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What is monetary policy?

by Puja

Monetary policy is the process of drafting, announcing, and implementing the plan of actions taken by the central bank, currency board, or other competent monetary authority of a country that controls the quantity of money in an economy and the channels by which new money is supplied.

Monetary policy aims at meeting macroeconomics objectives such as controlling inflation, consumption, growth, and liquidity which consist of the management of money supply and interest rates. Therefore, this is achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating foreign exchange (forex) rates, and changing the amount of money banks are required to maintain as reserves.

Instruments of monetary policy

1. Bank rate policy –

Firstly, the minimum lending rate is the bank rate of the central bank at which it rediscounts first class bills of exchange and government securities held by the commercial banks. Central banks raise the bank rate when it finds that inflationary pressures have started emerging within the economy. Commercial bank borrows less as borrowing from central bank become costly. In turn, commercial banks raise their lending rate to the business community and the borrowers borrow less from commercial bank.

On the other hand central banks lower the bank rate when prices are depressed. On the part of commercial bank it is cheap to borrow from the central bank.  Similarly, the commercial bank lowers their lending rate and encourages business men to borrow more.

2.  Open market operation –

Open market operations refer to sale and purchase of securities in the money market by the central bank. The central bank sells securities, when prices are rising and there is need to control them.

On the other hand, the central bank buys securities, when recessionary forces start in the economy. The commercial bank raised the reserves and they lend more to the business community.

3. Changes in reserves ratio –

Every bank keep certain percentage of its total deposits with the central bank. The central bank raise the reserve ratio when prices are rising. Banks keep more with the central bank. Their reserves reduce and they lend less. In the opposite case, they raise reserves of commercial banks, when the reserve ratio is lower. They lend more and the economic activity is affect favorably .

4.  Selective credit controls –

For particular purposes selective credit controls used to influence specific types of credit. The central bank raises the margin requirement when there is brisk speculative activity in the economy or in particular sectors in certain commodities and prices start rising. In case of recession in a particular sector, the central bank encourages borrowing by lowering margin requirements.

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