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Essay on Monetary Policy
Essay Contents:
- Essay on the Meaning of Monetary Policy
- Essay on the Significance of Monetary Policy
- Essay on the Instruments of Monetary Policy
- Essay on the Monetary Policy in India
- Essay on the Role of Monetary Policy in Developing Countries
- Essay on the Conclusion to Monetary Policy
Essay # 1. Meaning of Monetary Policy:
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it.
Monetary decisions today take into account a wider range of factors, such as:
i. Short term interest rates;
ii. Long term interest rates;
iii. Velocity of money through the economy;
iv. Exchange rates;
v. Credit quality;
vi. Bonds and equities;
vii. Government versus private sector spending/savings;
viii. International capital flows of money on large scales;
ix. Financial derivatives such as options, swaps, futures contracts, etc.
According to A.J. Shapiro, “Monetary policy is the exercise of the central banks control over the money supply as instrument for achieving the objectives of economic policy.” R.P. Kent defines monetary policy as “the management of the expansion and contraction of the volume of money in circulation for the explicit purpose of attaining a specific objective such as full employment.” In the words of D.C Rowan, “The monetary policy is defined as discretionary action undertaken by the authorities designed to influence (a) the supply of money; (b) cost of money or rate of interest and (c) the availability of money”.
Monetary policy is important instrument with which objectives of macroeconomic policy can be achieved. It is concerned with the changes in the supply of money and credit. The techniques of monetary policy are the same as the techniques of credit control at the disposal of the central bank. It is not an end in itself, but a means to an end. It involves the management of money and credit for the furtherance of the general economic policy of the government to achieve the predetermined objectives.
Three important goals of monetary policy are:
(a) To ensure economic stability to full-employment or potential level of output;
(b) To achieve price stability by controlling inflation and deflation; and
(c) To promote and encourage growth in the economy.
There are four major tools of monetary policy that use for economic and price stability are:
(a) Open market operations;
(b) Changing the bank rate;
(c) Changing the cash reserve ratio; and
(d) Undertaking selected credit controls.
Essay # 2. Significance of Monetary Policy:
Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves).
It has various objectives:
(a) Neutrality of money;
(b) Price stability;
(c) Exchange stability;
(d) Full employment; and
(e) Economic growth.
Economists like Wicksteel, Hayek, Robertson, advocated that the main objective of the monetary policy is to maintain complete neutrality of money. In the United States, the Federal Reserve is in charge of monetary policy. Monetary policy is one of the ways that the U.S. government attempts to control the economy.
If the money supply grows too fast, the rate of inflation will increase; if the growth of the money supply is slowed too much, then economic growth may also slow’. ‘It measures the employed by governments to influence economic activity, specifically by manipulating the supplies of money and credit and by altering rates of interest.
The usual goals of monetary policy are to achieve or maintain full employment, to achieve or maintain a high rate of economic growth, and to stabilise prices and wages. Monetary policy is the domain of a nation’s central bank.
When the economy is faced with recession or involuntary cyclical unemployment that comes about due to fall in aggregate demand, the central bank intervenes to cure such a situation. Central bank takes steps to expand the money supply in the economy and lower the rate of interest with a view to increase the aggregate demand which will help in stimulating the economy.
When aggregate demand rises sharply due to large consumption and investment expenditure, it is known ad demand-pull inflation. To check the demand-pull inflation contractionary monetary policy or tight monetary policy is use. It can be due by various ways.
The central bank sells the government securities to the banks, other depository institutions and the general public through open market operations. The bank rate may be raised which will discourage the banks to take loans from the central bank. The most important anti-inflationary measure is the raising of statutory cash reserve ratio.
The monetary policy strategy of a Central bank depends on a number of factors that are unique to the country. Given the policy objectives, any good strategy depends on the macro-economic and the institutional structure of the economy. An important factor in this context is the degree of openness in the economy.
The second factor is the stage of development of markets, institutions and technological development. In such a setup, where these conditions are satisfactory, it is possible for the Central bank to signal its intention with one single instrument or a combination of instruments. According to the Keynesians, monetary policy is ineffective and less reliable because of the following reasons.
Monetary policy is only among many factors that determine the level of nominal national income in the short-run.
The central bank of a country has usually three instruments of monetary control:
i. Open market operations,
ii. The discount rate, and
iii. The required reserve ratio.
Of these instruments, open-market operations are the most frequently used.
Essay # 3. Instruments of Monetary Policy:
Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income. This is necessary because money is a medium of exchange and changes in its demand relative to supply, necessitate spending adjustments. The instruments of monetary policy used by the Central Bank depend on the level of development of the economy, especially its financial sector.
1. Reserve Requirement:
The Central Bank may require Deposit Money Banks to hold a fraction of their deposit liabilities as vault cash and or deposits with it. Fractional reserve limits the amount of loans banks can make to the domestic economy and thus limit the supply of money.
2. Open Market Operations:
The Central Bank buys or sells securities to the banking and non-banking public (that is in the open market). One such security is Treasury Bills.
3. Interest Rate:
The Central Bank lends to financially sound Deposit Money Banks at a most favourable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest rate regime in the money market and thereby affects the supply of credit, the supply of savings and the supply of investment.
4. Prudential Guidelines:
The Central Bank may in writing require the Deposit Money Banks to exercise particular care in their operations in order that specified outcomes are realized. Key elements of prudential guidelines remove some discretion from bank management and replace it with rules in decision making.
5. Exchange Rate:
The balance of payments can be in deficit or in surplus and each of these affect the monetary base, and hence the money supply in one direction or the other. By selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction, through the balance of payments and the real exchange rate.
Essay # 4. Monetary Policy in India:
Establish on April 1. 1935, the Reserve Bank of India is the central bank in India. As the country’s Central bank, it is the apex monetary and financial institution responsible for the efficient working of the monetary mechanism which is indispensible for a rapid development of the economy.
The three major objectives of economic policy in India have been growth, social justice and price stability. Government of India tries to manipulate its Monetary Policy, the Reserve Bank of India which is the monetary authority in the country.
The Monetary Policy of the Reserve Bank has been characterised are as of controlled monetary expansion. The Monetary Policy of RBI has major changes during the economic reforms. Monetary Policy is separated from Fiscal Policy after 1991.
Monetary policy is the process by which monetary authority of a country, generally a central bank controls the supply of money in the economy by exercising its control over interest rates in order to maintain price stability and achieve high economic growth. In India, the central monetary authority is the Reserve Bank of India. It is so designed as to maintain the price stability in the economy.
Other objectives of the monetary policy of India, as stated by RBI, are:
1. Price Stability:
Price Stability implies promoting economic development with considerable emphasis on price stability. The centre of focus is to facilitate the environment which is favourable to the architecture that enables the developmental projects to run swiftly while also maintaining reasonable price stability.
2. Controlled Expansion of Bank Credit:
One of the important functions of RBI is the controlled expansion of bank credit and money supply with special attention to seasonal requirement for credit without affecting the output.
3. Promotion of Fixed Investment:
It’s is to increase the productivity of investment by restraining non-essential fixed investment.
4. Restriction of Inventories:
Overfilling of stocks and products becoming outdated due to excess of stock often results is sickness of the unit. To avoid this problem the central monetary authority carries out this essential function of restricting the inventories. The main objective of this policy is to avoid over-stocking and idle money in the organisation.
5. Promotion of Exports and Food Procurement Operations:
Monetary policy pays special attention in order to boost exports and facilitate the trade. It is an independent objective of monetary policy.
6. Desired Distribution of Credit:
Monetary authority has control over the decisions regarding the allocation of credit to priority sector and small borrowers. This policy decides over the specified percentage of credit that is to be allocated to priority sector and small borrowers.
7. Equitable Distribution of Credit:
The policy of Reserve Bank aims equitable distribution to all sectors of the economy and all social and economic class of people.
8. To Promote Efficiency:
It is essential aspect where the central banks pay a lot of attention. It tries to increase the efficiency in the financial system and tries to incorporate structural changes such as deregulating interest rates, ease operational constraints in the credit delivery system, to introduce new money market instruments etc.
9. Reducing the Rigidity:
RBI tries to bring about the flexibilities in the operations which provide a considerable autonomy. It encourages more competitive environment and diversification. It maintains its control over financial system whenever and wherever necessary to maintain the discipline and prudence in operations of the financial system’.
The monetary policy in India underwent gradual changes concerning both its strategy and its implementation. Quite some progress has been done in the direction indicated by best practices and the economic theory. Price stability is an important but not the exclusive goal of monetary policy in India.
The monetary policy strategy as well as the operational framework followed by the RBI underwent significant changes over the last two decades, mirroring in part the process of general economic liberalisations initiated in the early 1990s. The RBI is now more able and more responsible for controlling the overall growth of money and credit in a manner best suited for moderating inflation, while meeting the genuine credit needs of the economy.
Its capacity for effective monetary management or any inflation control needs to be further strengthened through rapid deepening and broadening of primary and secondary markets for Government securities. With greater autonomy comes more responsibility.
Although development was important, stability of the monetary and financial systems also remained a major objective. Since, given the support to the plans, it was not possible to control aggregate credit, the RBI turned towards controlling sectorial credit and secondary liquidity creation to achieve its twin goals of development and stability. Liquidity provisions in the Banking Companies Act were also strengthened and became the Statutory Liquidity Ratio (SLR).
The basic objectives of monetary policy remained price stability and development, but the operating procedures shifted from credit controls towards flexible monetary targeting with ‘feedback’ from the mid-1980s till 1997-98. But deregulation and liberalisation of the financial markets combined with the increasing openness of the economy in 1990s made money demand more unstable and broad money more endogenous.’
‘Every bank is required to maintain a minimum percentage of their net demand and time liabilities as liquid assets in the form of cash, gold and unencumbered approved securities. This ratio of liquid assets to demand and time liabilities is known as statutory Liquidity Ratio. At present, SLR is 25per cent in India. RBI is empowered to increase this ratio up to 40 per cent.
Essay # 5. Role of Monetary Policy in Developing Countries:
In a developing country, the monetary policy can play a significant role in accelerating economic development by influencing the supply and uses of credit, controlling inflation and maintaining balance of payment. The primary aim of the monetary policy in a developing economy must be to improve its currency and credit system.
To meet the developmental needs the central bank of an underdeveloped country must function effectively to control and regulate the volume of credit through various monetary measures. In a developing country monetary policy should aim at promoting economic growth. The monetary authority can play a vital role by adopting monetary policy which creates conditions necessary for rapid economic growth.
The effectiveness of monetary policy in underdeveloped countries is at best limited mainly because of structural and institutional factors. There is vast non-monetised sector in underdeveloped countries which lies outside the influence of the central bank and to that extent reduced the effectiveness of monetary policy. The money market is generally unorganised and divided in various compartments. In such countries people use cash for transaction purposes and deposit amount is less.
Essay # 6. Conclusion to Monetary Policy:
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. It to a great extent is the management of expectations.
There are several monetary policy tools available to achieve these ends:
i. Increasing interest rates by fiat;
ii. Reducing the monetary base; and
iii. Increasing reserve requirements.
The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.
Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment.