Monetary policy and its implications

Nature of Monetary Policy

Monetary policy is as old monetary system as money itself. There are evidences which  suggest that even in ancient period monetary management was known in Greece.The prince who minted the first coin was a monetary reformer and the princes who debased their coins to finance deficit were also monetary reformers. Managedw currency was not entirely unknown to the ancient Egyptians, Greeks and Chinese who shifted to and from the shrines of their temples in order to counteract movements in the price level. But, before 1914, the whole thinking about monetary policy was based upon the idea of automatic gold exchange system.

During the Ist World War (1914-1919), this notion was almost shattered and monetary policy assumed new dimensions. In the modern sense, monetary policy aims at systematic regulation of the volume of money (currency as well as credit) with definite objective in view. Monetary policy should be able to work both ways -forward, irrespective of the objective of monetary policy, it has attained a definite dimension, in which it works, the objectives of monetary policy generally revolve around expansion or contraction of credit. It implies a positive endeavour to regulate, the volume and value of currency and credit, a way that is considered to be in accordance with the interests of increase of the welfare of the community independently of the technical international considerations which has been in the past, regarded as being of the paramount importance.

The genesis of monetary policy took place after the World War I when the gold exchange standard showed a breakdown. Inflation in Germany and two conferences in 1920 in Burssels and in 1922 in Geneva compelled the statesmen in the world to
think about a new monetary system which was bound to effect the monetary policy in every country. Before that, as has already been stated, automaticity of gold exchange system was cherished because of which the idea of central banking was nebulous. In due course, the return of Great Britian to the gold standard was hailed as giving a lead in the great work of monetary reconstruction. But this was only the beginning of a herculean task. At the time, scarcely any one considered that price level could or ought to be the care and pre-occupation, for less a main objective of policy of a central bank.

To define monetary policy in specific terms, it is control of availability, cost and the use of money and credit. The traditional agent of monetary policy is the central bank which works through the monetary system. More or less, it deals with the monetary system of a country. It may have been defined in different words by different monetary economists, all of them testify its concern with the measures and decisions of a monetary nature.

Monetary policy can be defined from another point of view also. All monetary decisions and measures irrespective of whether their aims are monetary or non- monetary, and all non-monetary decisions and measures that aim at effecting the monetary system, constitute monetary policy. In this category will be included the steps taken to influence the value and volume of money and the monetary measures which pursue non monetary, economic, social or political aims. Monetary measures like debasements, inflation, deflation, devaluation etc. and non-monetary measures like price and wage controls, physical controls, budgetary device, export drives, import cuts, quota system etc., will all come under monetary policy because these aim to influence the monetary situation in a country.differ with the economic conditions of the country, still there is a spectrum of objectives that a country can adopt. Since monetary policy is a means to an end in itself, it is expected to achieve certain objectives determined by the monetary authority and/or the State. Its objectives must be regarded as being part of overall economic objectives to the extent that monetary policy is concerned with subsidiary objectives of its own,however, these latter must assist in attaining the basic objectives of economic policy.

The objectives of monetary policy have been changing from time to time. The instruments available to the central banks also differ from country to country. Even within the same country, the objectives differ at different times. Monetary policy in the narrow sense has signified one thing at one time and the other at another time. Its objectives change with the changes in the conditions of the economy. Empirically also this type of generalisation can be tested. Still monetary policy has been directed to achieve a few traditional and set objectives.

Under gold standard, maintenance of exchange stability was the most important objective of monetary policy. Because the monetary system was an automatic system, the central bank was practically passive. The supply of money was regulated by the automatic inflow and outflow of gold. At that time, scarcely anyone considered that price level would ought to be the care and pre occupation, far less a main objective of policy of a central bank.

Instruments or Tools of Monetary Policy

Having set out the general framework for the operation of monetary policy, we can examine the instruments of monetary policy. In fact, the effectiveness of monetary policy depends upon the instruments of credit control. The technique of monetary control have to be conditioned by the pattern of banking and financial institutions. The extent of success of the policy depends upon the instruments employed.

The techniques available to monetary authorities to maintain internal stability consists of (a) regulating quantity to the money and to some extent of the near money with the purpose of directing and influencing the volume of expenditure (b) manipulating the level of interest rates or the relationship between short-run and long-run rates and (c) regulation quality of credit according to purpose of use of it. The powers of the monetary authorities to regulate creation of money and near money depends largely on their power to control by direct or indirect means, the credit and instruments policies of the money creating institutions.The techniques of monetary policy in a contemporary world are undergoing a rapid transformation. Formerly, exclusive instrument which most of the central banks in the world were the variation in the rates of interest at which the central banks in the world were using, was willing to discount bills. During the depression of the 1930’s, however, monetary orthodoxy was gradually abandoned.

In recent years, central banks have become concerned, not only with the control of the volume of credit, but also with the flow of credit into specific sectors of the economy.

In India, this changed role of central banking has been the guideline since the Ist Five Year Plan. The First Plan states thus: “Central banking in a planned economy can hardly be confined to the regulation of the overall supply of credit or to somewhat negative regulation of the flow of bank credit. It would have to take on a direct and active role, firstly in creating or helping to create themachinery needed for financial developmental activities all over the country and, secondly, in ensuring that the finance available flows in the directions needed”

1)Bank Rate

The bank rate, or the discount rate as it is called in the United States, is the officially announced rate charged by the central bank for discounting of advances to member banks. In other words, it can be called as the cost of borrowing by the banking institution from the central bank. By changing bank rate, the central bank affects the cost of borrowing and thereby influences the volume of credit. In the monetary market, if it is an organised one, there is a close relationship between the bank rates and the short-term money. The presence of an organised money market is very essential for the effective use of this technique because it is only in an organised money market, that the central bank can come to know that the current flow to bank credit and money is or is not in commensurate with the needs of the economy. Consequently, a change in the bank rate is commonly viewed as an amber light, an important index of the direction of the official policy. Ostensibly, the official policy is successfully implemented through a responsive banking system, but technically the effectiveness of a change in the bank rate should take into account its influence on the following :

1. Effect on enterpreneur’s expectations as to the profitability of new investments and the resulting effect on their demand schedule for credit.

2. Effect on credit rationing policies by financial institutions.

3. Effect on the increasing government bond rates, on the willingness of investors to take the capital loss resulting from the sale of securities to make private loans.

4. Effect of rising yields on government securities on the eagerness of lending institution to earn higher incomes on private obligation.

5. Effect of declining capital value on the propensity to consume.

6. Multiplier effect of any initial decline of
spending resulting from the above changes.

The above mentioned factors go to prove that banking system must view a change in the official rates as a ‘caution light’. The demand for credit must also be sensitive to cost. While as Hawtrey suggests “there is nothing to prevent for Central Bank from pushing the rate up to the required” level, it is only to small increases, the bank rate owes its real effectiveness. In recent years, a great deal of controversy has entered around the question of efficacy of the bank rate. Even monetary commissions of international repute, like The Radcliffe Committee, have expressed their mixed feeling regarding the potentiality of this instrument. The final word has not been said, but it is definite that most economists regard it of some importance.

2)Open Market Operations

In the broad sense, open market operations refer to the purchase or sale of the securities in the market by the central bank. The objective is to influence the reserve position of banks which indirectly would bring about relative changes in money rates and credit conditions. The end result is to effectdesired adjustment in domestic prices, cost of credit conditions and production. A notable feature of open market operations is that regardless of the parties involved : these operations have a direct and positive impact on the volume of bank reserves. It can be applied in desired magnitudes, and be quickly reversed. These operations are, therefore, an active reflection of the prevailing monetary philosophy of country.

3)Variable Reserve Requirements

A change in the variable reserve ratio does not change the total reserve position of the commercial banks. It only affects the amount of excess on secondary reserves.
The logical reason for this is that the power of the banks to create credit mainly depends upon the excess reserves. Hence a change in the reserve requirement affects the credit creating capacity of the banks and, in turn, their power to effect supply. A change in the reserve requirements has two-fold effects :

1. Assuming that there is an increase in the reserve requirement, there is an immediate decline in the excess reserve of commercial banks. They find additional funds to meet the large reserve on the basis of which credit is created.

2. An increase in requirement would reduce the rate of multiple expansion of deposits for the entire banking system.

The instrument of variable reserve requirements is generally considered to be blunt and clumsy, the reason being that it has technical and psychological limitations. For one thing, it is difficult to use this instrument in moderate doses; even a very small change in the rate results in a substantial change in the liquidity position of commercial bank. For another, the instrument does not take into account the relative strength of the banks and, therefore, affects the smaller banks more severely. Furthermore, there is a difficulty in managing it too.

4)Selective and Direct Regulations

Overall quantitative controls operate by affecting overall bank reserves and overall credit. Selective controls, by contrast are applied to influence specific sectors of the economy which are most vulnerable. Under this type of regulations, no attempt is made to restrict the general flow of credit, rather restrictions are imposed upon the use of credit into specific sectors regardless of the quantum of credit available for such purposes. The rationale of selective control is that,consistent with the general credit situation appropriate to a healthy economic system, credit may be so easy to obtain for some purpose that demand expands unduly in particular directions, or speculative activities are over-activated, endangering the stability of the whole economy.

5)Direct Action :

In one form or another, many central banks also make use of direct regulations either as an alternative to the qualitative and quantitative controls or in conjunction with them. Direct action can be very important in countries which have considerable Central planning and supervision by government business. These controls also assumed to have special importance in situations where the banking system is either non-responsive to central bank's appeals or consist of a few large banks which could be easily directed to follow the central bank’s general policy.

Monetary Policy & Growth

Sustainable economic growth has been widely accepted as a very important objective of monetary policy. The primary function of an economy is to provide the people means to satisfy their wants. Money is perhaps, the best mean to satisfy one’s wants. But mere providing of money without providing real resources does not lead the economy anywhere, economic growth does not mean higher money income without being accompanied by higher real income. In short ,growth means providing real output, satisfaction of consumer’s wants and economic freedom. Things should be produced according to the wants of the consumer. These things can be achieved only if the following conditions are fulfilled :

1. The production capacity of the economy should increase.

2. The demand for the things should increase.

Falure of one will cause imbalance in the economy. For example, if things are being produced in abundance but the demand for these things is lagging behind, there will be idle capacity, recession and unemployment. On the contrary, if the demand for things is there, but production is not taking place at the acquired pace, inflation will creep in. Both these imbalances act as barrier to sustained economic growth.

Monetary policy can ensure the maintenance of both conditions. It can ensure necessary production capacity as well as required demand for the goods. Monetary policy promotes sustained economic development by maintaining equilibrium between the total money demand and economy’s production capacity. When the production is more than the demand for the goods, monetary policy applies its-brakes of the flow of credit to the production sector. On the other hand, to-check increased demand for the goods, the monetary policy restricts its advances to the consumer sector and tries to give a boost to the production sector.

Monetary Policy for a Developing Country

The handling of the instrument of monetary policy is mainly governed by the economic environment and the general objectives of monetary control in the wider national context. In a developing country, like India, monetary policy is concerned with the monetary regulation with a view to promote economic development with reasonable price; stability.

Monetary policy has to, therefore, both promotional and regulatory. The scope for effective application of monetary and credit policies in developing economy, while it is modest should not be under-estimated. Since the scope is modest every effort should be made to have the best possible results. In an underdeveloped economy experiencing inflation, additional investment for development must be financed bygenuine savings or external resources. Owing to imperfections at market mechanism in such economies, the state has to direct the resources, physical and financial, through state participation to achieve the maximum rate of growth over a period of time. There will have to be a secular expansion of credit and public expenditure. The growth of public sector in most of the developing countries reflects partly, this way of thinking.

Conclusion:-

The first and most important lesson that history teaches about what monetary policy can do is a lesson of the most importance that monetary policy can prevent moneyitself from being a major source of economic disturbance. It has got potential of using money only as catalytic agent. It can set the monetary machinery on right track without affecting anything else. It is an important and positive task for the monetary authority to suggest improvements in the mechanism that will abolish or reduce the chances that it will get out of order, and to use its own powers so as to keep the mechanism in good working order.

The second thing which monetary policy can do is to provide a stable background for the economy. It can keep the monetary machine well oiled. The economic system will work best when producers, consumers and employers can proceed with the full confidence that average level of prices will behave in a predictable way in future. The
monetary authority could act as an alternative to gold standard, which had an element of automaticity in the behaviour prices.

Finally monetary policy can contribute to offset major disturbances in economic system arising from other sources.