Explain in detail about Monetary Policy

    Monetary Policy refers to the use of instrument within the control of of the Central Bank to influence the level of aggregate demand for goods and services or to influence the trends in certain sectors of the economy. It operates through varying cost and availability of credit, producing desired changes in the assets pattern of credit institutions, principally commercial banks. These variation affect the demand for and the supply of credit economy in the same that credit forms the basis of most of the economic activities in such an economy. The central banks policies are very important to the industrial and commercial sectors as credit forms a very important competent of money supply.

Measures of Money stock: 

    The Reserve Bank of India employs four measures of money stock namely- M1, M2, M3, and M4

M₁: 

    It is usually described as the money supply. The components of money supply are currency with the public and deposits. As at the end of September 1995, M, was Rs. 1,92,699 crores whereas currency with the public forms less than half of the total money supply the demand deposits constitute more than 50% of the money supply today.

M₂: 

    M₂ is M, + post office Savings Bank deposits. As the last Friday of September 1995 M, was Rs. 1,97,790 crores.

M3: 

    M, is M, + time deposits with the banks. M, is money supply plus deposits with the banks. M, is usually referred to aggregate monetary resources. As on last Friday of September 1995 M, was Rs. 5,49,785 crores.

M4: 

    M, is M₂, plus the total post office deposits. As on the last Friday of September 1995. M, was Rs. 5,75,754 crore.

Instrument of Monetary Policy:

    The statutory basis for the regulation of credit in India is embodied in the Reserve Bank of India Act and the Banking Regulation Act. The former Act confers on the Bank the usual powers available to Central Banks generally while the latter provides special powers of direct regulation of the operations of Commercial and Co-operative Banks.

General Quantitative Credit Controls:

    There are three generals or quantitative instrument of credit control namely the Bank Rate, Open Market Operations and Variable Reserve Requirements. All the three instruments affect the level of bank reserves. Open market operations and the Reserve Requirements directly affect the Reserve base while the Bank Rate produces its impact indirectly by variation in the cost of acquiring the reserve.

Bank Rate: 

    The Bank rate, also known as the discount traditionally is the oldest instrument of monetary policy. Bank rate is the rate at which the Central Bank discounts or more accurately, rediscounts eligible bills. However today the term Bank Rate refers to the minimum rate at which the Central Bank provides financial accommodations to commercial banks in the discharge of its functions as the lender of the last resort. As the Central Bank is the leader of the last resort, a commercial bank which is loaned up can obtain financial accommodation from the Central Bank and re-lend it to its own customers.

    An increase in the Bank Rate means an increase in the rate of interest charged by the Central Bank on its advances to commercial banks. It compels commercial banks to raise the rate of interest they charge on their loans and advances to their customers and vice versa.

Open Market Operation: 

    Open Market operation include the purchase and sale by the Central Bank of a variety of assets, such as foreign exchange, gold, Govt. securities and even company shares. In India they are confined to the purchase and sale of govt. securities under the Open Market operations. The Central Bank seeks to influence the economy either by increasing the money supply. The Central Bank buys securities from commercial banks and public.

    When the Central Bank purchases securities from commercial banks the increase in their reserves might result in a multiple credit creation. Sometimes the purchase from the public may lead to an increase in the reserves of the banking system and credit expansion if the sellers of securities deposit the receipts with commercial banks. A sale of securities by the Central Bank has the opposite effects.

Variable Reserve Ratios: 

    Commercial banks maintain a certain percentage of their deposits in the form of balances with the Central Bank. The Central Bank has the power to vary this reserve requirement. It affects the credit creating capacity of commercial bank.

    The Reserve Bank is empowered to vary cash reserve ratio between 3% and 15% of the total demand and time liabilities. It has also been vested with the power to require the scheduled banks to maintain with it additional cash reserve computed with reference to the excess of their total demand and time liabilities over the level of such liabilities on the base date to be notified by the Reserve Bank, subject to the proviso that the total reserves to be maintained with the Bank should not exceed 15% of their demand and time liabilities.

Selective (Qualitative) Credit Regulation:

    Selective or qualitative credit control means regulation of credit for specific purposes of branches of economic activity. While general credit controls operate on the cost and total volume of credit selective controls relate to the distribution or direction of credit supplies.

    Selective Controls discourage such forms of activity as are considered to the relatively essential or less desirable. Many Central Banks have acquired powers to direct regulation of total magnitude as also the distribution of advances and investment of individual banks as well as of the entire banking system.

    Selective credit controls are useful supplement to general credit regulation. Their effectiveness is gently enhanced when they are used together with general credit controls. They are designed to curb excesses in selected areas without affecting other types of credit. They attempt to achieve a reasonable stabilisation of the prices of particular commodities on the demand side by regulating the availability of bank credit for purchasing and holding them before beginning of financial year and legislative sanction for expenditure is secured through similar procedure.

    As in Union Govt, concentration has provided for establishment of consolidated fund, a public account and contingency fund for each state.