Monetary policy refers to the control of credit and total money supply. This policy is also known as the central bank’s policy in control of credit. Control of money supply is very important for the economic growth of a country. If there is excess supply of money then the result will be inflation whereas tight control over money may cause depression and unemployment. Therefore monetary policy is implemented to achieve various objectives such as achievement of price stability, increase employment opportunities, stimulate economic growth, achieve stable rate of the currency and increase in investment. Monetary policy is implemented by the central bank and it uses different methods for this purpose. These are classified into two types and are given below.
Bank rate refers to the rate at which central bank rediscounts bills of exchange. In other words it is the rate of interest at which central bank advances loans to the commercial banks. In case of inflation central bank increases the bank rate due to which commercial banks have to increase the interest rate. Due to increase in the interest rate demand for the loans of commercial banks reduces and the money supply in country shrinks. In this way inflation is controlled. On the other hand bank rate is reduced in case of depression which results in the reduction of interest rate and the money supply in country is increased.
Open Market Operations
When the central bank purchase or sale government securities in the open market such as stock exchange it is called open market operation. If central bank wants to reduce the money supply in country it sells government securities to the commercial banks and people. In this way the amount of cash with people and commercial banks is reduced due to which commercial banks decrease the number of loans whereas people’s demand for goods and services shrinks. Similarly if the central bank wants to increase the money supply it purchases government securities due to the amount of cash with commercial banks and people increases.
Changes in Reserve Ratio
Every member bank keeps a percentage of its total deposit with the central bank known as cash reserve ratio. Central bank uses reserve ratio to increase or decrease the money supply in country. For example if the central bank wants to decrease the money supply it raises the reserve ratio due to which less amount of cash is left with the commercial banks to lend. Due to lower lending the supply of money reduces along with the demand for goods and services which results in the control of inflation. Similarly central bank can increase the money supply by lowering the reserve requirements.
Central bank uses credit rationing to fix the credit ceiling allowed for each and every commercial bank. It means that central bank fixes the credit limit for each commercial bank and does not give credit to them beyond that limit. Whenever the central bank desires to decrease the money supply it decreases the limit up to which it can give loans to the member banks. Similarly central bank can increase the money supply by increasing the credit limit.
Change in Margin Requirement
Every commercial bank has to keep a margin whenever it extends loans against the security. It means that the amount of loan is lower than the actual value of security. For example actual value of security is 100 and the amount of loan is 85, therefore margin requirement is 15%. Central bank can increase or decrease the money supply by changing the margin requirements. For example if central bank wants to decrease the money supply it can do so by increasing the margin requirements. In this way amount of loans decreases.
Regulation of Consumer’s Credit
Consumer credit facility refers to the act of selling a consumer good on a credit basis to the people. The method is used by government or central bank to implement certain regulations on goods sold on credit. If the central bank wants to increase the money supply it can do so by adopting a lenient policy about the credit for purchase of consumer goods. Similarly central bank can reduce the money supply by putting restrictions on consumer credit.
In some cases central bank morally persuades or requests the commercial banks not to indulge themselves in such economic activities which are against the interest of country. It regularly advises and guides the member banks to follow a particular policy for loans and refrain themselves from giving loan for speculative purposes.
Central bank also publishes details concerning its policies and important information about assets and liabilities, credit and business situation etc of commercial banks. This helps to make commercial banks as well as general public realize the monetary needs of country. Central bank reveals some of the important information about the commercial banks so that the people know about the various activities of commercial banks and can protect themselves from any potential loss in the future.
Direct action is the last resort through which central bank takes a direct action against the bank which does not act in accordance with the policy of central bank. In case of direct action the central bank can impose fine and penalty and can refuse to give out loans to the commercial bank. Such type of pressure keeps commercial banks away from undesired credit activities.