MCom I Semester Business Environment Monetary Policy Study Material Notes

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MCom I Semester Business Environment Monetary Policy Study Material Notes

Table of Contents

MCom I Semester Business Environment Monetary Policy Study Material Notes: Meaning of Monetary Policy Definition of Monetary Policy Instruments of an Indian Monetary Policy Important and Objective of Monetary Policy Banking Policy and Trends Strategy of Poverty Alleviation Exercise Questions Long Answer Questions Short Answer Questions Objectives Questions :

Monetary Policy Study Material
Monetary Policy Study Material

MCom I Semester Business Environment Unemployment Notes study Material

Monetary Policy

In the monetary policy, money and the banking system plays an important role both in terms of being frictionless on work and growth. In a modern economy, money has been considered as the most dynamic element in the economy. Money being inherently unstable is not likely to manage itself in the best interests of the economy. It has to be deliberately managed with a view to assisting in the achievement of certain definite socio-economic objectives. The moment money ceases to work smoothly, everything is rendered chaotic.

MEANING OF MONETARY POLICY

Monetary policy may be defined as an instrument used by the central bank to influence and make amenable to control variables such as volume of credit, cost of credit, purpose of credit with a view to achieving certain pre-determined objectives. The monetary policy refers to a regulatory policy where by the central bank maintains its control over the supply of money for the realisation of general economic goals. This concept of monetary policy may be right in the context of developed economies, but in less developed countries like India, monetary policy can not remain confined only to controlling the supply of money.

DEFINITIONS OF MONETARY POLICY

Monetary policy has been defined as follows:

1 Prof. Hennery Johnson opined, that monetary policy is a policy by which the central bank controls the supply of money to attain general economic policy.

2. According to Redcliffe Committee, “Monetary policy should be supplemented by non-monetary policies. In a way, monetary policy is not a policy in itself but a part of one general economic policy which includes among its instruments fiscal and monetary measures and direct physical controls.”

3. The Chakravarty Committee has emphasised that price stability, growth, equity and social justice, promoting and nurturing new monetary and financial institutions have been important objectives of monetary policy in India.

4. Y. Venugopal Reddy has remarked, “In India monetary policy has always emphasised the objectives of price stability and growth.”

It is clear from the above definitions that the money affects and is affected by the different aspects of the economy. Monetary policy includes monetary and non-monetary measures to control price and wages, trade and investments, and tries to eliminate unemployment. action of productive resources.

Monetary Policy Study Material

IMPORTANCE AND OBJECTIVES OF MONETARY POLICY

The fundamental objective of monetary policy in a developing economy is the promotion of economic growth with economic stability. The monetary authority can promote economic growth by directing the flow of funds in the desirable channels of investment. The importance and objectives of monetary policy are discussed below:

1 Arrangement of full employment : To attain the objectives of production, employment and raise level of incomes in an economy, the monetary policy is an instrument which helps to attain the level of full employment by the maximum utilismic development.

2. Increase in savings: An adequate monetary policy helps maintaining the level of full employment in the economy. It promotes the level of savings, investments and as a result economic development .

3. Stability in income : The Keynesian approach to monetary policy emphasised the maximum utilisation of resources and the stabilisation of the levels of income and employment. The fundamental aim of the monetary policy in a developing economy is the economic stability.

4. Stability in exchange rate: A degree of price stability and exchange stability is essential for a steady economic growth. The central bank of the country has the responsibility to maintain and stabilise the external value of currency.

5. Rapid economic growth : The monetary policy should be designed to create the machinery needed for financing development activities all over the country. Thus, the major interest now is in monetary policy which at any rate in a developing economy lies in its utility for economic growth. The central bank of a developing country has to pursue a monetary policy which assists in accelerating economic development. The Reserve Bank of India has been following a monetary policy which fits in with the priorities of economic development in a country.

6. Neutrality of money : The objective of the monetary policy should be designed in such a way so as to meet the fluctuations in the economy. In the pursuit of neutrality of money, the monetary authority has to regulate the supply of money that the production levels, price levels and the volume of transactions are such as if the community did not use any money.

7. Expansion of credit facilities : The central bank creates special financial institutions for promoting economic development in different sectors of economy. These institutions provide much needed finance to accelerate development in their respective spheres.

8. Miscellaneous objectives: A good and successful monetary policy helps in the achievement of following other objectives :

9. In a developing economy, the balance of payments turns adverse. The monetary authority tackles this problem by export promotion, import substitutions and raising foreign loans.

10. Foreign exchange reserves increase.

11. More credit facilities are provided to the primary and backward areas.

12. Stabilization in exchange rates.

13. It makes funds available to finance the development programmes.

14. It increases the rate of capital formation and provides sound base for banking facilities.

Monetary Policy Study Material

INSTRUMENTS OF INDIAN MONETARY POLICY

The Reserve Bank of India is the cont to influence the volume of credit created by banks in India. The objective

India is the controller of credit, i.e., it has the power credit control are as :

1 To control and reduce inflationary pressure in the economy.

2. Make funds available to finance the development programme according to the priorities of plans.

3. Speed up economic development in the country to raise national income and standard of living.

This policy of the Reserve Bank of India since the first plan period was termed as one of the controlled expansion, i.e., policy of “adequate financing of economic growth and at the same time ensuring reasonable price stability.” RBI helped the economy to expand via expansion of money and credit by the use of following methods :

Credit control: The RBI has various weapons for control of credit. These weapons are quantitative and qualitative controls. Quantitative controls are used to control the volume of credit and indirectly, to control inflationary and deflationary pressures.

(i) Change in cash reserve ratio : Under the RBI Act, 1934, every commercial bank has to keep certain minimum cash reserves with RBI. Under the RBI (Amendment) Act, 1962, the RBI is empowered to determine CRR for the commercial banks in the range of 3 percent to 15 percent for the aggregate demand and time liabilities. This technique of credit control was used quite often during the 1970s and 1980s for controlling inflation. However, in a bid to control inflationary tendencies in the economy, the CRR was subsequently raised in stages. At present, CRR is 4 percent.

(ii) Trend of complete expansion : As for checking credit expansion and cheking inflation, the Reserve Bank’s policy of monetary regulation has not been effective. Total money supply has been increasing rapidly as conpared to the flow of real goods and services. This imbalance has been the major factor in accentuating inflationary pressures in the country. The imbalance has been caused by an inadequate increase in real output or supply and a much larger increase in demand. Expansion in farm output and the output of industry lagged behind. But the aggregate demand went up on account of growing investment expenditure and rising unemployment and income levels and also growing population and urbanisation. The increase in government expenditures, especially defence expenditure, and deficit financing have also extended expansionary influence on the demand side.

(iii) Costly currency : The Reserve Bank of India has tried to regulate (a) the cost of credit, (b) the quantity of credit, and (c) the purpose or use of credit. For regulating cost and the quantity of credit, the Reserve Bank has used the weapon of regulating bank rate. In order to curb the run away expansion in bank credit and bill discounting RBI offered incentives to savings by raising rates of interest on fixed deposits. It is good that the Reserve Bank adopted various credit freeze measures.

It must be said to the credit of the Reserve Bank of India that it has fully risen to the occasion to meet the requirements of developing economy. Besides taking monetary measures to maintain the general financial stability in the country and restraining inflationary pressures, it has helped in the creation of specialised institutions so that financial facilities are made available to agriculture and industry. Its development effort is indeed commendable. The RBI has thus, helped to broaden and deepen the structure of institutional finance for accelerating economic development of the country with itself as the central arch of the banking and monetary framework of the country.

(iv) Investment and savings intent: Recently, the monetary policy has been moved towards to increase savings and investment in the economy. The interest rate can be controlled through a control over saving. The rate of interest continues to be the core of the monetary policy. A rise in interest rates has important effects, both direct and indirect, upon those who borrow and those who lend and also on the flow funds to and from the country. A sharp rise in the interest rate is expected to increase the more desirable kinds of savings. Now a days the rate of interest has been reduced to invest the savings in the capital market.

Monetary Policy Study Material

CONTENTS AND PERFORMANCE OF MONETARY POLICY

The most important function of the Reserve Bank is the control of credit creation and money supply. This has increased the importance of an institution which could coordinate, control and manage the various complicated and conflicting factors, economic and financial which affect the economic stablity in the national and international field. The monetary policy of the Reserve Bank contains the following contents:

1 Proper interest rate policy : The RBI, like other central banks, is empowered to use bank rate as an instrument of credit control. The RBI adopted dear money policy to curb inflation in the economy. In accordance with the traditions of the 1930s, the RBI started with a cheap money policy and had fixed a low bank rate (3%) and did not change it till November 1953 when it raised the bank rate to 3.5 percent. The Bank rate gradually rose to 10% in July 1981, these were the only changes during this period. The bank rate remained unchanged at 10 percent for another 10 years (1980-1991). It was revised upwards to 11 percent in July 1991 and further to 12 percent in October 1991. Since the later part of 1995, India passed through a severe liquidity crunch and as a result the prime lending rates were ruling high. Industrial production was affected adversely. One step which RBI took was to reduce the bank rate from 12 to 11 percent in April 1997, and has maintained at 8 percent during 1999-2000. It has been brought down to 60 percent per annum during the period 2000-2002. On February 2015, bank rate was 8.75 percent.

The bank rate or the central bank’s rediscount rate is an important monetary instrument in modern economics. If monetary policy is effective and credible, a change in the bank rate will result in change in prime lending rate of banks and thus act as an independent instrument of monetary control. However, the role of the bank rate as an instrument of monetary policy has been very limited in India because of these basic factors:

(a) The structure of interest rates is administered by RBI- they are not automatically linked to the bank rate;

(b) Commercial banks enjoy specific refinance facilities, and may not necessarily rediscount their eligible securities with RBI at bank rate; and

(c) The bill market is underdeveloped and the money market is not influenced by the bank rate.

The Government of India and RBI are reviewing the rules and p for general access to RBI rediscount facilities so as to make bank rate an

I are reviewing the rules and procedures instruments of monetary policy as in other modern economies.

2. Expansion of financial institutions: The Reserve Bank has done a few things in the field of developmental finance. It has made available shortterm, medium-term and long-term finance to agriculture through the hierarchical network of cooperative banks and societies. It has been instrumental in setting up Agricultural Refinance and Development Corporation. It has helped in the creation of Industrial Finance Corporation of India, State Financial Corportions, Refinance corporation, National Small Industries Corporation, National Industrial Development Corporation, Industrial credit and Investment Corporation and the Industrial Development Bank. It has introduced a scheme of guarantee of bank loans to small industies.

3. Expansion of credit facilities: The RBI has adopted following steps:

(1) Introduction of foreign bills of exchange (1963).

(2) Modification in open market operation and liberalisation of bills market (1957).

(3) Vary the minimum cash reserve ratio (1972).

(4) Credit liberalisation to the priority sectors.

4. Equilibrium in demand and supply of money: The RBI helps to restore equilibrium between demand for and supply of money. As for controlling credit expansion and checking inflation, the Reserve Bank has done its best and used all possible weapons of credit control. But somehow we have landed ourselves in a situation in which aggregate monetary demand had risen faster than the flow of real goods and services.

Monetary Policy Study Material

BANKING POLICY AND TRENDS

During current financial year the banking sector concentrated on current reforms such as bank rates on liberal conditions, increasing efficiency of banks, making exchange system strong, etc. The Narsimham Committee had recommended that banking supervision had to be strengthened and its character must be drastically changed, away from intensive micro-intervention over credit decisions towards prudential regulations. Hence, to this end, the RBI issued guidelines for income recognition, asset classification and provisioning and adopted the base capital adequacy standards.

1 Changes in bank rates: The bank rate is the rate at which the central government rediscounts the papers presented by commercial banks or makes advances to them directly against approved securities. The discount rate represents the price at which the central bank stands ready to sell or lend resources to member banks. A change in the interest rate means that the central bank has raised or lowered the price at which it will sell or lend reserves to the banking system. Changes in the bank rate, accompanied by changes in the lending potes of banks, tends to influence the market rate of interest. Thus, ‘dear money means that the borrowing rates or interest rates are high and ‘cheap money means the interest rates are low. On February 2015, the bank rate was 8.75 percent.

2. Changes in statutory liquidity ratio : The Banking Regulation (Amendment) Act 1962 provides for maintaining a minimum statutory liquidity ratio (SLR) of 25 percent by the banks against their net demand and time liabilities. The RBI is vested with the power to determine SLR for commercial banks. Since 2007, RBI has finished the minimum statutory liquidity ratio. In February, 2015, this ratio was 21.50 percent.

3. Consumers credit control: The RBI uses this instrument to provide loans to consumers at low rate of interest to increase the demand of durable consumer goods. Consumer credit relates to an arrangement.

That enables consumers to buy goods and services immediately and pay for them later. Consumer credit is essentially short-term debt which includes instalment credit and non-instalment credit. The regulation of consumer credit consists in laying down rules regarding payments and maximum maturities of instalment credit for the purchase of specified durable consumer goods. It involves two devices (i) fixation of minimum down payments and (ii) laying down maximum period of repayment.

4. Selective credit control : Regulation or control of credit for specific purposes or branches of economic activities is termed as selective or qualitative credit control

The aim of selective control is to restrict the use of credit for such forms of activity as are regarded relatively unessential or less desirable.

The selective credit control is used to regulate the following:

(1) It may determine the debt policies of the companies.

(2) Reserve Bank fixes the quota for member banks as well as their limits for payment of bills.

(3) The Reserve Bank is empowered to issue directive to the banking companies regarding the maximum amount up to which guarantee may be given by the banking company on the behalf of any firm, company etc. It may fix the rate of interest and other terms and conditions for granting advances.

At present RBI has directed to the member commercial banks that they will grant 40 percent of their total loans and advances to the priority sector.

5. Establishment and Direction of financial institutions: The success of monetary policy depends on the sound banking system. The RBI has created special financial institutions for promoting economic development in different sectors such as Industrial Finance corporation, Industrial Development Bank, Industrial Finance and Investment Corporation, State Finance Corporation, Unit Trust of India etc.

Monetary Policy Study Material

LIMITS OF MONETARY POLICY IN DEVELOPING COUNTRIES

In developing countries, the monetary policy had limited success on account of the following factors :

(1) Limited area of monetary policy:

(i) Large non-monetary sector: The existence of a large non-monetised sector, perhaps one-third of the economy, in developing countries seriously limits the scope of the use of the monetary weapons.

(ii) Less importance of credit money policy : In develop like India currency occupies a relatively more important position than bar credit money policy : In developing countries deposits. By habit and custom associated custom associated with the paucity and backwardness of appropriate institutions, people prefer to make use of cash rather than cheques. This reduces the capacity of banking system to create fresh credits on the basis of an increase in reserves.

(2) Limited impact of monetary policy:

(i) Lack of Organized Money Market: The money market in developing countries is not properly organised. Monetary control can succeed only in systematically organised economy. In India, the RBI has no control over the indigenous bankers and non-banking financial institutions. These institutions give liberal loans for hoarding and black marketing purposes. Moreover, when deposits with the banks are fast increasing, the monetary controls cannot effectively check the credit expansion capacity of the banks. When the banks are in the position to make advances out of their deposits and resources, they do not require loans and reference facilities from the RBI. Consequently, changes in bank rates and net liquidity ratio shall prove to be ineffective in checking credit expansion. Changes in statutory reserve ratio during a period of fast expanding deposits can meet with only limited suceess.

(ii) Lack of bill market: The developing countries lack in well-organised and well-developed bill market. As a result, credit system does not prove to be effective.

(iii) Other reasons : There are some other factors responsible for the limited success of monetary policy in a developing country:

(a) The central bank has no control over private sector banking system.

(b) Lack of effective coordination between the RBI and its member banks.

The weapons and powers available to RBI are such that they cover only organised banking sector of commercial banks and cooperative banks. To the extent, inflationary pressure is the result of bank finance, the RBI’s controls have positive effects. But if the inflationary pressure is really brought about by deficit financing and shortage of goods, RBI’s control may not have any effect at all. This is what is probably happening in India in the recent years.

Monetary Policy Study Material

REASONS FOR FAILURE OF MONETARY POLICY

The RBI is not successful to control credit due to the following reasons :

1 No determination of monetary targets : The policy of monetary targeting helps RBI in the use of monetary policy instruments. In the last two decades, the increase in reserve money and in money supply has been largely due to a rise in the level of RBI credit to government which reflects a significant monetisation of debt. The Chakrawarty Committee has made recommendation that the target for increase in money supply in M, during a year should be announced in advance and it should be based on anticipated growth in output and in the light of the price situation.

2. Flow of black money: A serious obstacle in the way of efficient working of monetary policy is the circulation of large amount of money in the black market. The black money is not recorded since the borrowers and lenders keep their transactions secret. Consequently the supply and demand of money also does not remain as desired by the monetary policy.

3. Lack of financial discipline : It is a matter of regret that the nationalised banks are advancing huge amounts to traders for speculative accumulation of stocks. In other words, the nationalized banks have not only disciplined themselves but have also failed to follow the government policy.

4 . Role of capital market: Some transactions of the capital market also influence price level; such as loans on national saving certificates and on insurance policies.

5. Slow growth of money market: Indian money market is not developed adequately. The Indian economy is underdeveloped, unorganised and plagued by shortages which make the monetary control innocuous.

6. Limited work scope of RBI : RBI’s area of operation is limited up to the commercial banks and it has no control over inflation generated by the action of deficit financing.

7. Use of electronic currency : The use of electronic money contracts the use of physical currency which also creates problem for monetary policy.

8. No-control on non-banking institutions : The RBI has no control over non-banking institutions. Thus monetary policy has only limited scope.

9. International monetary crises : International monetary crisis has also adversely affected the operation of RBI.

10. Excess cash reserve in banks : Excessive deposits with the banks cannot check effectively the credit expansion capacity of the banks.

EXERCISE QUESTIONS

Long Answer Questions

1 Define the monetary policy and explain various instruments of monetary policy.

2. What do you understand by monetary policy? Explain the objectives of monetary policy.

3. What is monetary policy ? Explain limitations of monetary policy in developing countries.

4. What do you understand by monetary and credit policy? Explain reasons for failure of monetary policy in any country.

5. Give the definition of monetary policy and explain the subject matter of monetary policy.

Monetary Policy Study Material

Short Answer Questions

1 What do you understand by monetary policy?

2. Write the objectives of monetary policy.

3. What do you understand by credit control ?

4. Explain the subject matter of monetary policy.

5. What are statutory liquidity requirements ? Objective Questions

(I) Select the Correct Alternatives:

1 The cause of failure of monetary policy is :

(a) Large non-monetized sector

(b) existence of black money

(c) lack of credit money

(d) all of above.

2. “Controlled expansion of total money is :

(a) subject matter of money

(b) saving and investment

(c) monetary objectives

(d) none of these.

3. Under monetary policy, ‘dear money is :

(a) monetary objective

(b) characteristics of monetary policy

(c) instrument of monetary policy

(d) none of these.

4. When changes in bank rates create instability, it is known as:

(a) limit of monetary policy

(b) defect of monetary policy

(c) objective of monetary policy

(d) all of above.

5. Among following which policy helps economic development:

(a) monetary policy

(b) price policy

(c) fiscal policy

(d) none of these

[Ans. 1. (b), 2. (c), 3. (c), 4. (a), 5. (a).]

Monetary Policy Study Material

(II) Write true or false :

1 Most of the recommendations of the Narsimham Committee have been accepted by the government.

2. In post-reform period, the bank rate has been reduced.

3. RBI has no control over the indigenous bankers and non-banking financial institution while they have big impact on trade and business.

4. Nationalized banks have followed the financial disciplines.

[Ans.: 1. True, 2. True, 3. True, 4. False.)

(III) Fill in the Blanks :

1 The credit control operation of the Reserve Bank is limited only to the ….

2. …………… limits the scope of monetary policy in India.

3. There is a …………. between money supply, production and prices.

4. The success of monetary policy depends on the well-organised …………

[Ans. 1. Scheduled banks, 2. The parallel economy, 3. deep relation, 4. money mrket.]

Monetary Policy Study Material

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