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solved question papers Q2. What is monetary policy? Explain the general objectives and instruments of monetary policy.


Monetary Policy
Monetary policy is a part over all economic policy of a country. It is employed by the government as an effective tool to promote economic stability and achieve certain predetermined objectives.
Meaning and definition:

Monetary Policy deals with the total money supply and its management in an economy. It is essentially a programme of action undertaken by the monetary authorities generally the central bank to control and regulate the supply of money with the public and the flow of credit with a view to achieving economic stability and certain predetermined macro economic goals.
Monetary policy can be explained in two different ways. In a narrow sense, it is concerned with administering and controlling a country’s money supply including currency notes and coins, credit money, level of interest rates and managing the exchange rates. In a broader sense, monetary policy deals with all those monetary and non-monetary measures and decisions that affect the total money supply and its circulation in an economy. It also includes several non-monetary measures like wages and price control, income policy, budgetary operations taken by the government which indirectly influence the monetary situations in an economy.
Different writers have defined monetary policy in different ways. Some of the important ones are as follows.
1. According to RP Kent, “Monetary policy is the management of the expansion and contraction of the volume of money in circulation for the explicit purpose of attaining a specific objective such as full employment”.
2. In the words of D.C.Rowan, “The monetary policy is defined as discretionary act undertaken by the authorities designed to influence the supply of money, cost of money or interest rate and the availability of money”.
Monetary policy basically deals with total supply of legal tender money, i.e., currency notes and coins, total amount of credit money, level of interest rates, exchange rate policy and general liquidity position of the country.
Credit policy which is different from the monetary policy affects allocation of bank credit according to the objective of monetary policy.
The government in consultation with the central bank formulates monetary policy and it is generally carried out and implemented by the central bank. It is evolved over a period of time on the basis of the experience of a nation. It is structured and operated with in the institutional framework and money market of the country. Its objectives, scope and nature of working etc is collectively conditioned by the economic environment and philosophy of time. Monetary policy along with fiscal policy and debt management lumped together form the financial policy of the country.
Monetary policy is passive when the central bank decides to abstain deliberately from applying monetary measures. It is active when the central bank makes use of certain instruments to achieve the desired objectives. It may be positive or negative. It is positive when it promotes economic activities and it is negative when it restricts or curbs economic activities. Similarly, it is liberal when there is expansion in credit money and it is restrictive when it leads to contraction in money supply. Again, a cheap money policy may be followed by cutting down the interest rates or a dear money policy by raising the rate of interest.
The Scope and effectiveness of monetary policy depends on the monetization of the economy and the development of the money market.
General objectives of monetary policy.
1. Neutral money policy:
Prof. Wicksteed, Hayak, Robertson and others have advocated this policy. This objective was in vogue during the days of gold standard. According to this policy, money is only a technical devise having no other role to play. It should be a passive factor having only one function, namely to facilitate exchange. It should not inject any disturbances. It should be neutral in its effects on prices, income, output, and employment. They considered that changes in total money supply are the root cause for all kinds of economic fluctuations and as such if money supply is stabilized and money becomes neutral, the price level will vary inversely with the productive power of the economy. If productivity increases, cost per unit of output declines and prices fall and vice-versa. According to this policy, money supply is not rigidly fixed. It will change whenever there are changes in productivity, population, improvements in technology etc to neutralize fundamental changes in the economy. Under these conditions, increase or decrease in money supply is allowed to result in either fall or raise in general price level. In a dynamic economy, this policy cannot be continued and it is highly impracticable in the present day economy.
2. Price stability:
With the suspension of the gold standard, maintenance of domestic price level has become an important aim of monetary policy all over the world. The bitter experience of 1920’s and 1930’s has made all most all economies to go for price stability. Both inflation and deflation are dangerous and detrimental to smooth economic growth. They distort and disturb the working of the economic system and create chaos. Both of them are bad as they bring unnecessary loss to some groups where as undue advantage to some others. They have potential power to create economic inequality, political upheavals and social unrest in any economy. In view of this, price stability is considered as one of the main objectives of monetary policy in recent years. It is to be remembered that price stability does not mean that prices of all commodities are kept constant or fixed over a period of time. It refers to the absence of sharp variations or fluctuations in the average price level in the country. A hundred percent price stability is neither possible nor desirable in any economy. It simply implies relative price stability. A policy of price stability checks cyclical fluctuations and smoothen production and distribution, keeps the value of money stable, prevent artificial scarcity or prosperity, makes economic calculations possible, introduces an element of certainty, eliminate socio-economic disturbances, ensure equitable distribution of income and wealth, secure social justice and promote economic welfare. On account of all these benefits, monetary authorities have to take concrete steps to check price oscillations. Price stability is considered as one of the prerequisite condition for economic development and it contributes positively to the attainment of a steady rate of growth in an economy. This is because price stability will build up public morale and instill confidence in the minds of people, boost up business activity, expand various kinds of economic activities and ensure distributive justice in the country. Prof Basu rightly observes, “A monetary policy which can maintain a reasonable degree of price stability and keep employment reasonably full, sets the stage of economic development”.

3. Exchange rate stability:
Maintenance of stable or fixed exchange rate was one of the major objects of monetary policy for a long time under the gold standard. The stability of national output and internal price level was considered secondary and subservient to the former. It was through free and automatic imports and exports of gold that the country was able to remove the disequilibrium in the balance of payments and ensure stability of exchange rates with other countries. The government followed the policy of expanding currency and credit with the inflow of gold and contracting currency and credit with the outflow of gold. In view of suspension of gold standard and IMF mechanism, this object has lost its significance. However, in order to have smooth and unhindered international trade and free flow of foreign capital in to a country, it becomes imperative for a county to maintain exchange rate stability. Changes in domestic prices would affect exchange rates and as such there is great need for stabilizing both internal price level and exchange rates. Frequent changes in exchange rates would adversely affect imports, exports, inflow of foreign capital etc. Hence, it should be controlled properly.
4. Control of trade cycles:
Operation of trade cycles has become very common in modern economies. A very high degree of fluctuations in over all economic activities is detrimental to the smooth growth of any economy. Economic instability in the form of inflation, deflation or stagflation etc would serve as great obstacles to the normal functioning of an economy. Basically, changes in total supply of money are the root cause for business cycles and its dampening effects on the entire economy. Hence, it has become one of the major objectives of monetary authorities to control the operation of trade cycles and ensure economic stability by regulating total money supply effectively. During the period of inflation, a policy of contraction in money supply and during the period of deflation, a policy of expansion in money supply has to be adopted. This would create the necessary economic stability for rapid economic development.
5. Full employment:
In recent years it has become another major goal of monetary policy all over the world especially with the publication of general theory by Lord Keynes. Many well-known economists like Crowther, Halm. Gardner Ackley, William, Beveridge and Lord Keynes have strongly advocated this objective in the context of present day situations in most of the countries. Advanced countries normally work at near full employment conditions. Their major problem is to maintain this high level of employment situation through various economic polices. This object has become much more important and crucial in developing countries as there is unemployment and under employment of most of the resources. Deliberate efforts are to be made by the monetary authorities to ensure adequate supply of financial resources to exploit and utilize resources in the best possible manner so as to raise the level of aggregate effective demand in the economy. It should also help to maintain balance between aggregate savings and aggregate investments. This would ensure optimum utilization of all kinds of resources, higher national output, income and higher living standards to the common man.
6. Equilibrium in the balance of payments:
This objective has assumed greater importance in the context of expanding international trade and globalization. To day most of the countries of the world are experiencing adverse balance of payments on account of various reasons. It is a situation where in the import payments are in excess of export earnings. Most of the countries which have embarked on the road to economic development cannot do away with imports on a large scale. Imports of several items have become indispensable and without these imports their development process will be halted. Hence, monetary authorities have to take appropriate monetary measures like deflation, exchange depreciation, devaluation, exchange control, current account and capital account convertibility, regulate credit facilities and interest rate structures and exchange rates etc. In order to achieve a higher rate of economic growth, balance of payments equilibrium is very much required and as such monetary authorities have to take suitable action in this direction.
7. Rapid economic growth:
This is comparatively a recent objective of monetary policy. Achieving a higher rate of per capita output and income over a long period of time has become one of the supreme goals of monetary policy in recent years. A higher rate of economic growth would ensure full employment condition, higher output, income and better living standards to the people. Consequently, monetary authorities have to take the necessary steps to raise the productive capacity of the economy, increase the level of effective demand for various kinds of goods and services and ensure balance between demand for and supply of goods and services in the economy. Also they should take measures to increase the rate of savings, capital formation, step up the volume of investment, direct credit money into desired directions, regulate interest rate structure, minimize economic and business fluctuations by balancing demand for money and supply of money, ensure price and overall economic stability, better and full utilization of resources, remove imperfections in money and capital markets, maintain exchange rate stability, allow the inflow of foreign capital into the country, maintain the growth of money supply in consistent with the rate of growth of output minimize adversity in balance of payments condition, etc. Depending upon the conditions of the economy money supply has to be changed from time to time. A flexible policy of monetary expansion or contraction has to be adopted to meet a particular situation. Thus, a growth-friendly monetary policy has to be pursued by monetary authorities in order to stimulate economic growth.
It is to be noted that the above-mentioned objectives are inter related, inter dependent and inter connected with each other. Each one of the objectives would affect the other and in its turn is influenced by the others. Many objectives would come in clash with others under certain circumstances. A proper balance between different objectives becomes imperative. Monetary authorities have to determine the priorities depending upon the economic environment in a country. Thus, there is great need for compromise between different objectives
Instruments of Monetary Policy
Broadly speaking there are two instruments through which monetary policy operates. They are also called techniques of credit control.
I. Quantitative techniques of credit control:
They include bank rate policy, open market operations and variable reserve ratio.
II. Qualitative techniques of credit controls:
They include change in margin requirements, rationing of credit, regulation of consumers credit, moral suasion, issue of directives, direct action and publicity etc.
I. Quantitative techniques of credit control:
The operation of the quantitative techniques or general methods will have a general impact on the entire economy regulating the supply of credit made available to different activities.
The Bank Rate is the rate at which the central bank of a country is willing to discount first class bills. If the Bank Rate is raised, the market rates and other lending rates of the money market also go up. Conversely, the lending rates go down when the central bank lowers its bank rate. These changes affect the supply and demand for money. Borrowing is discouraged when the rates go up and encouraged when they go down.
The flow of foreign short term capital also is affected. There is an inflow of foreign funds when the rates are raised and an outflow when they are reduced.
Internal price level tends to fall with the contraction of credit. And it tends to rise with its expansion.
Business activity, both industrial and commercial, is stimulated when the rates of interest are low, and discouraged when they are high.
Adverse balance of payments in foreign trade can be corrected through lowering of costs and prices.
Thus bank rate through its influence on supply of and demand for money helps in the establishment of stability in the economy.
Open Market Operations refer to the purchase or sale of government securities, short-term as well as long-term, by the central bank. When the central bank sells securities cash balances with the commercial banks decline, they are compelled to reduce their lending. Thus credit contracts. On the other hand purchases of securities enable commercial banks to expand credit.
This method is sometimes adopted to make the bank rate effective.
Varying Reserve Ratio – Variations of reserve requirements affect the liquidity position of the banks and hence their ability to lend. By raising the reserve requirements inflationary trend can be kept under control. The lowering of the reserve ratio makes more cash available with the banks. The Reserve Bank of India has been empowered to vary the Cash reserve ratio from the minimum requirement of 3 % to 15 % of the aggregate liabilities. Cash Reserves maintained by commercial banks is called statutory reserve and the reserve over and above the statutory reserves is called excess reserve.
II. Qualitative Techniques of Credit Control
Changes in the margin requirements, direct action, moral suasion, rationing of credit, issue of directives, and regulation of consumer credit are some of the qualitative techniques which are in practice generally.
While lending money against securities banks keep a certain margin. Central Bank can issue directives to commercial banks to maintain higher margins when it wants to curtail credit and lower the margin requirements to expand credit.
Direct action implies a coercive measure like, central bank refusing to provide the benefit of rediscounting of bills for such banks whose credit policy is not in accordance with the wishes of the central bank.
The central bank on the other may follow a mild policy of moral suasion where it requests and persuades a member bank to refrain from lending for speculative or non essential activities.
The Credit is rationed by limiting the amount available to each applicant. Central bank may also restrict its discounts to bills maturing after short periods.
Central bank, in the form of directives to commercial banks can see that the available funds are utilized in a proper manner.
Regulation of consumer credit can have a direct impact on the demand for various consumer durables.
Thus Crowther concludes that the policy 0f the central bank using its free discretion within limits that are normally very broad can control the volume of money and credit, in its own field the central bank is clearly a dictator. Hence, Modern economists do not give much importance to monetary policy as a tool to keep economic activity in proper trim.

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