Monetary Policy - Meaning, Effect on economy & Objectives

     Monetary Policy

Generally we read RBI announces Monetary Policy or some changes happened in monetary policy.

So what is Monetary policy & how it effects our day to day life..!

                    Monetary policy is how central banks manage liquidity to create economic growth. Liquidity is how much there is in the money supply. That includes credit, cash, checks and money market mutual funds. The most important of these is credit. It includes loans, bonds and mortgages. 

RBI Reserve Bank of India. Every country has its own Central bank(Reserve or Monetary bank).

Meaning of Monetary Policy

The term monetary policy is also known as the 'credit policy' or called 'RBI's money management policy' in India. How much should be the supply of money in the economy? How much should be the ratio of interest? How much should be the viability of money? etc. Such questions are considered in the monetary policy. From the name itself it is understood that it is related to the demand and the supply of money.

The Role of Central Bank with making Monetary Policy

Overview

• Most countries have some form of Central Bank serving as the principle authority for the nation's financial matters.
• Primary duties for a Central Bank include:
• Implement a monetary policy that provides consistent growth and employment
• Promote the stability of the country's financial system
• Manage the production and distribution of the nation's currency
• Inform the public of the overall state of the economy by publishing economic statistics

Fiscal and Monetary Policy

• Fiscal policy refers to the economic direction a government wishes to pursue regarding taxation, spending, and borrowing.
• Monetary policy is the set of actions a government or Central Bank takes to influence the economy in an attempt to achieve its fiscal policy.
• Central Banks have several options they can use to affect monetary policy, but the most powerful tool is their ability to set interest rates.

How Central Banks Use Interest Rates to Implement Fiscal Policy

• A primary role for most Central Banks is to supply operational capital to the country's commercial banks. This is done by offering loans to these banks for short time periods – usually on an overnight basis.
• This ensures the banking system has sufficient liquidity for businesses and individual consumers to borrow money, and the availability of credit has a direct impact on business and consumer spending.
• The Central Bank charges interest on the short-term loans it provides. The rate charged by the Central Bank affects the interest rate that the banks charge their customers as the banks must recover their cost (the interest they paid) plus earn a profit.
• Central Banks use the relationship between the short-term rates at which it offers loans, and the interest rate the banks charge, as a way to influence the cost for the public to borrow money.
• If the Central Bank feels that an increase in consumer spending is needed to stimulate the economy, it can lower short-term rates when providing loans to the commercial banks. This usually results in the banks lowering the interest they charge, making borrowing less costly for consumers which the Central Bank hopes will lead to an increase in overall spending.
• If a tightening of the economy is needed to slow inflation, the Central Bank can increase interest rates making loans more expensive to acquire, which could lead to an overall reduction in spending.

Supply and Demand of Currency

• Just like any commodity, the value of a free-floating currency is based on supply and demand.
• To increase a currency's value, the Central Bank can buy currency and hold it in its reserves. This reduces the supply of the currency available and could lead to an increase in valuation.
• To decrease a currency's value, the Central Bank can sell its reserves back to the market. This increases the supply of the currency and could lead to a decrease in valuation.
• International trade flows can also influence supply and demand for a currency. When a country exports more than it imports (a positive trade balance), foreign buyers must exchange more of their currency for the currency of the exporting country. This increases the demand for the currency.

 Objectives of Monetary Policy

Monetary Policy of India: Main Elements and Objectives!

Monetary Policy of India is formulated and executed by Reserve Bank of India to achieve specific objectives. It refers to that policy by which central bank of the country controls(i) the supply of money, and (ii) cost of money or the rate of interest, with a view to achieve particular objectives.

In the words of D.C. Rowan, “The monetary policy is defined as discretionary act 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 for achieving specific objective.”

Thus, monetary policy of India refers to that policy which is concerned with the measures taken to regulate the volume of credit created by the banks. The main objectives of monetary policy are to achieve price stability, financial stability and adequate availability of credit for growth.

Central banks use contractionary monetary policy to reduce inflation. They have many tools to do this. The most common are raising interest rates and selling securities through open market operations.

They use expansionary monetary policy to lower unemployment and avoid recession. They lower interest rates, buy securities from member banks and use other tools to increase liquidity. 

Following are the main elements of the monetary policy of India:

·       It regulates the stocks and the growth rate of money supply.

·        It regulates the entire banking system of the economy.

·        It determines the allocation of loans among different sectors.

·        It provides incentives to promote savings and to raise the savings-income ratio.

·        It ensures adequate availability of credit for growth and tries to achieve price stability.

According to RBI Governor Dr. D. Subba Rao, “The objectives of monetary policy in India are price stability and growth. These are pursued through ensuring credit availability with stability in the external value of rupee and overall financial stability.”

Following are the main objectives of monetary policy:

i. To Regulate Money Supply in the Economy:

Money supply includes both money in circulation and credit creation by banks. Monetary policy is farmed to regulate the money supply in the economy by credit expansion or credit contraction. By credit expansion (giving more loans), the money supply can be expanded. By credit contraction (giving less loans) money supply can be decreased.

The main aim of the monetary policy of the Reserve Bank was to control the money supply in such a manner as to expand it to meet the needs of economic growth and at the same time contract it to curb inflation. In other words monetary policy aimed at expanding and contracting money supply according to the needs of the economy.

ii. To Attain Price Stability:

Another major objective of monetary policy in India is to maintain price stability in the country. It implies Control over inflation. Price level, is affected by money supply. Monetary policy regulates money supply to maintain price stability.

iii. To promote Economic Growth:

An important objective of monetary policy is to make available necessary supply of money and credit for the economic growth of the country. Those sectors which are quite significant for the economic growth are provided with adequate availability of credit.

iv. To Promote saving and Investment:

By regulating the rate of interest and checking inflation, monetary policy promotes saving and investment. Higher rates of interest promote saving and investment.

v. To Control Business Cycles:

Boom and depression are the main phases of business cycle. Monetary policy puts a check on boom and depression. In period of boom, credit is contracted, so as to reduce money supply and thus check inflation. In period of depression, credit is expanded, so as to increase money supply and thus promote aggregate demand in the economy.

vi. To Promote Exports and Substitute Imports:

By providing concessional loans to export oriented and import substitution units, monetary policy encourages such industries and thus help to improve the position of balance of payments.

vii. To Manage Aggregate Demand:

Monetary authority tries to keep the aggregate demand in balance with aggregate supply of goods and services. If aggregate demand is to be increased than credit is expanded and the interest rate is lowered down. Because of low interest rate, more people take loan to buy goods and services and hence aggregate demand increases and vice-verse.

viii. To Ensure more Credit for Priority Sector:

Monetary policy aims at providing more funds to priority sector by lowering interest rates for these sectors. Priority sector includes agriculture, small- scale industry, weaker sections of society, etc.

ix. To Promote Employment:

By providing concessional loans to productive sectors, small and medium entrepreneurs, special loan schemes for unemployed youth, monetary policy promotes employment.

x. To Develop Infrastructure:

Monetary policy aims at developing infrastructure. It provides concessional funds for developing infrastructure.

xi. To Regulate and Expand Banking:

RBI regulates the banking system of the economy. RBI has expanded banking to all parts of the country. Through monetary policy, RBI issues directives to different banks for setting up rural branches for promoting agricultural credit. Besides it, government has also set up cooperative banks and regional rural banks. All this has expanded banking in all parts of the country.