MONETARY
POLICY
1 Concept of Monetary Policy
Monetary policy is one of the
successful macro-economic policies. It has important role for in general
economic management and growth. Monetary policy is the work out of the central
bank to control over the money supply as a tool for achieving the objectives of
universal economic policy. Monetary policies attempt to make different types of
good quality economic activities mainly through money and credit supply as well
as interest rate. Similarly, monetary policy will be more successful through
the period of galloping or hyperinflation.
The process, formulation, completion
and estimate of monetary policy are calculated by the central bank under the
rules and directives of government of the state as well as increase and
development of an economy. Therefore, monetary policy is adopted to achieve
different types of economic objectives like accelerated economic growth and
progress, full service, price constancy, economic constancy etc. So monetary
policy can be defined as the management of the expansion and contraction of
quantity of money in movement. So we can say, monetary policy can change
quantity, quality, availability and cost of money as well as rate of interest,
investment, service, output, revenue etc. for the balance economic growth and
development.
According to Edward Shapiro "Monetary
policy is the exercise of the central bank's control over the money supply as
an instrument for achieving the objective of general economic policy". In
the words of D.C. Rowen, "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". According to RP Kent monetary policy is, "The
management of expansion and contraction of the volume of money in circulation
for the explicit purpose of attaining a specific objective such as full
employment".
Hence, we can say monetary policy is
a purposeful effort of central bank to control monetary policy and ratio of
credit in an economy for achieving definite objective like economic stability
and best allocation of resources. So monetary policy is measured as an
important tool of the government to plan various types of economic policies.
The main instruments of monetary policy and bank rate, open marketplace
operation and required reserve ratio.
Generally, there are two types of
monetary policies according to economic arrangement of an economy i.e.
expansionary monetary policy and concretionary monetary policy.
(A) Concretionary Monetary Policy
The usefulness of concretionary
monetary policy is appeared through the time of hyperinflation, where prices
are rising very rapidly and most of the economic variables start to fall. In
such state, monetary policies are formulated to manage money supply and
expenditure pattern by lowering the insist for consumption and investment some
techniques for concretionary monetary prices are:
(a) Selling the bonds, securities and treasury
bills in the open market.
(b) Increasing the discount rate.
(c) Rising the
minimum required reserve ratio.
(A) Expansionary Monetary Policy
The monetary policy, which normally
expands money supply and credit in an economy are called expansionary monetary
policy. Usually, to increase various economic activities in increasing
countries such as trade, commerce, industry and infrastructure development; the
expansionary monetary policies are applied some techniques for expansionary
monetary policy are:
(a) buy of bonds and funds bills in open market.
(b) Lowering the diminution rate or bank rate.
(c) Lowering the requisite reserve ratio.
Hence, the monetary policy used by
the central bank to fulfill the objective of country's economic policy which is
related to supply of money, credit creation, interest rate, exchange rate etc.
2 Objectives of Monetary Policy
Monetary
policy is one of the great tools to stabilize the economic systems. It contains
the following objectives:
(i) Price constancy: The most
important objective of monetary policy is to establish internal price
stability. Stable price does not means that the average of prices on the
general price level should not be allowed to fluctuate beyond certain minimum
limit. Price instability creates great disturbances in the economy and helps to
create inflation or deflation. Both are economically disturbing and socially
undesirable. Both can create problems of production and distribution.
Thus to establish price stability
central bank should properly control the quantity of money and credit. So, the
monetary policies are designed by central bank through by changing open market
operation, bank rate and minimum required ratio. During the period of
inflation, government issues different types securities and the selling of
securities in open market absorbs bills and excess money. Similarly, central
bank increases bank rate and minimum required ratio to control the problem of
inflation.
(ii) Attain complete service: joblessness
is the cancer of an economy. Until the joblessness remains the same, economy
cannot progress. joblessness is associated with low investment. Monetary policy
can help the economy to achieve full employment through the increment of
investment. Unemployment is mainly due to deficiency of investment. The main
task of monetary policy is the expansion of money provides and the reduction of
interest rate to that optimum level which raises the investment, demand and
equals it with full employment.
(iii) Replace
rate constancy:
It is a traditional objective to establish exchange rate stability, but very
important objective of monetary policy. Stable exchange rate helps to create
international beliefs and for the promotion of smooth trade. Fluctuations in
the exchange rates adversely affects in the volume of trade, price levels,
production, balance of payment, foreign investment etc.
The objective of exchange rate
stability is achieved through establishing equilibrium in the balance of
payment. Monetary policy plays an important role in bringing balance of
payments balance without disturbing the stable exchange rate. The modern
welfare governments are more concerned with establishing internal price
stability quite than maintaining exchange stability because of international
monetary fund.
(iv) Accelerate profitable progress: One of the
major objectives of monetary policy is to accelerate economic development.
Economic development involves the increase in the productive capacity of the
economy by developing additional economic resources, improving technology and
exploiting new investment opportunities. For this, it is necessary to increase
the rate of capital formation and investment because the levels of saving and
investment are very low. Directly or indirectly monetary policy helps to
increase capital formation and investment, through encouraging savings and
concept of investment.
(v) Impartiality of cash: various
economists such as Robertson, Hayek and Wicksteed developed the neutrality of
money. The policy of neutrality of money seeks to do away with the disturbing
effect of changes in the quantity of money on important economic variables,
like income, output, employment and prices. According to this policy, money
supply should be neutral in such a way that money should be neutral its
effects. In other words, the changes in money supply should not change the
total volume of output and total transactions of goods and services in the
economy.
The policy of neutrality of money is
based on the assumption that money is purely a passive factor. It functions
only as a medium of exchange. The function of money is only to reproduce the
relative values of goods and not to distort them. The exponents of the neutral
monetary policy believed that monetary changes are the root case of all
economic ills. They bring changes in the real variables such as income, output,
employment and relative prices. They cause inequity between demand and supply,
consumption and production.
Thus, according to the policy of
impartial money, if the money is made neutral and the money supply is kept
constant, there will be no disturbance in the economic system. In such a
situation, relative prices will change to the changes in the demand and supply
of goods and services, economic resources will be allocated according to the
wants of the society, and there will be no inflation and deflation. However,
this policy is based on classical assumptions. It cannot control the economic
insecurity and fluctuations in the economy.
3. Importance/Objectives of Monetary Policy
in Developing Countries
The
implication of monetary policy may be explained as follows:
The citizen like inflation,
deflation, lack of employment opportunity, investment, output income etc
defines developing country as a country where different types of economical and
social harms are facing. In developing countries various types of economical
problems are solved through the monetary policy. Monetary policy influences
most of all inexpensive variables and activities through change in money supply
in circulation and rate of interest.
So suitable monetary is formulated
and implemented according to economic structure of an economy. The main
importance of monetary policy is developing countries are summarized on
following points.
(i) Progress Role: Monetary
policy plays a significant role in developing countries in accelerating economic
development by influencing the money supply and rate of interest. Monetary
policy is able to create hearten towards investment by the help of scheming
inflation and deflation. Similarly, correction of balance of payment plays an
important role for over all economic progress. That's why monetary policy is
able to run about development activities through by changing bank rate and
minimum required ratio.
(ii) Stepping up to Economic progress: In developing
countries, the monetary policy should aim at promoting economic development.
The monetary policy can play a vital role in acceleration to economic
development. It influences the supply and uses of credit. Controlling inflation
and maintaining equilibrium balance of payment.
(iii) Progress
of Banking and Financial organizations: One of the main functions of central
bank or primary aim of monetary policy is to establish more banks and financial
institutions. Underdeveloped countries lack these facilities. These facilities
will help in increasing banking habit, mobilizing voluntary savings of the
people, channel zing them into productive uses and raising the rate of capital
formation.
(iv) Debt
organization:
In the developing economy, debt management is one of the main functions of
monetary policy. The tools under the aims of debt management are deciding
correct timing and issuing of government bonds, stabilizing their prices and
minimizing the cost of servicing the public debt. These tools collect the means
and sources of economic development. Monetary policy helps it in goal specific
way.
(v) Facilitate to manage price increases: Monetary
policy is an effective measure to control inflation. It plays a significant
role in checking inflation. Increase in government expenditure on developmental
schemes increase aggregate demand but collective supply of consumer's goods
does not increase in the same time. This increases the price level. The
monetary policy controls inflationary tendencies by growing saving, checking
expansion of credit by banking system and hopeless deficit financing by the
government through tightening monetary policy.
(vi) Help to
accurate the unfavorable balance of payment: Monetary policy in the form of
interest rate policy plays as important role in corrects the balance of
payments deficit. In the developing countries like Nepal, there is serious
balance of payment difficulties to fulfill the planned targets of development.
To develop infrastructure' such as power, irrigation, transport, etc. and
directly productive activities like iron, steel, chemicals, electrical,
fertilizers, etc., developing countries have to import capita] equipment,
machinery, raw materials, spares and components thereby raising their imports.
The exports are almost stagnant. They are high priced due to inflation. As
results, an imbalance is created between imports and exports, which lead to
misbalance in the balance of payments. Monetary policy can help in decreasing
the gap balance of payments deficit through high rate of interest. The high
rate of interest attracts the inflow of the foreign investments and help in
bridging the balance of payment gap.
(vii)
Reduction of Economic Inequality: In an underdeveloped economy, there
is wide disparity of income and wealth and absence of an integrated interest
rate structure. Monetary policy can play a significant role to maintain equal
distribution of income and wealth and a suitable rate of interest rate. The
central bank should take effective steps that benefit the poor and to integrate
the interest rate structure of the economy. For this, low rate of interest
should be fixed for the poor and small farmers, and entrepreneurs and subsidy
may be given for them. A suitable interest rate structure encourages savings
and investment in economy and discourages unproductive loans and speculative.
4. Expansionary Monetary Policy to manage
Recession or Depression
When the economy is faced with
recession or involuntary cyclical unemployment, which comes 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 that will help in
stimulating the economy. The following three monetary policy measures are
adopted as a part of an expansionary monetary policy to measures are adopted to
cure recession and to establish the equilibrium of national increase at full
employment level of output.
(i) Release marketplace process: The central
bank undertakes open market operations and buys securities in the open market.
Buying to securities by the central bank, from the public, chiefly from
commercial banks will lead to the increase in reserves of the banks or amount
of currency with the general public. With greater reserves, commercial banks can
issue more credit to the investors and businessmen for undertaking more
investment. More private investment will cause aggregate demand curve to shift
upward. Thus buying of securities will have an expansionary effect.
(ii) Reduce in Bank Rate: The Central
Bank may lower the bank rate or what is also called discount rate, which is the
rate of interest charged by the central bank of country on its loans to
commercial banks. At a lower bank rate, the commercial banks will be induced to
borrow more from the central bank and will be able to issue more credit at the
lower rate of interest to businessmen and investors. This will not only make
credit cheaper but also increase the availability of credit or money supply in
the economy. The expansion in credit or money supply will increase the
investment demand, which will tend to raise aggregate output and income.
(iii)
Decrease of Cash Reserve Ratio (CRR): Thirdly, the central bank may reduce
the Cash Reserve Ratio (CRR) to be kept by the commercial banks. In countries
like India, this is a more effective and direct way of expanding credit and
increasing money supply in the economy by the central bank. With lower reserve
requirements, a large amount of funds is released for providing loans to
businessmen and investors. As a result, credit expands and investment increases
in the economy, which has an expansionary effect on output and employment.
5 Contraction Monetary Policy to manage
Inflation
When aggregate demands rises sharply
due to large consumption and investment expenditure or more importantly, due to
the large increase in government expenditure relative to its revenue resulting
in huge budge deficits, a demand-pull inflation occurs in the economy. Besides,
when there is too much creation of money for one reason or the other, it
generates inflationary pressures in the economy. The following monetary
measures, which constitute tight money policy, are generally adopted to control
inflation:
(i) Promotion rule Securities: The Central
Bank sells the Government securities to the banks, other depository
institutions and the general public through open market operations. This action
will reduce the reserves with the banks and liquid funds with the general
public. With less reserve with the banks, their lending ability will be
reduced. Therefore, they will have to reduce their demand deposits by
refraining from giving new loans as old loans are paid back. As a result, money
supply in the economy will shrink.
(ii) Add to Bank Rate: The bank rate
may also be raised which will discourage the banks to take loans from the
central bank. This will tend to reduce their liquidity and also induce them to
raise their own lending rates. Thus this will reduce the availability of credit
and also raise its cost. This will lead to the reduction in investment spending
and help in reducing inflationary pressures.
(iii)
Adapting Anti-inflationary actions: The most important anti-inflationary
measures are the raising of statutory Cash Reserve Ratio (CRR). To meet the new
higher reserve requirements, banks will reduce their lending. This will have a
direct effect on the contraction of money supply in the economy and help in
controlling demand pull inflation. Besides Cash Reserve Ratio (CRR), the
Statutory Liquidity Ratio (SLR) can also be increased through which excess
reserves of the banks are mopped up resulting in contraction in credit.
(iv) Use of Qualitative acknowledgment manage
calculate: Fourthly,
an important anti-inflationary measure is the use of qualitative credit
control, namely, rising of minimum margins for obtaining loans from banks
against the stocks of sensitive commodities such as food grains, oilseeds,
cotton, sugar, vegetables oil. As a result of this measure, businessmen
themselves will have to finance to a greater extent the holding of inventories
of goods and will be able to get less credit from banks.
