Lesson-14:

Monetary Policy
Objectives:

After going through this lesson, you will be able to understand

 Meaning of Monetary policy

 Objectives of Monetary policy
 Tools of Monetary Policy

14.1 Introduction
14.2 Objectives of Monetary Policy
a) Exchange rate stability
b) Price stability
c) Neutrality of money
d) Full Employment
e) Economic Growth
14.3 Instruments of Monetary Policy
a) Quantitative tools
b) Qualitative tools
14.4 Summary
14.5 Glossary
14.6 Model Questions
14.7 Further readings.
14.1 Introduction

Macroeconomic policy consists of two sub policies. One is monetary policy and second one
is fiscal policy. Monetary policy objective is to see that money flow should be entered into
productive ways. Within Monetary policies, there are two sub policies. One is cheap money
policy and second one is dear money policy. Cheap money policy implies that the reduction
in the supply of money and Dear money policy means that the increase in the money supply.
Similarly, fiscal policy also having instruments under its control the flow of money into an
economy in turn to attain economic development. They are: Taxation, Public Debt and
Public expenditure. Above mentioned instruments under each policy are to be used to
achieve the objectives under macroeconomic policy.

Monetary policy refers to the credit control of a central bank. Paul Einzing defines monetary
policy, as” including all monetary decisions and measures irrespective of whether their aims
are monetary or non-monetary, and all none monetary decisions and measures that aim at
affecting the monetary system”

For the purpose of effective functioning of monetary policy, certain methods of credit
control have been developed attempts have been made to make monetary policy more
effective and more selective in its impact on the economy. According to Classical, monetary
policy is simply used as a tool for the maintenance of cheap money policy. But the modern
theory of money is almost the reverse of the traditional theory. In fact, monetary policy has
a positive role to play in bridging about non-monetary reforms as an instrument to
implement the economic policy of the state.
There was a long debate about the role of monetary policy before and after Great
Depression. Classical always emphasized on “Money does matter” or “Money alone
matter”. Keynes stressed upon “Money does not matter” later, Milton Friedman expressed
that the “Money also matters”. But these days, the Governments have been making use of
both monetary and fiscal policies in economic management so that we can say that “Both
Money and Fiscal policies are Matter”. It means that, the changes in both Money and
changes in the instruments of fiscal policy will have effect on economic development of
economy. Either a change alone in Money or in fiscal instruments would not have sufficient
impact to attain macroeconomic objectives set forth in the planning process.

14.2 Objectives of Monetary Policy

As stated in our earlier, monetary policy means by implementing its sub policies, it tries to
control both the situations like inflationary and deflationary in an economy. Until unless
control either inflationary or deflationary conditions, achievement of monetary policy
objectives is just impossible. Thus, by using monetary policy instruments under its control,
Monetary Authority of a country will move towards attain the objectives through which
stability in an economy is possible.

Therefore, here it is an important to know the main objectives of monetary policy. Broadly
speaking Monetary Policy has been used towards the fulfillment of its objectives. They are:

 Exchange Rate Stability

 Price stability
 Neutrality of money
 Full Employment
 Economic Growth
 a) Exchange Rate Stability:

In the 19th Century and during the early decades of 20th Century, Stability of Exchange rate
was the most important objective of monetary policy. But it has lost its significance since
the breakdown of Gold standard. In the event of favorable balance of payments and inflows
of gold, the monetary authority of the country used to expand currency (Dear money policy)
and credit which resulted in a rise in the internal price level making exports to fall and
imports rise. Similarly, when there was unfavorable balance of payments and the outflow of
gold, the monetary authority took steps to contract (Cheap Money policy) the currency and
credit proportionately which resulted in a fall in the internal price level and hence in the
increase exports and decrease of imports.

Thus unfavorable balance of payments would become favorable balance of payments or

disappears the disequilibrium in the balance of payments without any change in exchange
rate. So inflow and outflow of gold under gold standard maintain the stability in the
exchange rate and equilibrium in an economy.

Fluctuations in exchange rate is not only harmful for foreign trade, but also disastrous for
domestic trade. Hence, exchange rate stability is essential for stability in international
economic relations, so that now days, all the countries of the world attached more
importance to the stability of exchange rates than to price stability.
 b) Price Stability:

Since Great Depression, Price stability as an objective of monetary policy gained

importance in the place of Exchange rate stability. Gustav Cassel and J M Keynes were the
supporters of Price Stability as an objective of monetary policy. A number of advantages
have been claimed for a policy of Price Stability. Price Stabilization policy renders the trade
cycle inoperative and will make the stability in the economy. It removes economic
uncertainty which is detrimental for promoting business activity and ensures equitable
distribution of economic gains among various sections of the society. Further, it will help
money to perform its basic functions properly and smoothly, ultimately, promote economic
welfare of the community.

c) Neutrality of Money:

Economists like, Wick steed, Koopmans, Hayek, Robertson etc., proposed and advocated
that the Neutrality of Money as an objective of monetary policy. According to them,
monetary policy should be to keep the money neutral. It is to ensure that the quantity of
money in circulation does not affect the prices. A neutral money policy implies that the
monetary authority will have to be given authority to counter balance changes in the
velocity of circulation of money caused by hording and dishoarding of people. Secondly,
unless basic changes in the structure of the economy are compensated by changes in the
quantity or velocity of circulation of money, there would be such disturbances as would be
quite contrary to the neutral money theory.
 d) Full Employment:

J M Keynes who was advocated Full Employment as an objective of Monetary Policy.

Further he stated that “The object of a monetary policy should be to reduce the ebb and flow
of the trade cycles, and bring about equilibrium between Savings and investment at the level
of full employment”. Therefore, monetary policy objective should be not only to cure the
booms and depressions, when already occurred, as said by classical but also to check the
recessionary or inflationary tendencies in their initial stages.

To achieve full employment monetary policy should aim at increasing the level of
consumption and investment spending in the economy. By fallowing cheap money policy
during short period, aim at raising the level of investment and it is due to multiplier and
accelerator effect will raise the level of investment, Income and employment. Once full
employment objective is achieved the process has to be reversed to maintain stability and
full employment equilibrium. In short we can say that the full employment objective is the
ideal one because in its achievement, the other two objectives-- Price Stabilization and
Exchange rate stabilization--- are automatically achieved.

e) Economic Growth:

Modern economists of the opinion that Economic Growth should be as an important

objective rather than other four objectives. It is because, full employment is not possible
without increasing the rate of economic growth and an increasing rate of economic growth
is also necessary because of the desire among people of enjoying a high standard of living.
Further ever increasing economic growth rate is must for the survival of less developed
economies due to intensive competition prevailing in the world. In fact this particular
objective is considered as a prime even in developed countries also. Economic growth
implies a sustained increase in the real national income or per capital output.
The growth objective is superior to other objectives such as exchange rate stability; price
stability and full employment involve the concentration of the monetary authority on the
short term requirements only.

However, monetary policy tools available do not influence directly or indirectly the policy
variables like Prices, Employment and Growth. Therefore, they have to depend on
intermediate targets which they feel can reasonably controlled by the instruments available
to them.

Thus now let us concentrate on the tools or instruments are in the hands of monetary
authority to control credit or currency aim at achieving these objectives of monetary policy.

14.3 Credit Control Tools or Monetary Policy Instruments:

Monetary authority of a country is responsible to announce and implement objectives of

monetary policy. As we have discussed in earlier, all most all objectives are linked with
changes in money. Money supply will be determined exogenously by Reserve Bank of India
with Government of India. It means that Monetary Authority will play active role in
bringing changes in money supply as well as see proper flow of money supply into
economy to achieve monetary policy objectives. Hence, for the purpose of regulation or
controlling of credit into productive channels, monetary authority is having monetary tools
or instruments under its control. They are classified as:

 Quantitative Tools of monetary policy

 Qualitative Tools or Selective Credit Controls of Monetary Policy
 Methods of Credit Control of Central Bank
|
| |
| |
Quantitative Controls Qualitative or Selective
| Controls
|Bank Rate or Discount Rate |
|Open Market Operations |Regulation of Margin Requirements
|Reserve Ratio requirement |Regulation of Consumer Credit
|Rationing of Credit
|Moral Suasion
|Direct action

a) Quantitative Controls:

Various tools available to Central Bank to control credit with commercial banks. Some
of these are traditional and have been using since a long time. On the other hand, some
tools have developed recently. Among these, certain measures are adopted to influence
the total credit without regard for the purpose for which credit is disbursed by
commercial bank. We call them as Quantitative Tools. As is given in above figure, types
of Quantitative Control tools include:

 Bank Rate or Discount Rate

 Open Market Operations
 Reserve Ratio Requirements
Bank Rate or Discount Rate:

Central Bank fixed the Bank Rate. At this rate Central Bank rediscounts first class bills of
exchange as well as government securities held by Commercial Banks. By bringing changes
in Bank Rate, Central Bank regulated credit flow of commercial banks. Whenever Central
Bank increases bank rate it makes borrowing costly from and borrowing by bank will
decline. It is because bank rate is closely associated to all other interest rates in money
market thus changes in bank rate followed by variations in lending rates of Commerical
Banks.

Open Market Operations:

Open market operations means direct purchasing and selling of securities and bills in money
market by Central bank. Main objective of Open market operations is to influencing
reserves of commercial banks to control their credit creation powers and also affecting
market rates of interest to control commercial bank credit. This instrument of monetary
policy directly affects lonable funds of banks and interest rates.

Reserve Ratio Requirement:

Commercial banks will maintain certain reserve ratio with central bank out of its total
deposits. By bringing changes in Reserve Ratio by Central Bank will control credit flow
into an economy under either inflationary or deflationary conditions. Main objective of this
tool is to provide Central bank with supply of deposits for local requirements and to ensure
liquidity and solvency of individual commercial banks and of banking system as a whole.

Qualitative or Selective Credit Control Tools:

The second form of credit control instruments in the hands of Central Bank or known as
Qualitative or Selective Credit Control Instruments. Main objective of these is to channelize
flow of bank credit from speculative and undesirable purpose to socially desirable and
productive as well as economically useful uses.

Regulation of Margin Requirements:

This measure is adopted to prevent excessive use of credit by speculators. Central Bank
fixes the minimum margin requirements on loans for purchasing Securities. They are
percentage of value of security which cannot be lent or borrowed.

Regulation of consumer credit:

The purpose of this instrument is to control demand for consumer durables for the interest
of achieving economic stability. Central bank controls the utilization of bank credit by
consumers to purchase consumer durables on installment and also by higher purchase.

Rationing of Credit:

This refers to the power of Central Bank to permit only a fixed amount of accommodation
to member banks by rediscounting facility.

Moral Suasion:
The term moral suasion refers persuasion and request made by central bank to commercial
banks to adopt monetary policy of Central Bank. These instruments only advise the
commercial banks not to disburse the loan into unproductive activities. Finally it all depends
on responsiveness and respect towards the words of Central Bank.

Direct Action:

This instruments or tool will be adopted by Central bank when it fails in controlling the
credit flows by using all other monetary instruments. Under this method Central bank
ultimately take a decision to close all the activities of commercial bank which are not
following instructions of Central Bank.

14.4 Summary:

To sum up, in order to have effective function of monetary policy Central Bank must have
absolute control over currency and banking system of an economy. Credit control is a part
of monetary policy. As we discussed in earlier, monetary policy has its own objectives and
achieved in association with Central bank by the Government. Neutrality of money,
Stabilization of Price, Exchange rate stabilization, achievement of full employment and
achievement of the highest economic growth in an economy are the important objectives of
monetary policy. These objectives were developed gradually one after another depend upon
the changes in economic situation. These objectives are mutually exclusive each other.
Tradeoff will be prevailing in achieving these objectives. It is not possible to isolate one
objective from another objective because if monetary authority would like to achieve one
objective at the same time there may be contradiction emerges with other objective.
Further, to achieve these objectives by the Central Banks it has to have control on credit
supply by commercial banks. For which monetary authority is having two types of credit
control tools. One is Quantitative tools and another one is Qualitative Tools. Based on the
changes in economic conditions, Central bank adopts individual instruments and tries to
achieve its objective of stability in an economy.

14.5 Glossary:

Price Stabilization
Exchange Rate Stabilization
Economic Growth
Neutrality of Money
Full Employment
Quantitative Instruments
Selective Credit Control tools
Monetary Policy
Money Matters
Money does not matters

14.6 Model Questions:

Short answer Questions:

1. What is Monetary Policy

2. Enlist the objectives of monetary policy
3. What are the instruments of Credit Control
Essay answers Questions:
1. Critically evaluate the role Credit control tools on an economic growth
2. How to achieve Monetary policy objective under Great Economic Depression

14.7 Further Readings:

1. Chakra borty Suma K : Macro Economics, Himalaya Publishing house, Delhi,

2014
2. Hajela HN : Macro Economics,
3. Paul Einzing : Monetary Policy, Ends and Means,
4. S B Gupta : Planning for Monetary policy,
5. R D Gupta : Keynesian and Post Keynesian Economics