What are the Instruments of Monetary Policy? Describe its Objectives.

There are a number of instruments of monetary policy, which are important for a business to understand, but, here it is also important to know what Monetary Policy is? Credit performs important functions. Being the major part of the total supply of money in a modern economy, the value of money is influenced by the volume of credit.

The volume of credit in the country is regulated for economic stability. This regulation of credit by the central bank is known as “Monetary Policy”. It is also called Credit Control. Monetary policy refers to the measure which the central bank of a country takes in controlling the money and credit supply in the country with a view to achieving certain specific economic objectives. It is also being defined as the regulation of cost and availability of money and credit in the economy.

Instruments of Monetary Policy

The instruments or methods of credit control or instruments of monetary policy are of two kinds:

• Quantitative control
• Qualitative control

1. Quantitative Control

It seeks to control the total quantity of money and bank credit or to make the bank lend more or less. These are four ways of quantitative control.

1. Credit Rationing
2. Change in Reserve Ratio
3. Open Market Operation
4. Bank Rate policy

• Bank Rate policy

The bank rate is the rate at which the central bank is willing to discount the first-class bill of exchange. Bank rate is different from “Market Rate”. The market rate is that rate of which the money market is willing to discount bill of exchange. The market rate is influenced by the bank’s rate. A rise in bank rate is generally followed by a rise in market rate and similarly, a fall or rise in the bank rate is followed by increase and decrease in the borrowing, and the volume of credit will be adjusted accordingly to the requirements of the market.

• Open Market Operation

Open market operation is the most important instrument of monetary policy. It refers to purchase or sale of government securities, short term as well as long term, at the initiative of the central bank, as deliberate credit policy. These Bonds and securities are purchased or sold from or to the commercial banks and the general public in the country.

• Change in Reserve Ratio

The commercial banks are required to keep a limited percentage of their deposits by law with the central bank. The central bank charges the ratio according to the need of controlling the credit. If the ration is raised, the cash available with the bank will be reduced, which will compel them to contract the volume of credit. Similarly, when the ratio will be lowered, the credit power will expand.

• Credit Rationing

This instrument of monetary policy is applied only in time of financial crises. The bank can collect by re-discounting bill of exchange when credit is rationed by fixing the amount. This method of controlling credit can be justified only as a measure to meet exceptional emergencies because it is open to serious abuses. There can be a danger, the rationing may not be satisfactory and the central bank may abuse the power by giving preferential treatment to favourite customers.

2. Qualitative Control

It aims to influence the special type of credit, or to divert bank advances into certain channels, or to discourage from lending for a certain purpose. These methods managing monitory policy areas below.

1. Consumer Credit Rationing
2. Moral Persuasion
3. Direct Action

• Consumer Credit Rationing

The consumer credit method of money management can be applied only when there is a rise of the scarcity of certain listed articles in the country. The central bank will impose specific restraints on consumer credit by raising the required down payments and shorting the maximum period of payment.

• Moral Persuasion

The central bank of the country also implies a minor instrument of moral persuasion to influence the total borrowing at the central bank. Moral Persuasion, refer to the appeal to the commercial bank to act according to the directive of the central bank. The central bank may issue directives to commercial banks to follow the policies of the central bank.

• Direct Action

The central bank may take direct action if his policies are not followed by commercial banks. Direct action involves direct dealings of a central bank with the commercial banks. Direct action may be a refusal on the part of the central bank to re-discount the bill of exchange or it may be in the shape of penalty rate of discounting for the banks not following the required policies.

Objectives of Monetary Policy

The main objectives of monetary policy are here below

1. Stability of Internal Prices

Heavy fluctuation in the general price level is not good for an economy. They result in uncertainty, damaging production and un-employment. To ensure healthy growth of the economy, stability in prices is advised through monetary policy

2. Stability in Exchange Rate

Fluctuations in the external value of currency reduce the volume of foreign trade. So the stability in the exchange rate is essential, and this objective is achieved by regulating the volume of currency to stabilize the rate of exchange.

3. Full Employment

Another major objective of monetary policy is to achieve full employment of resources. Central bank adopts a suitable policy for this purpose.

4. Economic Growth

In order to raise the living standard of people through higher production and general economic growth, the volume of credit is regulated for the proper supply of credit to the producers.