Instruments of Monetary Policy

The instruments of monetary policy are of two types: first, quantitative, general or indirect; and second, qualitative, selective or direct. The level of aggregate demand through the supply of money, cost of money and availability of credit. They are meant to regulate the overall level of credit in the economy through commercial banks. The selective credit controls aim at controlling specific types of credit. They include changing margin requirements and regulation of consumer credit. 

A) Quantitative Credit Controls

The first category includes bank rate variations, open market operations and changing reserve requirements.

1. Open Market Operations

Open market operations are the most important monetary policy tools because they are the primary determinants of changes in interest rates and the monetary base, the main source of fluctuations in the money supply. The technique of open market operations as an instrument of monetary policy refers to purchasing or selling of government securities from large banks or government securities dealers. Open market operations refer to the buying and selling of government securities, treasury bills, gold and foreign exchange by a central bank in the open market. Government borrows to finance its deficits. Reserve Bank of India purchases government securities from the public, bank reserves are increased by corresponding amount because government pays for these securities and money flows from government accounts towards public who, in turn, deposit the amount in their respective accounts thereby increasing banks deposits. Banks utilizing their powers of creation of credit increase the credit supply in the economy. This results in more expenditure, output and employment. Thus, open market operations directly affect the monetary base and the purchases of government securities increase the monetary base. Open market purchases expand the monetary base, thereby raising the money supply and lowering short-terms interest rates.

Similarly, Reserve Bank of India sells the governments securities in open market to the public. The cash with public and with banks decreases because they have to pay for these securities by writing cheques. The sell of government securities, thus, decreases the monetary base. Open market sales shrink the monetary base, lowering the money supply and raising short term interest rates.

Thus, the open market operations gives direct control over monetary base and over the past few decades open market operations have been done to prevent unchecked expansion of liquidity through monetization of government debt. Accordingly, sale of government securities exceeds purchases on an annual basis. 

2. Reserve Requirements

The instrument of monetary policy has not been actively used in India for quite long period until 1956. This weapon was suggested by Keynes in his ‘Treatise on money’ and the USA was the first to adopt it as a monetary devices. Every bank is required by law to keep a certain percentage of its total deposits in the form of a reserve fund in its vaults and also a certain percentage with the central bank. When prices are rising, the central bank raises the reserve ratio. Banks are required to keep more with the central bank. Their reserves are reduced and they lend less. The volume of investment, output and employment are adversely affected. In the opposite case, when the reserve ratio in lowered, the reserves of commercial banks are raised. They lend more and the economic activity is favorably affected. Changes in reserve requirements affect the money supply by causing the money supply multiplier to change. A rise in reserve requirements reduces the amount of the deposits that can be supported by a given level of the monetary base and will lead to a contraction of the money supply. Conversely, a decline in reserve requirements leads to an expansion of the money supply because more multiple deposits creation can take place.

In India RBI act, 1934 puts that all scheduled banks were required to maintain a minimum cash reserve of 5 percent of their demand deposits and 2 percent of their time deposits with the Reserve Bank of India. This system continued till 1956 and this instrument of monetary policy was never used for complete two decades. The RBI act was amended in 1956 and it was given the power to change reserve requirements between 5 to 20 percent of demand deposits and 2 to 8 percent of time deposits. The Amendment also empowered RBI to issue instructions to scheduled banks to maintain with it certain percentage of its liabilities in cash over and above the minimum cash reserve requirements (CRR). The RBI used its power for the first time in 1960 and the additional reserve requirements were fixed at 25 percent of the increase in deposits but it did not yield the desired results. Commercial banks satisfied the reserve requirements by making portfolio adjustments. They sold government securities to fulfill the cash reserve ratio requirement. In1962, RBI act was again amended and statutory liquidity ratio (SLR) was fixed at 15 percent over and above reserve requirement. The act was also empowered RBI to determine statutory liquidity ratio for commercial banks. The SLR was raised up to 38 percent in 1988. During the economic reforms era on the recommendation of Narsimha Committee SLR and CRR have been reduced. The rate of CRR and SLR maintained by scheduled commercial banks on total net demand and time liabilities was fixed at not less than 14.5 percent and 25 percent respectively in 1996.

The technique of reserve requirement (CRR) has been employed quite often in recent years along with the statutory liquidity ratio (SLR). The purpose of the extensive use of cash reserve ratio (CRR) is to control credit creation power of banks in the wake of the expanding liquidity in the banking system due to higher growth of primary deposits. It is observed that the nationalized banks were defaulting in maintaining CRR and the SLR, thus, defeating the very purpose. It is also true that CRR as an instrument of credit control cannot be used beyond a certain point since Reserve Bank has to consider the necessity of meeting the needs of productive credit of key sectors of the economy. Compared to other instruments of monetary policy such as open market operation, reserve requirements are more difficult to change frequently. The CRR does not have quick and selective impact on bank reserves.

A high cash reserve ratio is inevitable at the present time. Before we can substitute the cash reserve ratio by indirect instruments of control, we need to undertake comprehensive institutional development of the government securities market.  

3. Discount Rate

It is also called the bank rate policy. Commercial banks and other financial institutions can borrow from the central banks of a country at discount rate. The amount that these banks and institution borrow from central bank affects the monetary base. The important thing about the bank rate or discount rate is that it is lower than bank lending rate, therefore banks have an incentive to borrow from the central bank at discount rate and lend those funds at higher interest rates.

Discount rate policy, which primarily involves changes in the discount rate, affects the money supply by affecting the volume of discount loans and the monetary base. A rise in discount loans adds to the monetary base and expands the money supply, a fall in discount loans reduces the monetary base and shrinks the money supply.

The Reserve Bank of India like all other central banks is empowered to use discount rate as an instrument of credit control. The discount rate may be raised or lowered depending upon the requirement of credit and overall economic conditions prevailing in the country. The effectiveness of his instrument depends upon:

A. The availability of funds with the banks,

B. Availability of such credit instruments which can be presented to central bank for rediscounting and,

C. Dependence of commercial banks for financial assistance on the central bank of a country.

When bank rate is lowered, theoretically speaking, banks have incentive to borrow more and expand credit as they earn more by lending the funds to business firms at market interest rate. Similarly, when it is raised commercial banks borrow less and it lowers their power to expand credit. Increase in discount rate is indication of tight money policy and lowering of discount rate is the indication that government is following easy or cheap money policy. The use of discount rate as a tool of monetary policy has been criticized by many. Iyenger says, in a planned economy which has a large public sector of investment and where government has a battery of powers of direct regulation of investment the efficiency of bank rate changes is less clear than it is in industrially advanced countries with a free economy. But it would be fallacious to argue that changes in bank rate are out of place in Indian conditions.

B) Qualitative Credit Controls

It aims at regulating the volume of credit given for specific purposes. Selective credit controls include the following credit controls measures.

1. Credit Rationing

When there is shortage of institutional credit available for the business sector, the large and financially strong sectors or industries tend to capture the lion’s share in the total institutional credit. As a result, the priority sectors and weaker but essential industries are starved of necessary funds, mainly because bank credit goes to the non-priority sectors. In order to curb this tendency, the central bank resorts to credit rationing measures.

Generally, three measures are adopted:

a)Imposition of upper limits on the credit available to large industries and firms,

b.)Charging a higher or progressive interest rate on bank loans beyond a certain limit.

c.)Providing credit to weaker sectors at lower internal rates.

2. Change in Lending Margins

The banks advance money more often than not against a mortgage of property-land, building, jewellery, shares, stock of goods etc. The banks provide loans only upto a certain percentage of the value of the mortgaged property. The gap between the value of the mortgaged property and amount advanced is called ‘lending margin.’ The central bank is empowered to increase or decrease the lending margin with a view to decreasing and increasing the bank credit.

3. Moral Suasion

The moral suasion is a method of persuading and convincing the commercial banks to advance credit in accordance with the directive of the central bank in the economic interest of the country. This method is adopted in addition to quantitative and other selective methods, particularly, when effectiveness of these methods is doubtful. Under this method, the central bank writes letters to and holds meetings with banks on money and credit matters with the objectives of persuading banks to act according to the instructions and advise of the central bank in the interest of the economy as a whole.

4. Direct Controls

Where all other methods prove ineffective, the monetary authorities resort to direct central measures with clear directive to the banks to carry out their lending activity in a specified manner. There are however rare instances of direct control measures. As a matter of fact it is difficult to say which of the two methods is more useful. Their choice depends on the economic conditions of the country concerned. If the objective of the central bank is to achieve price stability or to remove the evil affects of inflation and deflation, then it should adopt quantitative credit control. On the other hand, if the objectives are: economic development, increase in level of employment, and equal distribution of income, then it should enforce qualitative or selective credit control. Consequently, different industries, sectors and people should be provided credit in accordance with the priorities stated in the plans.