Monday, October 15, 2012

Business Environment - Nov '2011 (Solved)

Monetary Policy and Its objectives:
Monetary policy refers to policy formulated and implemented for achieving the following objectives:
                     i.      Regulating the supply of money including credit money and adjusting it to the needs of the economy
                   ii.      To control the cost of money by regulating the rates of interest.
                  iii.      Directing the supply of money to the required channels in accordance with the plan of priorities prepared by the planning authority.
According to A.G. Hart "A policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy."
From the above discussion, it is clear that a monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives.

Objectives of Monetary Policy: The objectives of a monetary policy in India are similar to the objectives of its five year plans. In a nutshell planning in India aims at growth, stability and social justice. After the Keynesian revolution in economics, many people accepted significance of monetary policy in attaining following objectives.
a)      Rapid Economic Growth
b)      Price Stability
c)      Exchange Rate Stability
d)     Balance of Payments (BOP) Equilibrium
e)      Full Employment
f)       Neutrality of Money
g)      Equal Income Distribution

a)      Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth.

b)      Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both inflation and deflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities.

c)       Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate.

d)      Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved.

e)      Full Employment: Full Employment refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However it does not mean that there is Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment.

f)       Equal Income Distribution: Many economists used to justify the role of the fiscal policy are maintaining economic equality. However in recent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality.
Instruments of Monetary Policy or Credit Control tools:  
The instruments used by the central Bank for controlling the supply of bank money are classified into two categories namely
A)     General Instruments and
B)      Selective Instruments.

A)     The General Instruments of Credit Control:  These instruments are called general because they are uniformly applicable to all commercial banks and in respect of loans given for all purposes. The general instruments are as follows:
i)        The Bank rate policy: Bank rate is the official rate at which the central bank of the country rediscounts bills offered by the commercial banks.
When the central bank wants to bring about a reduction in bank credit, it raises the bank rate. The effect is that the commercial banks raise the market rate in order to retain their profit margin. Rise in the market rate brings about a reduction in the volume of bills offered by the customers to the commercial banks. If the volume of bills is less, the amount of money going out from the commercial banks to the people is less i.e.: the supply of money is less.
If the central bank wants to bring about an expansion of Bank credit it lowers the bank rate. The commercial banks can lower the market rate due to which the people offer more bills for discounting and the supply of money increases.
ii)      Open Market Operations:  The Central bank enters in to the bond market and purchases or sells government securities for bringing about expansion or reduction of credit.
iii)     Variable Reserve Ratio: Every commercial bank in the country is under a legal obligation to keep a certain proportion of their deposits in the form of cash with the central bank of the country. The ratio of these cash deposits to the total deposits of a commercial bank is called the cash reserve ratio. RBI is authorised to change the rate within that margin depending upon the requirements of the time.  When the banks keep more cash with the central bank they are left with less cash for advancing loans. The supply of credit money declines.
iv)     Statutory Liquidity Ratio (SLR): It is legally obligatory on the part of all commercial banks to invest a certain part of their deposits in government bonds. The ratio of the money invested in government bonds to the total deposits is called the statutory liquidity ratio. The RBI is authorised to fix and change the SLR within this margin.
When it wants to bring about a reduction of credit, it increases the SLR. The commercial banks have to invest a larger part of their deposits in government bonds. To that extent they are left with less cash for advancing loans that puts a brake on their capacity to extend credit.
v)      Repo Rate: This is the rate at which RBI advances short term funds to the commercial banks. A rise in the repo rate means that the commercial banks have to pay higher rates of interest to RBI. Consequently they have to charge higher rates of interest to their customers. The cost of money is raised. The demand for money falls and the amount of money flowing from the RBI to the commercial banks and thereafter from the commercial banks to the public is reduced.

B)      Selective Instruments of Credit Control: These instruments of monetary policy can be used in respect of any particular bank or in respect of a loan given against a particular security. Hence they are called selective instruments. The prominent amongst them are as follows:
i)        Regulation of credit margin: Whenever a commercial bank gives a loan against a tangible security, it maintains a margin between the value of the security and the amount of the loan given. This is necessary for maintaining safety of the bank. It also provides an instrument to the central bank to control the volume of credit given against a particular security.  This instrument is especially used for preventing cornering of stocks of essential raw materials.

ii)      Direct Action:  The central bank gives instructions to the commercial banks in respect of their lending policies. If a particular bank ignores the instructions RBI can take disciplinary actions against it. The action consists of charging a penal rate of interest to the offending bank, stopping lending to that bank or rejecting the bills offered by that bank for discounting. In any case the bank has to raise the rate charged to the customers which drives the customers away from that bank.

iii)    Moral suasion: The central bank interacts with the commercial banks and urges them to adopt a particular credit policy. The commercial banks accept the policy suggested by the central bank because they have a respect for the central bank. Moral suasion is better than direct action. It is preventive whereas direct action is curative. A frequent direct action taken by the central bank spoils the atmosphere between the central bank and the commercial banks. Hence as far as possible the central bank relies upon moral suasion.

iv)    Consumer credit: The commercial banks advance loans to enable their customers to purchase durable costly consumer goods. The central bank can prescribe the rate of interest which they have to charge on these loans. It can also fix the installments in which the loans are to be recovered. If the rate of interest is raised and the number of installments is reduced it is difficult for the people to use them. The demand for the concerned consumer commodity falls.

v)      Publicity: The central bank of the country gives a wide publicity to its policy through its publications. The commercial banks accept that policy even when the central bank does not insist upon it. This method is also widely used by the central banks in developing countries.

In a developing country like India, the selective instruments are used more. They produce positive as well as negative effect. They directly bring about the desired change. They can be effective even if the country does not like a well organized money market and capital market.


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