in them. – Variation in the Reserve Ratios (VRR)The change in the VRR brings out a change in commercial banks reserves positions. Thus by varying VRR commercial banks lending capacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves of commercial banks and thus it can affect the banks credit creation multiplier. The central bank increases VRR during the inflation to reduce the purchasing power and credit creation. But during the recession or depression it lowers the VRR making more cash reserves available for credit expansion.2. Qualitative Instruments or Selective Tools The Qualitative Instruments are also known as the Selective Tools of monetary policy. These tools are not directed towards the quality of credit or the use of the credit. They are used for discriminating between different uses of credit. It can be discrimination favoring export over import or essential over non-essential credit supply. This method can have influence over the lender and borrower of the credit. The Selective Tools of credit control comprises of following instruments.