INTRODUCTION

Monetary policy is part of and a tool of macroeconomic policy. It is a set of

measures and policies that have to meet the required targets through monetary or
currency policy instruments. Interpretation will involve money and the money
supply, which is under the control of the central bank. The term monetary policy
change in the money supply and basic interest rates and the term currency policy is
understood as interventions at foreign exchange markets (for the purpose of foreign
exchange rate changes). Monetary policy is a tool the central bank and its primary
purpose is monitoring and active influence on the rate of inflation. In the Czech
Republic the Czech National acts as the central bank. The main objective of the
CNB is to maintain price stability. The central bank uses to enforce its monetary
policy targets a variety of instruments that affect both the functioning of individual
commercial banks and the operation of the entire economy of the state. The tool
used by the central bank to implement its policies and how these tools work. There
are two opposing types of policies, explanation of their principles and their use
cases. We will see that it is not as straightforward talk about the effects of
monetary policy instruments. It will be explained what a dilemma of central bank
is and what are the basic approaches to the implementation of monetary policy.

WHAT IS MONETARY POLICY

Monetary policy is a set of economic policy that manages the size and growth rate
of the money supply in an economy. It is a powerful tool to regulate
macroeconomic variables such as inflation and unemployment. Monetary policies
are implemented through different tools, including the adjustment of the interest
rates, purchase or sale of government securities, and changing the amount of cash
circulating in the economy. The central bank or a similar regulatory organization is
responsible for formulating monetary policies.

OBJECTIVES OF MONETARY POLICY

The primary objectives of monetary policies are the management of inflation or

unemployment, and maintenance of currency exchange rates.

INFLATION

Monetary policies can target inflation levels. The low level of inflation is
considered to be healthy for the economy. However, if the inflation is high, the
monetary policy can address this issue.

UNEMPLOYMENT

Monetary policies can influence the level of unemployment in the economy. For
example, an expansionary monetary policy generally decreases unemployment
because the higher money supply stimulates business activities that lead to the
expansion of the job market.

CURRENCY EXCHANGE RATES

Using its fiscal authority, a central bank can regulate the exchange rates between
domestic and foreign currencies. For example, the central bank may increase the
money supply by issuing more currency. In such a case, the domestic currency
becomes cheaper relative to its foreign counterparts.
TOOLS OF MONETARY POLICY

Central banks use various tools to implement monetary policies. The widely
utilized monetary policy tools include:

INTEREST RATE ADJUSTMENT

A central bank can influence the interest rates by changing the discount rate. The
discount rate (base rate) is an interest rate charged by a central bank to banks for
short-term loans. For example, if a central bank increases the discount rate, the cost
of borrowing for the banks increases. Subsequently, the banks will increase the
interest rate they charge their customers. Thus, the cost of borrowing in the
economy will increase, and the money supply will decrease.

CHANGE RESERVE REQUIREMENTS

Central banks usually set up the minimum amount of reserves that must be held by
a commercial bank. By changing the required amount, the central bank can
influence the money supply in the economy. If monetary authorities increase the
required reserve amount, commercial banks find less money available to lend to its
clients and thus, money supply decreases.

OPEN MARKET OPERATIONS

The central bank can either purchase or sell securities issued by the government to
affect the money supply. For example, central banks can purchase government
bonds. As a result, banks will obtain more money to increase the lending and
money supply in the economy.
EXPANSIONARY VS CONTRACTIONARY MONETARY POLICY

Depending on its objectives, monetary policies can be expansionary or

contractionary.

EXPANSIONARY MONETARY POLICY

It is a monetary policy that aims to increase the money supply in the economy by
decreasing interest rates, purchasing government securities by central banks, and
lowering the reserve requirements for banks. An expansionary policy lowers
unemployment and stimulates business activities and consumer spending. The
overall goal of the expansionary monetary policy is to fuel economic growth.
However, it can also possibly lead to higher inflation.

CONTRACTIONARY MONETARY POLICY

The goal of a contractionary monetary policy is to decrease the money supply in

the economy. It can be achieved by raising interest rates, selling government
bonds, and increasing the reserve requirements for banks. The contractionary
policy is utilized when the government wants to control inflation levels.

CENTRAL BANK - RBI{ RESERVE BANK OF INDIA }

The RBI is the central bank of India. It was established on 1ST April 1935 under a
special act of the parliament. The RBI is the main authority for the monetary policy
of the country. The main functions of the RBI are to maintain financial stability and
the required level of liquidity in the economy.
 The RBI also controls and regulates the currency system of our economy. It is the
sole issuer of currency notes in India. The RBI is the central banks that control all the
other commercial banks, financial institutes, finance firms etc. It supervises the entire
financial sector of the country.

OBJECTIVES

 Promotion of saving and investment: Since the monetary policy controls the rate
of interest and inflation within the country, it can impact the savings and
investment of the people. A higher rate of interest translates to a greater chance
of investment and savings, thereby, maintaining a healthy cash flow within the
economy.
 Controlling the imports and exports: By helping industries secure a loan at a
reduced rate of interest, monetary policy helps export-oriented units to substitute
imports and increase exports. This, in turn, helps improve the condition of the
balance of payments.
 Managing business cycles: The two main stages of a business cycle are boom
and depression. Monetary policy is the greatest tool using which boom and
depression of business cycles can be controlled by managing the credit to control
the supply of money. The inflation in the market can be controlled by reducing
the supply of money. On the other hand, when the money supply increases, the
demand in the economy will also witness a rise.
 Regulation of aggregate demand: Since monetary policy can control the demand
in an economy, it can be used by monetary authorities to maintain a balance
between demand and supply of goods and services. When credit is expanded and
the rate of interest is reduced, it allows more people to secure loans for the
purchase of goods and services. This leads to the rise in demand. On the other
 hand, when the authorities wish to reduce demand, they can reduce credit and
raise the interest rates.
 Generation of employment: As monetary policy can reduce the interest rate,
small and medium enterprises (SMEs) can easily secure a loan for business
expansion. This can lead to greater employment opportunities.
 Helping with the development of infrastructure: The monetary policy allows
concessional funding for the development of infrastructure within the country.
 Allocating more credit for the priority segments: Under the monetary policy,
additional funds are allocated at lower rates of interest for the development of the
priority sectors such as small-scale industries, agriculture, underdeveloped
sections of the society, etc.
 Managing and developing the banking sector: The entire banking industry is
managed by the Reserve Bank of India (RBI). While RBI aims to make banking
facilities available far and wide across the nation, it also instructs other banks
using the monetary policy to establish rural branches wherever necessary for
agricultural development. Additionally, the government has also set up regional
rural banks and cooperative banks to help farmers receive the financial aid they
require in no time

INSTRUMENTS

Monetary policy is a way for the RBI to control the supply of money in the economy.
So these credit policies help control the inflation and in turn help with the economic
growth and development of the country. So now let us take a look at the various
instruments of monetary policy that the RBI has at its disposal.

1. Open Market Operations Open Market Operations is when the RBI involves
itself directly and buys or sells short-term securities in the open market. This is
 a direct and effective way to increase or decrease the supply of money in the
market. It also has a direct effect on the ongoing rate of interest in the market.
Let us say the market is in equilibrium. Then the RBI decides to sell short-term
securities in the market. The supply of money in the market will reduce. And
subsequently, the demand for credit facilities would increase. And so
correspondingly the rate of interest would also see a boost. On the other hand,
if RBI was purchasing securities from the open market it would have the
opposite effect. The supply of money to the market would increase. And so, in
turn, the rate of interest would go down since the demand for credit would fall.

2. Bank Rate One of the most effective instruments of monetary policy is the
bank rate. A bank rate is essentially the rate at which the RBI lends money to
commercial banks without any security or collateral. It is also the standard rate
at which the RBI will buy or discount bills of exchange and other such
commercial instruments. So now if the RBI were to increase the bank rate, the
commercial banks would also have to increase their lending rates. And this
will help control the supply of money in the market. And the reverse will
obviously increase the supply of money in the market.

3. Variable Reserve Requirement There are two components to this instrument

of monetary policy, namely – The Cash Reserve Ratio (CLR) and the
Statutory Liquidity Ratio (SLR). Let us understand them both. Cash Reserve
Ratio (CRR) is the portion of deposits with the commercial banks that it has to
deposit to the RBI. So CRR is the percent of deposits the commercial banks
have to keep with the RBI. The RBI will adjust the said percentage to control
the supply of money available with the bank. And accordingly, the loans given
by the bank will either become cheaper or more expensive. The CRR is a great
 tool to control inflation. The Statutory Liquidity Ratio (SLR) is the percent of
total deposits that the commercial banks have to keep with themselves in form
of cash reserves or gold. So increasing the SLR will mean the banks have
fewer funds to give as loans thus controlling the supply of money in the
economy. And the opposite is true as well.

4. Liquidity Adjustment Facility The Liquidity Adjustment Facility (LAF) is an

indirect instrument for monetary control. It controls the flow of money through
repo rates and reverse repo rates. The repo rate is actually the rate at which
commercial banks and other institutes obtain short-term loans from the Central
Bank. And the reverse repo rate is the rate at which the RBI parks its funds
with the commercial banks for short time periods. So the RBI constantly
changes these rates to control the flow of money in the market according to the
economic situations.

5. Moral Suasion This is an informal method of monetary control. The RBI is

the Central Bank of the country and thus enjoys a supervisory position in the
banking system. If there is a need it can urge the banks to exercise credit
control at times to maintain the balance of funds in the market. This method is
actually quite effective since banks tend to follow the policies set by the RBI.

6. Repo Rate: The (fixed) interest rate at which the Reserve Bank provides
overnight liquidity to banks against the collateral of government and other
approved securities under the liquidity adjustment facility (LAF).

7. Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank
absorbs liquidity, on an overnight basis, from banks against the collateral of
eligible government securities under the LAF.
8. Liquidity Adjustment Facility (LAF): The LAF consists of overnight as
well as term repo auctions. Progressively, the Reserve Bank has increased
the proportion of liquidity injected under fine-tuning variable rate repo
auctions of range of tenors. The aim of term repo is to help develop the
inter-bank term money market, which in turn can set market based
benchmarks for pricing of loans and deposits, and hence improve
transmission of monetary policy. The Reserve Bank also conducts variable
interest rate reverse repo auctions, as necessitated under the market
conditions.

9. Marginal Standing Facility (MSF): A facility under which scheduled

commercial banks can borrow additional amount of overnight money from
the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR)
portfolio up to a limit at a penal rate of interest. This provides a safety valve
against unanticipated liquidity shocks to the banking system.

10.Corridor: The MSF rate and reverse repo rate determine the corridor for the
daily movement in the weighted average call money rate.

11.Bank Rate: It is the rate at which the Reserve Bank is ready to buy or
rediscount bills of exchange or other commercial papers. The Bank Rate is
published under Section 49 of the Reserve Bank of India Act, 1934. This
rate has been aligned to the MSF rate and, therefore, changes automatically
as and when the MSF rate changes alongside policy repo rate changes.

12.Cash Reserve Ratio (CRR): The average daily balance that a bank is
required to maintain with the Reserve Bank as a share of such per cent of its
Net demand and time liabilities (NDTL) that the Reserve Bank may notify
from time to time in the Gazette of India.
13.Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required
to maintain in safe and liquid assets, such as, unencumbered government
securities, cash and gold. Changes in SLR often influence the availability of
resources in the banking system for lending to the private sector.

14.Open Market Operations (OMOs): These include both, outright purchase

and sale of government securities, for injection and absorption of durable
liquidity, respectively.

15.Market Stabilisation Scheme (MSS): This instrument for monetary

management was introduced in 2004. Surplus liquidity of a more enduring
nature arising from large capital inflows is absorbed through sale of short-
dated government securities and treasury bills. The cash so mobilised is held
in a separate government account with the Reserve Bank.
CONCLUSION

Monetary policy refers to the use of monetary instruments under the control of
the central bank to regulate magnitudes such as interest rates, money supply and
availability of credit with a view to achieving the ultimate objective of economic
policy.
For an effective anti-cyclical monetary policy, bank rate, open market operations,
reserve ratio and selective control measures are required to be adopted
simultaneously. But it has been accepted by all monetary theorists that
(i) the success of monetary policy is nil in a depression when business
confidence is at its lowest ebb
(ii) (ii) it is successful against inflation. The monetarists contend that as
against fiscal policy, monetary policy possesses greater flexibility and it
can be implemented rapidly.
BIBLOGRAPHY

1. Investopedia: Monetary Policy

2. http://pib.nic.in/newsite/PrintRelease.aspx?relid=151264
3. CRR DATA TAKEN FROM RBI Archived 29 August 2011 at
the Wayback Machine
4. SLR Data from RBI Archived 29 August 2011 at the Wayback Machine
5. https://rbidocs.rbi.org.in/rdocs/Wss/PDFs/5TB4828141FBB549A7ACE9611
6ED78E69C.PDF
6. Bank rate data taken from RBI Archived 29 August 2011 at the Wayback
Machine
7. Change in Bank Rate as per RBI notification
8. CREDIT AUTHORIZATION SCHEME CAME INTO EXISTENCE
DURING THE TENURE OF P C BHATTACHARYA
9. Current Policy Rates, Reserve Ratio, Reserve Bank of India
10.Key Indicators, IndiaBulls.com
11.Change in Bank Rate as per RBI notification