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A glance at the development or evolution of monetary policy will reveal that its objectives and emphasis have been undergoing significant changes. The monetary policy of any country refers to the regulatory policy, whereby the monetary authority maintains its control over the supply of money for the realization of general economic objectives such as stable prices, full employment, etc. However, in the context of developing economies like India, monetary policy acquires a still wider role and it has to be designed to meet the particular requirements of the economy. Monetary policy as an instrument of economic policy has certain advantages when compared to fiscal policy. The lag between the time when action is needed and when action is actually taken is shorter in the case of monetary policy than fiscal policy. The important tools of monetary policy are
-- Minimum reserve requirements
-- Discount or bank rate
-- Open Market Operations (OMO).-
As per minimum reserve requirements, the commercial banks are required to maintain a minimum amount of balance with the Central Bank. This may be maintained either in the form of chest cash or in the form of deposits. A certain proportion of the total deposit liabilities, fixed by the Central Bank, is maintained by the commercial banks as 'statutory reserves'. The Central Bank's power to set the reserve requirements provides it with great powers over the lending behavior of the commercial banks. By changing the reserve requirement from time to time, it can directly influence the lending capacity of the banking system.
- Bank rate or discount rate refers to rate at which commercial banks can rediscount their bills with the Central Bank. By changing the bank rate, the Central Bank changes the cost of money supply with the commercial banks and therewith influences the incentive of the banks to borrow reserves.
- Open market operations involve purchase and sale of securities (generally government securities) by the Central Bank, to regulate the credit creating capacity of the commercial banks. When the Central Bank purchases securities it makes cheque payment to the sellers. The sellers deposit the cheques with the commercial banks, which automatically raise their reserve base. An increase in the reserve base of the banks provides a basis to multiple expansions of credit and deposits. Similarly, when the Central Bank performs open market sale of securities, it results in decrease in the bank reserves. So it can be said that, an open market purchase is expansionary in its effect and an open market sale is contractionary in its effect from the point of view of credit creation.
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