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.
Price Stability:-One of the policy objectives of monetary
policy is to stabilise the price level. Both economists and
laymen favour this policy because fluctuations in prices bring
uncertainty and instability to the economy.
Economic Growth:-One of the most important objectives of
monetary policy in recent years has been the rapid economic
growth of an economy. Economic growth is defined as “the
process whereby the real per capita income of a country
increases over a long period of time.”
Balance of Payments:-Another objective of monetary policy
since the 1950s has been to maintain equilibrium in the balance
of payments.
Instruments of Monetary Policy
The instruments of monetary policy are of two types: first,
quantitative, general or indirect; and second, qualitative, selective
or direct. They affect the level of aggregate demand through the
supply of money, cost of money and availability of credit. Of the two
types of instruments, the first category includes bank rate
variations, open market operations and changing reserve
requirements. They are meant to regulate the overall level of credit
in the economy through commercial banks. The selective credit
controls aim at controlling specific types of credit. They include
changing margin requirements and regulation of consumer credit.
We discuss them as under:
Bank Rate Policy:
The bank rate is the minimum lending rate of the central bank at
which it rediscounts first class bills of exchange and government
securities held by the commercial banks. When the central bank
finds that inflationary pressures have started emerging within the
economy, it raises the bank rate. Borrowing from the central bank
becomes costly and commercial banks borrow less from it.
The commercial banks, in turn, raise their lending rates to the
business community and borrowers borrow less from the
commercial banks. There is contraction of credit and prices are
checked from rising further. On the contrary, when prices are
depressed, the central bank lowers the bank rate.
It is cheap to borrow from the central bank on the part of
commercial banks. The latter also lower their lending rates.
Businessmen are encouraged to borrow more. Investment is
encouraged. Output, employment, income and demand start rising
and the downward movement of prices is checked.
Open Market Operations:
Open market operations refer to sale and purchase of securities in
the money market by the central bank. When prices are rising and
there is need to control them, the central bank sells securities. The
reserves of commercial banks are reduced and they are not in a
position to lend more to the business community.
Further investment is discouraged and the rise in prices is checked.
Contrariwise, when recessionary forces start in the economy, the
central bank buys securities. The reserves of commercial banks are
raised. They lend more. Investment, output, employment, income
and demand rise and fall in price is checked.
Changes in Reserve Ratios:
This weapon was suggested by Keynes in his Treatise on Money and
the USA was the first to adopt it as a monetary device. Every bank is
required by law to keep a certain percentage of its total deposits in
the form of a reserve fund in its vaults and also a certain percentage
with the central bank.
When prices are rising, the central bank raises the reserve ratio.
Banks are required to keep more with the central bank. Their
reserves are reduced and they lend less. The volume of investment,
output and employment are adversely affected. In the opposite case,
when the reserve ratio is lowered, the reserves of commercial banks
are raised. They lend more and the economic activity is favourably
affected.
Selective Credit Controls:
Selective credit controls are used to influence specific types of credit
for particular purposes. They usually take the form of changing
margin requirements to control speculative activities within the
economy. When there is brisk speculative activity in the economy or
in particular sectors in certain commodities and prices start rising,
the central bank raises the margin requirement on them.
The result is that the borrowers are given less money in loans
against specified securities. For instance, raising the margin
requirement to 60% means that the pledger of securities of the
value of Rs 10,000 will be given 40% of their value, i.e. Rs 4,000 as
loan. In case of recession in a particular sector, the central bank
encourages borrowing by lowering margin requirements.
