WHAT IS MONETARY POLICY

Monetary policy is the process by which the

government, central bank (RBI in India), or monetary
authority of a country controls
• the supply of money
• availability of money
• cost of money or rate of interest , in order to attain
a set of objectives oriented towards the growth
and stability of the economy. Monetary theory
provides insight into how to craft optimal monetary
policy.

Monetary policy is referred to as either being an

expansionary policy, or a contractionary policy.
An expansionary policy increases the total supply of
money in the economy. It is traditionally used to
combat unemployment in a recession by lowering
interest rates. On the other hand the contractionary
policy decreases the total money supply. It involves
raising interest rates in order to combat inflation.
Monetary policy is contrasted with fiscal policy, which
refers to government borrowing, spending and
taxation
WHY IT IS NEEDED
What monetary policy – at its best – can deliver is low
and stable inflation, and thereby reduces the volatility
of the business cycle. When inflationary pressures build
up, it is the monetary policy which raises the short-term
interest rate (the policy rate), which raises real rates
across the economy and squeezes consumption and
investment.
The pain is not concentrated at a few points, as is the
case with government interventions in commodity
markets.

Monetary policy in India underwent significant changes

in the 1990s as the Indian Economy became increasing
open and financial sector reforms were put in place. In
the 1980s, monetary policy was geared towards
controlling the quantum, cost and directions of credit
flow in the economy. The quantity variables dominated
as the transmission Channel of monetary policy.
Reforms during the 1990s enhanced the sensitivity of
price signals from the central bank, making interest
rates the increasingly Dominant transmission channel
of monetary policy in India.

WHEN WERE MONETARY POLICIES

INTRODUCED?
Monetary policy is primarily associated with interest
rate and credit. For many centuries there were only two
forms of monetary policy:
• Decisions about coinage
• Decisions to print paper money to create credit.
Interest rates, while now thought of as part of monetary
authority, were not generally coordinated with the other
forms of monetary policy during this time. Monetary
policy was seen as an executive decision, and was
generally in the hands of the authority with seigniorage,
or the power to coin. With the advent of larger trading
networks came the ability to set the price between gold
and silver, and the price of the local currency to foreign
currencies. This official price could be enforced by law,
even if it varied from the market price.
With the creation of the Bank of England in 1694, which
acquired the responsibility to print notes and back them
with gold, the idea of monetary policy as independent of
executive action began to be established.The goal of
monetary policy was to maintain the value of the
coinage, print notes which would trade at par to specie,
and prevent coins from leaving circulation. The
establishment of central banks by industrializing
nations was associated then with the desire to maintain
the nation's peg to the gold standard, and to trade in a
narrow band with other gold-backed currencies. To
accomplish this end, central banks as part of the gold
standard began setting the interest rates that they
charged, both their own borrowers, and other banks
who required liquidity. The maintenance of a gold
standard required almost monthly adjustments of
interest rates.
During the 1870-1920 period the industrialized nations
set up central banking systems, with one of the last
being the Federal Reserve in 1913.By this point the role
of the central bank as the "lender of last resort" was
understood. It was also increasingly understood that
interest rates had an effect on the entire economy, in
no small part because of the marginal revolution in
economics, which focused on how many more, or how
many fewer, people would make a decision based on a
change in the economic trade-offs. It also became clear
that there was a business cycle, and economic theory
began understanding the relationship of interest rates
to that cycle. (Nevertheless, steering a whole economy
by influencing the interest rate has often been
described as trying to steer an oil tanker with a canoe
paddle.) Research by Cass Business School has also
suggested that perhaps it is the central bank policies of
expansionary and contractionary policies that are
causing the economic cycle; evidence can be found by
looking at the lack of cycles in economies before
central banking policies existed.
GOALS OR OBJECTIVES OF MONETARY POLICY

 Full Employment:- one of the objectives of

monetary policy is attain full employment. It is not
only because unemployment leads to wastage of
potential output. But also because of the loss of
 social standing and self- respect. It also breeds
poverty.
 Price stability :- Another objective of monetary
policy is to stabilize the price level. Both , rising
and falling prices are bad as the bring unnecessary
loss to some and undue advantage to others. They
are associated with business cycles. So a policy of
price stability keeps the value of money stable,
eliminates cyclical fluctuations. Brings economic
stability, helps in reducing inequalities of income
and wealth, secures social justice and promotes
economic welfare

 Economic growth :-monetary policy can be imposed

to influence the rapid economic growth. Economic
growth is defined as “the process whereby the real
per capita income of a country increases over a
long period of time “it is measured by the increase
in the amount of goods and services produced in a
country. A growing economy produces more goods
and services in each successive time period. Thus,
growth occurs when an economy’s thus, economic
growth implies raising the standard of living of the
people, and reducing inequalities of inequalities of
income distribution.
 Balance of payments:- another objective of
monetary policy since the 1950s has been to
maintain equilibrium in the balance of payments. It
is also recognized that deficit in the balance of
payments will retard the attainment of other
 objectives. This is because a deficit in the balance
of payment leads to a sizeable outflow of gold,

ROLE OF MONETARY POLICY IN A DEVELOPING

ECONOMY

 Monetary policy plays an important role in

increasing the growth rate of the economy by
influencing the cost and availability of credit by
controlling inflation and maintaining equilibrium in
the balance of payments.

TO CONTROL INFLATIONARY PRESSURES:

 To control inflationary pressures, monetary policy
requires the use of both quantitative and
qualitative methods of credit control. The open
market operations are not successful in controlling
inflation in underdeveloped countries as the bill
market is small and undeveloped.

 The use of variable reserve ratio is more effective

than open market operations and bank rate policy
in LDCs. Since the market for securities is very
small, open market operations are not successful.
but a rise or fall in the variable reserve ratio by the
central bank reduces or increases the cash
available with the commercial banks without
affecting adversely the prices of securities.
TO ACHIEVE PRICE STABILITY:

 Monetary policy is important for achieving price

stability. It brings a proper adjustment between the
demand for and supply of money. An imbalance
between the two will be reflected in the price level.
A shortage of money supply will hamper the growth
while an excess will lead to inflation. As the
economy develops the demand for money
increases due to the gradual monetization of the
non-monetized sector, and the increase in
agricultural and industrial production. This will
increase the demand for transactions and
speculative motives. So the money supply will have
to be raised more than proportionate to the
demand for money, to avoid inflation.

TO BRIDGE BOP DEFICIT;

 Interest rate policy plays an important role in
bridging the BOP deficit. Underdeveloped countries
develop serious balance of payments. To establish
infrastructure like power, irrigation, transport etc…
and directly productive activities like iron and
steel, chemical, electricals, fertilizers , etc,
underdeveloped countries have to import capital
 equipment, machinery, raw materials, spares and
components thereby raising their imports,

INTEREST RATE POLICY:

High interest rate in an underdeveloped country acts as

an incentive to higher savings develops banking habits
and speeds up the monetization of the economy which
are essential for capital formation and economic
growth. a high interest rate policy is anti inflationary in
nature, for it discourages borrowing and investment for
speculative purpose, and in foreign currencies

TO CREATE BANKING AND FINANCIAL INSTITUTION:

 One of the monetary policies in an underdeveloped

country is to create and develop banking and
financial institution to mobilize and channelize
saving for capital formation. establishment of
branch banking in rural areas and urban areas
should be encouraged. It will help in monetizing
the non-monetised sector and encourage saving
and investment for capital formation.

DEBT MANAGEMENT;
 It is one of the important function of monetary
policy in an under developed country it aims at
proper timing and issuing of government bonds,
stabilizing their prices and minimizing the cost of
servicing the public debt. The primary aim of debt
management is to create conditions in which
public borrowing can increase from year to year
borrowing is essential in order to finance
development program and to control the money
supply.