BCom 3rd Year Money Financial System Monetary Policy Study Material Notes
Table of Contents
BCom 3rd Year Money Financial System Monetary Policy Study Material Notes: Definitions of Monetary Policy objective or goals or Monetary Policy Instruments of Monetary Policy Statutory Liquidity Ratio Increase in Bank Money Lack of Elasticity in Economy Exercise Questions Long Answer Questions Short Answer Questions ( Most Important Notes for BCom 3rd Year Students :
BCom 3rd Year Nature Importance Financial Money Study Material notes
MONETARY POLICY
Meaning of Monetary Policy: Monetary policy refers to that thought of the Reserve Bank of India through which the credit and supply of the money are controlled in the country. In practices, the central bank of the country bears the responsibility of declaring and implementing the monetary policy. The central bank gives a practical shape to the monetary principles for the reforms and development in the economy. These principles are termed as the monetary policy. In simple terms, monetary policy refers to that direction of the economic policy in which some steps to control the supply of money and credit, their uses and interest rates are taken to achieve certain objectives.
We know that in the modern economy the engine of progress travels on the two wheels of ‘money’ and ‘credit. But these two wheels can’t be allowed to move freely. Thus, the monetary policy plays the role of the driver to regulate and operate these two wheels in a balanced way. Thus, the monetary policy is that policy of the central bank through which the amount of money and credit in the economy is controlled and regulated.
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DEFINITIONS OF MONETARY POLICY
Many scholars have also defined the monetary policy. Some important definitions are as follows:
According to H.G. Johnson, “The monetary policy refers to that policy of the central bank through which the amount of money is regulated to fulfill the objectives of common economic policies.”
According to Paul Finzig, “Monetary policy includes all these monetary decisions and measures the objective of which is to influence the monetary system”.
According to Kent, “Monetary policy refers to the arrangement of expansion and contraction of the supply of currency for the fulfillment of a certain objectives.
After the study of the above definitions, it can be said that the monetary policy has been used in two senses – in a broad sense and in a narrow sense. In the broad sense, monetary and non- monetary measures are adopted in the managerial arrangement of the money and credit. The non- monetary measures includes those policies which have direct or indirect impacts on the monetary condition of the country for e.g. wages and prices control, trade and investment control, budget – related activities, income policies, employment etc. In the narrow sense, the monetary policy includes only those measures which include only the steps of regulating and controlling the amount of money and credit. It does not! include non-monetary measures.
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OBJECTIVES OR GOALS OF MONETARY POLICY
Before the World War II, in any country of the world that did not accept with prominence importance of the monetary policies. It was considered only a source of producing cheap money. That is why, monetary policy and its objectives were not very clear. But after the World War II, many countries including India realized the importance of monetary policy and it started to be adopted as a measure for the development of economy. Again, many changes took place according to the time and circumstances, so the objectives of monetary policy remained different. The monetary economists have mentioned certain objectives of monetary policy, the most prominent of these are as follow :
The Objectives of Monetary Policy
(1) Price Stability
(2) Full Employment
(3) Stability of Exchange Rates
(4) Economic Growth
(5) Neutrality of Money
(1) Price Stability: Normal life of the people gets badly disturbed due to instability in prices. Its effects are there on trade, industries, employment, production, debtors, creditors etc. So the price stability is considered to be a prominent objective of the monetary policy. Due to fluctuation in prices, the situation of inflation and deflation in money emerges and this bring great fluctuations in the economy. So, by maintaining stability in price the development with social justice is achieved.
But it is essential to clarify that it is not the meaning of the price stability that there should be no change in prices for a long time. There are many causes of change in price. Some of these are : change in the cost of production due to change in technique of production, change in demand due to change in the tastes of people, change in the rate of tax, import, export etc. So, the change in prices with change in the cost of production is essential. But with a little change in the cost of production a big change in prices is not justiceable. Differential change in price is essential for the proper distribution of resources in economy. Prof. Samuelson and Prof. Keynes held that two per cent annual inflation is essential for encouraging entrepreneurs and obtaining high level employment.
But many problems have to be faced in adopting the policy of a fixed price level. The first problem is that how stability in prices should be achieved and in which type of prices – in the wholesale prices or retail prices; the price level of consumer goods, or the price level of producer goods; the relative price level or the general price level ? In this respect, it is the opinion of Prof. Halm that, “The solution of the above questions should be that there should be stability in the rates of wages and consumer goods.” But if there is a need of increasing the amount of money for this, it should be only in such an amount which can keep the consumer price stable.
Similarly, when there are innovations the cost of production falls. But due to the policy of stability in prices, the production policy of stability in prices, the producers obtain much profits and consumers face loss. On the contrary if prices of imported raw materials rise, the cost of production goes up and due to stability in price, there is a fall in the profit of production. In such a situation, the policy of stable price will be a disturbance in economic development.
Considering the problem of ‘Price Stability Policy’ Prof. Hayak has considered that the concept of price stability is not in favour of the progressive economy. But most of economists are in favour of ‘Stable Price Policy. Thes economists held that the price stability can be made counter – cyclical by adopting the cheap currency policy during the recession and ‘Dear Currency Policy’ during the economic boom. But the price stability is so difficult in practice as it appears attractive because price are divided into many sections and a total control on these is impossible.
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(2) Full Employment : Unemployment is a curse for any country. This increases poverty and hurts the dignity of the society. So, it has been considered the prime objective of the monetary policy to achieve full employment in the present time. But there is a question what would be considered the condition of full employment. The economists have presented their opinion in this regard. Generally, full employment refers that condition in which every person willing to work in the country gets employment at the going rate and the other source of production are properly used. But it is not possible in the capitalist economy.
Lord Bewiz has considered that situation to be the condition of full employment in which the vacancy is more than unemployment so that in case of losing on job, the other may be obtained. But this argument may not be accepted because in this condition, there will be the pressure of employees and there can be the possibility of inflation.
Prof. Keynes has also considered the achievement of full employment essential for the monetary policy. According to him, the situation of full employment refers to that condition in which everybody who is willing to work gets employment. Prof. Keynes has also developed a principle for ‘Income and Employment for obtaining the situation of full employment. He has also suggested the concept of increasing both consumption and investment to eliminate unemployment and achieve the condition of full employment. But increase in investment depends on the rate of interest and the marginal utility. Thus, adopting the Cheap Monetary Policy by increase in investment. By adopting this policy, the credit will become cheap, consequently the ill industries will be healthy and there will be an increase in both employment and production. But this policy should not be adopted for a long time, but should be stopped just as the favourable time comes.
But it is also worth mentioning here that the objective of the monetary policy should not be only achieving the condition of full employment but also maintaining the level of full employment. To achieve this objective along with the monetary policy, the fiscal policy should also be used. Thus, there should be monetary policy for achieving full employment by establishing a balance between saving and investment.
(3) Stability of Exchange Rates : Before the fall of the International Gold Standard the prime objective of the monetary policy was considered to maintain stability in exchange rate. Those days, every country had to follow the rules of the International Gold Standard Policy. No country was allowed to follow an independent monetary policy. So, different countries had to face inflation or deflation sometimes to bring stability in the exchange rate, because it was a general rule of the International Gold standard that, “when gold is coming in the country expand currency and credit and gold is going out of the country contract these.” But after the global depression of 1930, the stability of prices got more importance than the stability of exchange rates. Again when the International Monetary Fund was established, it was given the responsibility of maintaining the stability of exchange rates and the objectives of the monetary policy was considered the stability of price. But in 1976, different countries were given the legal permission of determining their independent exchange rates. At present, there is no importance of exchange rate in the process of fulfilling those objectives which are achieved through monetary policies. But, it does not mean that there should be no check on the exchange rate, because due to much fluctuation in the exchange rate, there is no opposite impact on the foreign trade and the foreign capitalist lose their confidence in the currency of that country. Consequently, the foreign investment in that country decreases and the economy of that country weakens. Thus, it is suggested that the monetary policy should be used for maintaining stability in the exchange rates.
(4) Economic Growth : The economists of olden days used to see the use of monetary policy with the view of short-term development. So, in those days stability in prices and full employment were considered the objectives of monetary policy. But the modern economists see the monetary policy with long-term objectives. That is why in recent years encouraging the economic development has become a prime objective of the monetary policy. The economic development is a process in which the per capita income of a country increases in long terms. Modern economists lay emphasis on the economic development of undeveloped and semi-developed countries particularly. They held that the standard of living of people in these countries is very low. Thus, encouraging the economic development for the rise in the standards of living of people is essential. Among the classical economists Schumpeter and W.W. Rostow emphasised the importance of economic development. Joseph Alois Schumpeter has said that there is a qualitative improvement in the economy through economic development. Similarly, Rostow has also emphasised the need of economic development for the poorly developed countries. Thus, the reputed economist considered it essential to achieve economic development for the growth of economy, while the modern economists are in favour of using the monetary policy as an important device. Now, if encouraging the economic development through the monetary policy is considered important, it can be done by adopting the cheap currency policy and increasing the amount of bank money to implement the deficit financing to encourage the economic development up to a certain limit.
(5) Neutrality of Money: The concept of the neutrality of money is based on this hypothesis that the supply of money/currency should be stabilized to prevent the fluctuation in the economy. The economists like Prof. P.H. Wickstead, F.A. Von Hayak and D.H. Robertson have supported this theory.
In the opinion of the above economist, even if the demand of the goods and services rise due to supply of more money, the desired production and supply of these goods and services do not take place instantly. As a result, there is a sudden rise in the prices of goods and services. Similarly there is a fall in the price of goods and services due to a reduction in the supply of money because the supply of goods and services reduces gradually. As a result of all these, the economy gets unbalanced. In other words, the condition of inflation and deflation comes due to monetary reasons. These situations create unbalance in the economy. So, these economists considered that this objective can be fulfilled by stabilising the amount of money.
But it is a major fault of this concept that if people start storing money in great amount or there comes a fall in the flow of money, there will raise a monetary crisis in the market. Besides this, increase in population production and inventions the condition of neutrality of money will give rise to monetary crisis only.
Thus, by changing the amount of money according to the need, the objective of the neutrality of money can be achieved. However, in the monetary policy of present this objective has become unimportant.
Conclusion: After the study of these objectives of monetary policy, it seems that their objectives are contradictory to one another. Thus, all the objectives can’t be fulfilled together. For example, the stability in exchange rate and stability in prices are contradictory to each other. Similarly, if there will be stability in the exchange rate, the objectives like full employment can’t be achieved. Again, the conditions of different countries are different. Thus, it is suggested that the objective of monetary policy for undeveloped and semi-developed countries should be economic development and for the developed countries these countries should include savings and investment along with full employment. But the financial policy should also be an assistant element in this process.
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INSTRUMENTS OF MONETARY POLICY
The monetary policy in India is associated to the Credit Control Policy of the Reserve Bank of India. The Reserve Bank of India does the operation of Credit Control, generally in the following ways:
Quantitative or General Credit Control : Under it, the Reserve Bank of India controls the credit through following instruments.
(1) Bank Rate : Bank rate is the most important monetary measures of credit control. Bank Rate is the rate at which the RBI gives loans to the commercial banks and does the discounting of trade bills. When there is an expansion of the amount of credit in the market, the RBI increases the Bank Rate. As a result, the rate of interest rises in the market. The trading class starts repaying their loans and at the same time, there is also a decline in the rate of taking loans. On the contrary, when the RBI observes that the amount of credit in the market has reduced, it lowers the Bank rate consequently, the commercial banks also start giving credit on less interest rate. This increases the flow of credit.
Bank rate has been changed many times for the credit control. The bank rate was 4 per cent in 1862 which was raised to 4.5 per cent in 1963 and 5 per cent in 1964. Again in 1965 it became 6 per cent and it was raised to 7 per cent in 1973. After this, there were many increases in it. It became 9 per cent in 1974, 10 per cent in 1981, and 11 per cent on 4th July, 1991. After a short period only, it was raised to be 12 per cent on 1st October, 1991. Again, there was a great reduction in this also. It was lowered up to 6 per cent in April, 2003. At present also, it is 9 per cent only.
(2) Open Market Operations : Open Market Operations refer to the selling and purchasing of the government securities, first class bills and promissory notes by the RBI. The RBI sells and purchases the securities in the open market for regulating the amount of credit. According to the section 17 of the Reserve Bank of India Act, 1934, the RBI retains the right of selling, purchasing and rediscounting of such trading bills and promissory note which have to be paid in India within 90 days. The RBI can get the agricultural bills for the period of 15 months re-discounted or even sell and purchase these. The open market operations were very limited till the World War II, but after it, these activities were adopted on large scale for regulating the amount of credit by purchase of securities are done in the open market by RBI as per needs.
(3) Variable Cash – Reserve Ratio : According to the section 42 (1) of the Reserve Bank of India Act, 1934 every commercial bank has to keep a definite per cent of their deposit with RBI. It is called Cash Reserve Ratio (CRR). Initially, it was fixed at 5 per cent of demand deposit and 2 per cent of fixed deposit. After the two amendments in 1962, the RBI got the freedom of adopting a flexible approach. At the same time, in place of having two separate CRRs for two different deposits, it got the right of considering a common rate. In this amendment, the RBI got the right to determine the CRR between 3 and 15 per cent.
The RBI used this right many times. In June 1973 the CRR was raised from 3 per cent to 5 per cent and in September 1973 it was determined at 7 per cent. Again, it was fixed at 8.5 per cent in August 1983, 10 per cent in October 1987 and at its maximum 15 per cent in April, 1991. For many reasons, there were several reductions in it in 1997, but there remained a lack in stability. CRR was fixed at 4.5 per cent on 31st March, 2004 which was again raised up to 4.75 per cent on 18th September, 2004. Again on 2nd October, 2004, it was fixed at 5 per cent which remained stable for a long time. It was 5.25 per cent on 23rd December, 2006. After this also, it fluctuated frequently. On the rate declared on 21st April, 2009, it was 5 per cent. Similarly on 13th February, 2010 it was fixed 5.50 per cent, 27th February, 2010, 5.75 per cent and on 24th April, 2010 6 per cent. The RBI controls the liquidity of commercial banks through CRR.
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(4) Statutory Liquidity Ratio—(SLR): According to the section 24 of the Banking Companies Act 1949, it was made essential for the Scheduled Bank that they should keep at least 20 per cent of their wealth as cash, gold or government securities as a form of liquid money. Again, it was raised from time to time raise up to 25 per cent and 38.5 per cent in 1991. But after the recommendations at the Narsimham Committee in 1991, SLR was reduced in many steps and stabilised at 25 per cent. But on 8th November, 2008, it was reduced by 1 per cent and fixed at 24 per cent. Similarly on 5th August SLR was fixed at 22 percent.
(5) Direct Action : According to the Banking Companies Act, 1949, the RBI retains the authority of direct action. According to it, the RBI can ban any particular type of transactions by banks and do any special observation at any time. After the observation, it can give suggestion or order in any particular issue. The RBI has taken the help of direct action from time to time.
(6) Moral Suasion : The RBI also takes the help of Moral Suasion for credit control. According to it, the RBI persuades the commercial banks to follow the policies declared by it.
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ROLE OF MONETARY POLICY IN A DEVELOPING ECONOMY
The objectives of the monetary policy which have been discussed here are useful for every country. But these are not equally useful for every country. The objectives of the monetary policy which are given priority for the developing countries are not needed to be given priority for the developed country. A developing country has generally poverty, unemployment and low per capita income. Due to these there is less savings and investments. Consequently, the rate of capital formation is less and there is low production. Thus, the developing countries should have such monetary policy which may promote the rate of economic growth. In this respect, the monetary policy of developing countries should play following roles.
(1) Increase in Bank Money: Due to low income in developing countries, there is low saving and investment. So, with the objective of promoting the saving, it is fruitful to increase bank money. It brings the capital flow in the country and increases the employment. But it requires attention here that bank money should be used in production and investment activities. It should not be used on consumption.
(2) Control on Inflation: There is the need of running many projects for encouraging development in the developing countries. A lot of money is spent on these projects. Currency, that is issued to meet these expanses brings a substantial increase in demand but not the respective increase in the production of consumer goods. Consequently, there is a decline in supply and a condition of inflation. Thus, the monetary policy should be such that can have control on inflation.
(3) Increase in Industrial and Agricultural Production : Prices can be controlled by controlling the inflation, but the credit has to be expanded in developing countries for increasing the industrial and agricultural production. The history of developed countries also states that the credit has had an important contribution in the expansion of industrial production. But there should be a limit of the credit expansion.
(4) Cheap Money Policy : The cheap money policy lowers the rate of interest. By having a lower interest rate in a developing country, there is speedy economic development. Thus, the cheap money policy can be adopted in the monetary policy of developing countries.
(5) Stable Exchange Rate : The cycle of trade continues in developing countries but these countries have adverse cycle of trade most of time. Thus, by bringing stability in the exchange rate, the cycle of trade can be brought in the positive direction.
Thus, the monetary policy plays an important role in developing countries. In brief, it can be said that the main objective of the monetary policy in developing countries should be economic development and stability in prices. It is satisfactory that this objective is given priority in the monetary policy of India.
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LIMITATIONS OF MONETARY POLICY
Monetary policy plays an important role in the fast economic development of any country. Its importance is even more in underdeveloped and developing countries. But in developing countries it has certain limitations which are disturbing elements in the way of the success of the monetary policy.
These limitations are as given ahead:
(1) Existence of Non-Monetary Sector : The monetary policy can be successful only when all transactions in a country are in money or credit money. But in developing countries even these days, the barter system is in use. So long as, this system is in use, there will be no impact of the change made in the amount of money or the rate of interest on the economy.
(2) Lack of Organised Money Market : The presence of an organised money market is essential for the success of monetary policy. But it is found lack of organised money market in developing countries. The monetary trade in these countries is done by native bankers and money lenders. Their activities are not under the control of RBI.
(3) Lack of Organised Bill Market : The countries which have strong and organised bill market feel the wide impact of the monetary policy on the economy. But the developing countries lack in organised bill market. This creates barriers in the success of monetary policy.
(4) Lack of Elasticity in Economy : The monetary policy has a direct impact on the economy. But there is lack of elasticity in the developing countries. For example, if there is a change in the bank rate, it should have direct impact on the price of commodities, wages, rate of interest etc. But it is not so in practical
(5) Less Utilisation of Credit Money : The actual currency is more in use in the developing countries. There is less use of credit money in these countries. As a result the monetary policy doesn’t become effective.
Thus, there are many barriers in the way of success of the monetary policy. But the monetary policy breaks these barriers and plays an important role in the development of the economy of developing countries.
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EXERCISE QUESTIONS
Long Answer Type Questions
1 What do you mean by Monetary Policy ? Discuss the various objectives of monetary policy.
2. Define monetary policy and explain its goal.
3. What are the instruments of monetary policy in India ? Explain.
4. Explain the role of monetary policy in developing country
Short Answer Type Questions
1 What are the limitations of monetary policy?
2. What do you understand by neutrality of money?
3. Explain “Full Employment” as an objective of monetary policy.
4. What is ‘Price Stability’ objective of monetary policy?
III. Objective Type Questions
Choose the correct option
1 The monetary policy in India is declared by …..
(a) The Central Government
(b) The RBI
(c) The State government
(d) The commercial banks
2. Which of these is/are the objective of the monetary policy?
(a) Full employment
(b) Stability in price.
(c) The neutrality of money
(d) All of the above
3. Who said, “the full employment refers to a situation in which everybody who is willing to work, gets work.”
(a) Prof. Keynes
(b) Robertson
(c) Prof. Hayak
(d) Prof. Halm
4. The instrument (s) of monetary policy is/are …….
(a) Quantitative credit control
(b) Selective credit control
(c) Both (a) and (b)
(d) None of the above
5. Which of these is not a policy of the monetary policy ?
(a) Economic development
(b) Price Stability
(c) Stability in the exchange rate
(d) Taking foreign loans
6. Due to innovations, the cost of production ………
(a) reduces
(b) increases
(c) remains unchanged
(d) fluctuates
7. Monetary Policy and Fiscal Policy are mutually ………..
(a) contradictory
(b) co-operative
(c) sometimes contradictory and sometimes co-operative
(d) none of these
[Answer: 1(b), 2 (d), 3 (a), 4(c), 5(d), 6 (a), 7 (b)]
State whether the following statements are True or False :
1. CRR is one of the instruments of monetory policy.
2. The cheap money policy lowers the rate of interest.
3. Reserve Bank retains the authority of direct action.
4. SLR is always stable.
[Ans. : 1. True, 2. False, 3. True, 4. False.)
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