Economic Monetary Policies

Monetary Policy
Monetary Policy is a set of tools to control a country's money supply and facilitate economic
growth.

A country's monetary policy is the measures taken by its apex bank to control and manage the
money supply and demand. The policy, in turn, helps economic growth by considering the
demand of different sectors.

The Reserve Bank of India (RBI) is the primary institution responsible for driving monetary
policy in India. The apex bank plays a central role in shaping the country's economic policies
regarding money supply, interest rates, and financial stability. It decides the measures required
by assessing the current economic scenario, the country's needs, and how to facilitate its growth.
Inflation, gross domestic product, and growth rates influences Monetary Policy Economics.

The economy has two types of monetary policies: Expansionary and Contractionary.

Contractionary Monetary Policy

The RBI introduces a contractionary monetary policy to reduce the money supply and manage
Inflation. A decreased purchasing power characterizes inflation due to a high money supply in
the market. The basic idea is that if the money supply is reduced, it would also reduce the money
available to the customers. They would not be able to buy certain commodities with lesser
money, leading to lesser demand. This decrease in demand would then lead to a reduction in the
commodity prices and hence control inflation.

With this policy, the RBI aims to reduce the money supply and curtail the excessive price of
commodities. One such measure would be increasing the interest rate for borrowings, leading to
a reduced money supply.

Expansionary Monetary Policy

An expansionary monetary policy is introduced to tackle economic slowdown or recession. It

aims at increasing the money supply in the economy, leading to a higher purchasing power
among the people. Also, it leads to an increased disposable income for the customers, which
helps improve the demand for commodities. With an influx of money in the economy, people
would have more to buy and control a slowdown. They would spend more, helping with
unemployment and recession.

Some expansionary monetary policy examples include tax cuts or decreasing the lending rate.
This monetary policy would lead to an influx of money in the economy and encourage spending.

The monetary policy in developed and developing countries focuses on holistic economic
growth. Expansionary monetary policies are of great value in such countries as it encourages
spending and increases the easy availability of credit. For such nations, expansionary policies
and inflation control are necessary.

Monetary Policy Tools

The RBI has several tools and instruments to use for controlling the money supply in the market
with modern monetary policy. It uses monetary policy in economic development for growth
and stability in the country.

Open Market Operations

The RBI sells or buys short-term government securities to control the money supply in the
market. It can sell and buy back these securities from individuals or institutions to cater to
monetary policy goals. For example, if the RBI sells government securities, it would reduce the
money supply. This will consequently increase demand for borrowing and a higher interest rate.
Furthermore, if the RBI buys these securities, it would lead to a money inflow in the market. The
increased money supply would curtail the borrowing demand and lead to a lower interest rate.

Selective Credit Control

The selective credit control measure allows the RBI to control credit availability or growth by
the following measures.

 Differential interest rates and margin requirements

 Regulation of credit availability for consumer durables

Bank Rate

The interest rate at which the Reserve Bank of India (RBI) lends money to commercial banks.
An increase in bank rates would automatically make it more expensive for the banks to lend
money, leading to a higher interest rate for the public. It would have the opposite effect if the
RBI reduced the bank rate and subsequently made it cheaper for the public to borrow money
from the banks. This is an effective measure of the modern monetary policy to control the money
supply.

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Cash Reserve Ratio

The Cash Reserve Ratio (CRR) is the portion or percentage of deposits that any commercial
bank has to deposit with the RBI. Using modern monetary policy rule, the RBI can increase or
decrease this percentage to control the money supply. For example, an increased reserve ratio
would lead to lesser funds available with the commercial bank for lending to the public and vice
versa.
Statutory Liquid Ratio

The statutory liquid ratio (SLR) is the percentage of their deposits that a commercial bank has to
keep with them. It can be present in cash or gold with the bank. The RBI can increase or
decrease this percentage depending on the monetary policy and economic development. For
example, a decreased SLR would allow more funds to lend to the public, leading to an influx of
money in the economy.

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Liquidity Adjustment Facility

In the Liquidity Adjustment Facility, public banks borrow or lend money to the Reserve Bank of
India along with repurchase agreements.

Repo Rate

The Repo Rate is another measure for a modern monetary policy to control the money supply.
It is the rate at which commercial banks and other institutions borrow money from the RBI. The
central bank can increase this rate to curtail the money supply in the economy.

Reverse Repo Rate

It is the interest percentage at which the Central bank of India (RBI) borrows money from
commercial banks. It can increase or decrease the rate to influence the money supply in the
economy. For example, a higher interest rate would influence banks to lend money to the RBI,
thereby reducing public lending funds. The opposite would discourage banks from lending
money to the RBI and increase the money supply in the market.

Moral Suasion

This modern monetary policy method is informal but has effectively controlled the money
supply. The RBI can urge banks to hold credit or vice versa to maintain economic stability.

Monetary Policy Rule

A monetary policy rule, often referred to as a "monetary policy rule," is a set of guidelines,
principles, or mathematical equations used by a central bank to make decisions about the
management of a country's money supply, interest rates, and other monetary policy tools. These
rules help central banks achieve their macroeconomic objectives, such as price stability, full
employment, and economic growth. Monetary policy rules are a way of formalizing and
communicating the central bank's approach to managing the economy.

Here are some key aspects of monetary policy rules:

  Objective Alignment: Monetary policy rules are designed to align the central bank's
actions with its primary objectives. The primary objectives often include controlling
inflation, stabilizing the economy, and supporting sustainable economic growth.
 Transparency: Having a clear and well-defined monetary policy rule enhances the
transparency of central bank actions. This can help businesses, investors, and the public
understand and anticipate the central bank's moves, reducing uncertainty in financial
markets.
 Flexibility: While monetary policy rules provide a framework, they are not rigid. Central
banks can adjust their policies in response to changing economic conditions, unexpected
shocks, or revisions to their understanding of the economy.
 Interest Rate Targeting: Many monetary policy rules are expressed in terms of interest
rate targets. For example, the Taylor Rule is a popular monetary policy rule that suggests
how a central bank should adjust its policy interest rate (like the federal funds rate in the
United States) in response to changes in inflation and economic output.
 Inflation Targeting: Some central banks adopt inflation targeting rules. In this approach,
the central bank sets a specific target for the inflation rate and adjusts its monetary policy
to keep inflation close to that target.
 Output Gap Consideration: Monetary policy rules often take into account the "output
gap," which is the difference between actual economic output and potential output. When
the output gap is positive (indicating an economy operating above potential), a central
bank might adopt contractionary measures to cool down the economy and control
inflation.
 Real and Nominal Variables: Some monetary policy rules consider both real variables
(such as economic output) and nominal variables (such as inflation and interest rates).
These rules attempt to strike a balance between achieving price stability and supporting
economic growth.
 Empirical and Academic Research: Monetary policy rules are often developed based on
empirical analysis and academic research. Economists and policymakers study historical
data to derive relationships between policy variables and economic outcomes.

One of the most well-known examples of a monetary policy rule is the Taylor Rule, which
suggests how central banks should adjust their policy interest rates based on deviations of
inflation and economic output from their target levels. Various countries and central banks have
their own specific rules and approaches to monetary policy, tailored to their unique economic
conditions and goals. The specific rule or framework used can change over time as central banks
adapt to evolving economic circumstances.

Objectives of Monetary Policy

Monetary Policy affects the economy in following the objectives of the RBI and maintaining a
healthy economic environment in the country. Following are the major objectives of modern
monetary policy economic growth.
Price Stability

The monetary policy was previously used to control inflation and reduce the money supply in the
market. However, the limited scope of the monetary policy economics resulted in a hampered
growth of the economy and different sectors. That's why modern monetary policy aims at
promoting growth by providing credit. It also controls inflation within limits and maintains price
stability.

Regulation and Development of Financial Stability

Internal and external shocks to a country's economy can hamper stability. It would also reduce
the public's confidence in the economic system and further affect development. That's why
modern monetary policy regulates and supervises the economy's financial stability through
constant controls. It helps maintain confidence and allows for shock absorption in the country's
financial system. The development of the economy is also a major goal of the RBI.

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Growth of the Priority Sectors

The RBI also focuses on promoting the growth of priority sectors of the economy. These sectors
include agriculture, small-scale businesses, export, and weaker sections of the population. The
modern monetary policy ensures credit availability to these sectors to allow them to grow and
add to the developing economy.

Employment Generation

Employment generation is another primary goal of monetary policy economics. It can affect
investment in different sectors and lead to employment generation.

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External stability

The RBI has a certain influence over external stability as it can buy or sell foreign currency in
the market. However, the RBI previously had direct control as it determined the exchange rate
and controlled the foreign exchange market.

Savings and investments

The RBI can influence and encourage savings and investments through monetary policy
economics. It can reduce or increase lending rates to cater to the country's economic goals.
Income and wealth redistribution

The RBI can offer credit to specific sections of the population. It allows for income and wealth
redistribution to the weaker population.

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Regulating NBFIs

The RBI does not directly regulate non-banking financial institutions of the economy. However,
modern monetary policy can influence economic policies and functions.

Currency Exchange Rate

The RBI can also regulate foreign exchange rates with monetary policy. For example, an
increased money supply leads to cheaper domestic than foreign currency.

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Conclusion

The correct Economic Policies can ensure that the country is on a growing path where citizens
can access credit without the risk of high inflation. That's why the economic policy tools have an
integral impact on the country and help the apex bank control the economy and growth.
Economic monetary policies are a critical component of a country's economic management and
are primarily the responsibility of a nation's central bank. These policies play a vital role in
influencing the overall economic environment, promoting stability, and achieving specific
macroeconomic goals.