2. MONETARY POLICY
It is a policy which is adopted by the central bank of the country to control
the supply of money.
OR
We can say that all those methods which are adopted by central bank of the
country to control the supply of money are called Monetary Policy.
4. QUANTITATIVE METHODS
They consist of those methods which physically affect the amount of credit
creation in the economy. They are as:
1) CHANGES IN BANK RATE POLICY OR REDISCOUNT RATE:
The rate at which the central bank of the country gives loans to commercial
banks is known as Bank Rate / Rediscount Rate.
By changing such rate of interest, central bank can influence the supply of
money in the country.
To control inflation, the central bank increases the rate of interest. The
commercial banks will also increase the rate of interest.
Accordingly, the loan will decrease, investment, output and prices will fall.
5. Limitations
The fact that how flexible is the economic system. How rapidly, there will be
the effect of bank rate on other variables of the economy , like prices,
wages, interest and output etc
Commercial banks should abide by the instructions of the central bank. I f the
central bank brings changes in the rate of interest, the commercial bank
should also change the rate of interest.
If commercial banks already have excess reserves, then commercial banks will
not depend upon central bank. In this way, they will not care for changes in
the rate of interest from central bank.
6. OPEN MARKET OPERATIONS
This is the second instrument of monetary policy. Under this technique, the
central bank sells or purchases government securities.
If the central bank finds that commercial banks are providing excessive loans
which are creating inflation.
To remove the inflation, the central bank sells the government securities.
The commercial banks will purchase these securities to earn interest against
such securities, In this way the resources of commercial banks will go down,
They will advance less loans. Accordingly, inflation will be controlled.
7. LIMITATIONS
If commercial banks purchase government securities with their excess
reserves, their resources to advance will not fall and inflation would not be
controlled.
The problem is that, in most of the countries, the money market is not
organized where the securities could be sold or bought.
The funds which are collected through the sale of government securities
should not be spent on unproductive fields.
8. CHANGES IN RESERVE REQUIREMENTS
Each commercial bank has to keep certain proportion of its deposits in the
form of reserves just to meet the demands of the depositors.
As in the case of Pakistan, each commercial bank has to keep 30% of its
deposits to meet the needs of its depositors.
The central bank can influence this reserve rate.
If the central bank realizes that the commercial banks are advancing
excessive loans, it will increase the reserve requirement.
Accordingly, commercial banks would advance less loans.
9. CHANGES IN RESERVE RATIO
Each commercial bank has to keep a certain ratio of its deposits with central
bank.
In case of Pakistan, each commercial bank has to keep 5% of its deposits in
the central bank.
By changing the reserve capital, a central bank can control the supply of
money by commercial banks.
When there is inflation in the economy. To remove this inflation, the central
bank will increase the reserve ratio.
As a result, lending of commercial banks will fall. As a result, the supply of
money will decrease.
10. CHANGES IN MARGINAL REQUIREMENTS
Commercial banks do not give loans against leaves, rather they ask for
pledges to make.
How much a person will have to pledge is settled by the central bank. This is
given the name of marginal requirement.
The central bank can bring changes in the marginal requirements.
If there is inflation in the economy, the marginal requirements will increase.
In this way, people will get less loans.
As a result, the supply of money will decrease.
11. CREDIT CEILING/ RATIONING OF CREDIT
The central bank can issue directions that loans will be given to commercial
banks upto a certain limit.
As a result, the commercial banks will be careful in advancing loans to the
people.
But this is a very strict method, hardly adopted by the central bank.
Moreover, if the commercial banks are having other sources to borrow, they
will not bother for this policy.
12. QUALITATIVE METHOD
1. MORAL SAUSATION;
It is concerned with just as a moral request by central bank to commercial banks
that loans should not be given for unproductive fields which create inflation.
Again loans should not be given for speculative purposes and hoarding. But
such like request could be effective in the developed countries.
13. 2. CONSUMERS CREDIT CONTROL
This instrument is applied during inflation.
If the central bank wants to control the supply of money, it will issue
directions to commercial banks that loans should not be advanced for
consumption purposes or for consumer durables because they create inflation.
Again, under this method, the central bank can direct the business concerns
who sell the goods on instalments to raise their down-payments.
14. 3. DIRECT ACTION
The instrument of direct action is concerned with the policy of central bank
against commercial banks.
It can refuse to give loans to commercial banks. The central bank will not
advance loans to commercial banks for the sectors which create inflation.
Moreover, if commercial banks do not follow the instructions of the central
bank, it will refuse to lend commercial banks.
But this is a very strict method, it is hardly adopted by central bank.
15. 4. PUBLICITY
The central bank of the country is the overall incharge of economic stability
of the country.
Its aim is to protect the economy from inflation and deflation.
For this purpose, it analyses the whole economy. It keeps an eye over the
activities of the commercial banks.
If the commercial banks are found advancing loans which create inflation ,
their activities will be unhealthy for the whole economy.
The central bank can blacklist such banks. Thus to avoid such bad reputation
in future, they will be careful in advancing loans.
16. 5.MARGIN REQUIREMENTS
This is a method in which ‘margin’ refers to the difference between market value
of securities and the amount borrowed against these securities.
This method 1st of all tried in USA in 1934
The bank while advancing credit against a security does not lend the full of
amount but less.
17. OBJECTIVES OF MONETARY POLICY
PRICE STABILITY:
It must be kept in view that by price stability we mean that neither prices should
rise sharply nor fall sharply.
The slow rise in prices is called Price Stability.
When prices are rising, it is called inflation and when prices are falling, it is called
deflation. Both are undesirable. Particularly, during inflation, the fixed income
group is badly affected.
Moreover, there arises so many social and economic problems due to rising of
prices.
Therefore, with the help of monetary policy, we can attain price stability. In this
connection, if central bank rises the rate of interest, sells government securities,
increases reserve requirements of the commercial banks, they will have the effect
of decreasing the loaning power of commercial banks.
18. TO RAISE THE LEVEL OF EMPLOYMENT
In most of the developing countries, due to population growth, etc , the number of
unemployed are increasing .
This unemployment can be put off with the help of an easy monetary policy. In this
connection, the central bank will reduce the bank rate, purchase government
securities, reduce reserve requirements of commercial banks.
All this will increase the loaning sources of commercial banks. In this way, the
investment will increase. Hence, the level of employment will also move upward.
But whenever an easy monetary policy is adopted to raise the level of employment,
there develops inflation in the country.
Therefore, the easy monetary policy should be used carefully. But in countries like
ours, the commercial banks follow the traditional practices of lending.
They advance loans to big businesses to earn more profits. As a result, their incomes
increase but unemployment does not decrease.
19. ECONOMIC GROWTH:
The persistent rise in the real NI of a country is called economic growth.
The developing countries are very much ambitious to develop their economies as
soon as possible, but they have the shortage of resources.
This shortage can be met through an easy monetary policy. In this connection, if
central bank reduces the rate of interest , purchases government securities,
reduces reserve requirements of commercial banks, all these will increase the
advancing powers of the commercial banks.
When more is being advanced by commercial banks, the supply of money will
increase. In this state of affairs, investment will increase.
When investment increases, NI will also increase. We know that persistent
increase in the real NI of a country is called economic growth.
But easy monetary policy will generate inflation. This may sabotage the process
of growth. But just increasing monetary supply cannot compensate shortage of
natural resources, technology and manpower.
20. REMOVAL OF DEFICIT IN BALACE OF PAYMENTS
If the foreign receipts of a country are less than a foreign payments, then there is
deficit in balance of payments.
To remove this deficit in BOP, a tight monetary policy can be adopted. in this
connection if, the central bank raises the rate of interest, sells government securities,
and increase the reserve requirements of commercial banks, all this will reduce
loaning power of commercial bank.
In this way, when there is deflation in the country ,the domestic products become
cheaper.
Accordingly, the exports of a country will increase. Hence the country’s receipts will
increase. On the other hand, due to tight monetary policy, the income of the people
will come down. They will spend less on imports. Hence, the country’s payment will
fall.
Increase in receipts and fall in payments will remove deficit in BOP. But the tight
monetary policy will promote deflation and unemployment.
21. ROLE OF MONETARY POLICY IN NI
DETERMINATION
The concept of NI determination has been given by Prof. Keynes.
The level of NI can also be influenced by deliberate changes in the monetary
policy.
As during INFLATION, a strict monetary policy consisting of:
1)Increase in bank rate,
2)Increase in reserve requirements,
3)Sale of government securities, can be adopted
All these have an effect on the components of AD. Hence, level of NI can be
affected.
22. While during DEFLATION, an easy monetary policy consisting of :
1. Decrease in bank rates,
2. Decrease in reserve requirements,
3. Purchase of government securities, can be adopted.
All these will have the effect of increasing AD and hence the level of NI can be
raised.
23. HOW CHANGES IN BANK RATE PLAY THEIR
ROLE IN NI DETERMINATION
MONETARY POLICY IN DEFLATION
