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Chapter: 11th 12th std standard Indian Economy Economic status Higher secondary school College

Monetary Policy of India

The basic goals of macroeconomic policy in most of the countries are full employment, price stability, rapid economic growth, balance of payments equilibrium and economic justice.

Monetary Policy


The basic goals of macroeconomic policy in most of the countries are full employment, price stability, rapid economic growth, balance of payments equilibrium and economic justice. Economic justice refers to equitable distribution of income. The government tries to achieve the goals through macroeconomic policy. Macroeconomic policy can be broadly divided into monetary policy and fiscal policy. Of course, the government follows other policies such as industrial policy, agricultural policy, tariff policy and so on. But we limit our discussion only to monetary policy and the fiscal policy. In the present chapter, we shall study the monetary policy with reference to our country.


'Monetary policy is policy that employs the central bank's control over the supply and cost of money as an instrument for achieving the objectives of economic policy' (Edward Shapiro).


Instruments of Monetary Policy


Roughly we may say that monetary policy is credit control policy. The instruments of credit control can be broadly divided into :


1.        Quantitative credit control measures ; and


2.        Selective credit control measures.

Quantitative credit control instruments include bank rate policy, variation of cash reserve ratios and open market operations.


1.                Bank Rate : The Bank rate is the minimum rate at which the central bank of a country will lend money to all other banks. Suppose, there is too much of money in circulation. Then the central bank should take some money out of circulation. It can do it by increasing the bank rate. When the bank rate goes up, the rates charged by other banks go up. The belief is that if the rate of interest goes up, businessmen will be discouraged to borrow more money and producers will borrow less money for investment. Generally, to control inflation, the central bank will increase the bank rate.


2.                Variation of cash Reserve Ratios : The ability of a commercial bank to create credit depends upon its cash reserves. The central bank of a country has the power to vary the cash reserve ratios. During inflation, to check the sharp rise in commodity prices and to control credit, the central bank can make use of this weapon.


3.                Open Market Operations : In India, the open market operations have been conducted in Central Government securities and State Government securities. The success of open market operations as a weapon of credit control, depends mainly on (i) the possession by the central bank of adequate volume of securities ; (2) the presence of well developed bill (securities) market ; and (3) stability of cash reserve ratios maintained by commercial banks. These things are missing to a great degree in India. So, open market operations have not become a powerful weapon of credit control in our country. They have been largely used in India more to assist the Government in its borrowing operations rather than controlling credit.


Selective credit controls


Selective credit controls can play an important role in an under-developed money market with a planned economy. Unlike the instruments of quantitative credit control, the selective instruments affect the types of credit extended by commercial banks. They not only prevent flow of credit into undesirable channels, but also direct the flow of credit into useful channels. The Reserve Bank of India had started applying the selective credit controls since 1955.


The weapons of selective credit controls include (a) Fixing minimum margin of lending or for purchase of securities. (For example, shares or commodities like foodgrains and raw materials which are in short supply). In this case, the central bank specifies the fraction of the purchase price of securities that must be paid in cash. Unlike general controls, selective controls make it possible for the central bank to restrain what is regarded as an unhealthy expansion of credit. (eg. for financing the purchase of securities or automobiles) ;


1.        Ceiling on the amount of credit for expansion and


2.        Different rates of interest will be charged to encourage certain sectors and to discourage certain other sectors. In our country, the last weapon has been used especially, to encourage exports, agricultural production and production in small scale and cottage industries sector.


3.        The central bank will persuade the commercial banks to follow certain policies through moral suasion.


Conclusion : Monetary policy is usually effective for controlling inflation. But during the Great Depression of 1930s, it was found to be ineffective. So Keynes suggested a bold and dynamic fiscal policy to tackle the problems of mass unemployment and bad trade characterized by falling prices and deficiency in aggregate demand. But since 1970s, the world has been facing the problem of stagflation marked by stagnation and lack of demand on the one hand and inflation on the other. In the case of stagflation, both monetary policy and fiscal policy are found to be ineffective. So incomes policy such as voluntary restraint on wages by employees, and on prices by producers have been suggested as a complement to the monetary policy and the fiscal policy.


In India, the usual methods of credit control are not operative in an effective manner. The main reasons for the ineffectiveness of the monetary policy of the RBI is this. Two main conditions essential for the success of the credit policy are the dependence of the money market upon commercial banks and dependence of the commercial banks on the central bank for their funds. Both these conditions have been only partially fulfilled in India. That is why, the credit control measures of RBI have not been totally effective in India. Not only that, in recent times unaccounted money (black money) has been used for financing speculative dealings.

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