It is concerned with the changing the supply of money, stock and rate of interest for the purpose of stabilizing

the economy at full employment or potential output level by influencing the level of aggregate demand. At times of recession monetary policy involves the adoption of some monetary tools which tends to increase the money supply and lower interest rate so as to stimulate aggregate demand in the economy. At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money supply or raising the rate of return.

To ensure the economic stability at full employment or potential level of output. To achieve price stability by controlling inflation and deflation. To promote and encourage economic growth in the economy.

QUALITATIVE MEASURES

Bank rate policy Open market operations Changing cash reserve ratio Statutory Liquid Ratio

QUANTITATIVE MEASURES

Credit Rationing Change in Lending Margins Moral Suasion

Bank rate is the minimum rate at which the central bank of a country provides loan to the commercial bank of the country. Bank rate is also called discount rate because bank provide finance to the commercial bank by discounting the bills of exchange. When general bank raises the bank rate, the commercial bank raises their lending rates, it results in less borrowings and reduces money supply in the economy.

This phenomenon will happen only when commercial banks have to borrow money from the central bank. In modern times, the commercial banks have built their financial resources. With the growth of credit institutions and financial intermediaries, the borrowers need not always be dependant on commercial banks.

It means the purchase and sale of securities by central bank of the country. That is RBI can pump or restrict the money circulation. If they want to circulate more money, the RBI will call for withdrawing the securities issued and vice versa.

If commercial bank posses excess liquidity the open market does not work. The Popularity of Government Bonds and Securities in the public matters a great deal.

In developing countries like India in which banking system is not well developed and security capital market are not interdependent, open market operations have a limited effectiveness.

The bank have to keep certain amount of money with them selves as reserves against deposits. It is the % of total deposits which commercial banks are required to maintain in the form of cash reserves with the central bank. The increase in the cash reserve rate leads to the contraction of credit. The decrease in the cash rate leads to the expansion of credit and banks tends to make more money available to borrowers.

Problem: Measures:

Recession and unemployment (1) Central bank buys securities through open market operation (2) It reduces cash reserves ratio (3) It lowers the bank rate

Money supply increases

Investment increases Aggregate demand increases Aggregate output increases by a multiple of the increase in investment

Problem: Measures:

Inflation (1) Central bank sells securities through open market operation (2) It raises cash reserve ratio and statutory liquidity (3) It raises bank rate (4) It raises maximum margin against holding of stocks of goods Money supply decreases Interest rate raises Investment expenditure declines Aggregate demand declines Price level falls

This is some part of deposits which commercial banks have to keep liquidity in addition to CRR. Example: Festive Season.

Example: Sanctioning Loan in limited amount and also to limited number of people.

Its basically making changes in policies based on necessity. Example: There was a policy to clear all agriculture loans within a particular limit.

Risk weightage assigned for various lending's. Example: In case of Term Loans.

Variable time lags concerning the effect of money supply on the national income. Treating Interest rate as the target of monetary policy for influencing investment demand for stabilizing the economy.

It is the rate RBI and Banks buy or Exchange money. Repo Buying Securities and Pushing money Reverse Repo Selling Securities and Withdrawing money.

Repo refers to agreement for a transaction between RBI and banks through which RBI supplies funds immediately against government securities and simultaneously agree to repurchase the same or similar securities after a specified time which may be one day to 14 days.

MONETARY POLICY AND EQUILIBRIUM GDP

Sm1 Sm2 Sm3
Real rate of interest, i

10 8 6

10 8 6

Investment Demand

Dm
Quantity of money demanded and supplied

0 Amount of investment, i

AS
Price level

If the Money Supply Increases to Stimulate the Economy Interest Rate Decreases Investment Increases AD & GDP Increases with slight inflation

P3

P2 P1

AD3(I=25) Increasing money supply AD2(I=20) continues the growth AD1(I=15) but, watch Price Level.
Real domestic output, GDP