Policy Tools to Control Money Supply

Introduction: What is Monetary Policy?

The monetary policy includes actions taken by the central bank of a nation to promote healthy economic growth. The focus of monetary policy may be on cash, ledgers, credit, mortgage, bonds, loans, cheques, etc. These policies are aimed to control the economy and are helpful in situations of inflation and deflation.

Monetary policy is overseen by a board of members consisting of top-level managers of the central bank and government representatives. The monetary policy is regulated because without regulation it may head toward inflation or deflation. To regulate the money supply and thereby regulate the economy is the main objective of monetary policies.

Tools to Control Money Supply in India

The central bank of India called the Reserve Bank of India creates and uses various tools for controlling the money supply in India. However, three tools are the most important among them. These three tools are the following:

Reserve Requirements

Usually, every bank must maintain a reserve of financial resources, such as cash which is kept on hand overnight. This reserve can be stored in banks’ own vaults or at the central bank. If the reserve limit is low, banks can lend more of those resources as loans to individuals and businesses. Such low limits are expansionary in nature because they create credit.

Higher limits of reserves let lower amounts of loans to be distributed by banks because they need to save more of the sash at hand. It is contractionary in nature. Central banks hardly impose reserve requirements on small banks because they don’t have too much money in their hands. Moreover, the reserve requirement is changed not often because a change in reserve requirements would need the banks to change their management procedures.

Open Market Operations

Central banks may participate in the international open market of financial resources which usually refers to securities. These securities are either bought or sold from and to private banks of a particular nation respectively. When a bank buys securities, it expands the bank’s reserves by adding cash to it. So, the banks can increase lending.

On the other hand, when a bank sells securities, it has less cash left in its hands. So, it reduces the lending process. The central bank buys securities when it wants to make the economy expansionary while it sells the securities to make the economy tighter.

Discount Rate

The discount rate is the rate of interest the central bank charges for lending money to private banks. Usually, this rate is higher than the charge of normal banks, so banks take the money lent by central banks when they cannot access money from any other private bank.

There is a stigma that banks resort to the discount window when their financial condition is unwell. A bank that has no other helper will only look for discount rates. Therefore, the financial community believes that only weak banks look for discount- rated funds which may also be wrong to assume.

Monetary Policy Instruments in India

Policy instruments in India are devised by the RBI and they are categorized into two types. These are qualitative and quantitative instruments. They act as tools for controlling the money supply and they can have an excellent grasp on the economic health of a nation when applied appropriately.

Qualitative Instruments

• Licensing

• Credit Rationing

• Dynamic interest rates

• Requirement of margins

• The consumer rate is to be regulated.

Quantitative Instruments

• Bank rates

• Open market operations

• Repo rates and reverse repo rates

• Change in requirement

• Liquidity

Goals of Monetary Policy

• Price Stability − Keeping the prices stable helps in the growth of a nation’s economy. However, as the financial architecture must also be kept intact, the idea to inculcate here is to keep the prices stable without altering the financial scenarios.

• Expansion of Bank Credit − Central banks also want the private banks to hold more money for bank credit offered as loans. However, this expansion should be made without affecting the stability of the economy.

• Fixed Investments − The productivity of investments must be increased without affecting non-essential fixed investments. That is done by using various economic and financial tools by the central bank.

• Restricting Inventories − Overloaded inventories are a sign of sick organizations. Therefore, the central bank highlights the idle money in banks to restrict inventory formation. This is applicable to all kinds of manufacturing industries as well

• Promoting efficiency − The central bank also focuses on incorporating structural changes to improve efficiency. These changes usually include operational constraints, interest rates, and money market instruments.

• Credit distribution − The private banks and other monetary authorities should make money available for eligible borrowers and businesses. Monetary policy, therefore, looks into efficient credit distribution too.

• Diminishing Rigidity − Financial rigidity affects autonomy negatively which impacts the flexibility of organizations at work. Monetary policies that ease the money supply helps bring competitiveness among organization while maintaining diversification at the same time.

Monetary Policy Operations

The operations performed by the RBI in terms of monetary policy include the following −

• Price stability

• Money Supply

• Interest rate

• Financial stability

• Economic Growth

• Balance of payment (BoP)

• Stable currency exchange rate.

The Monetary Policy Framework

The RBI has the full right to manage the monetary policy framework in India. The framework looks into two special objectives which are −

• Deciding the repo rate based on the assessment of situations. The repo rate decides the interest rate at which money is lent to private banks and it has a direct effect on loans provided by private banks in India.

• Controlling and maintaining optimum liquidity conditions in the economy to anchor the money market. This means that the RBI will regulate all kinds of liquidity conditions when the situation of the economy is in trouble.

The RBI manages the day-to-day operations according to the new repo rate once the rate has been announced. Moreover, the central bank also manages the framework to remain active and work in all conditions of India’s economy.

Conclusion

Monetary policy control is one of the most important parts of a nation’s economy. In India, monetary policy is executed by the RBI. Therefore, knowing the various options of monetary tools, how the framework acts, and how it helps general and private banks to operate are important lessons for everyone interested in the economy.

FAQs

Qns 1. What is meant by monetary policy? Describe briefly.

Ans. The monetary policy includes actions taken by the central bank of a nation to promote healthy economic growth. The focus of monetary policy may be on cash, ledgers, credit, mortgage, bonds, loans, cheques, etc.

Qns 2. What are the three major tools of monetary policy?

Ans. Three major tools of monetary policy are Discount Rates, Reserve Requirements, and open market operations.

Qns 3. Mention any five goals of monetary policy.

Ans. The five goals of monetary policy include credit expansion, price stability, fixed investments, credit distribution, and controlling the rigidity of money markets.