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By Shefali Bansal Aanchal Bhatia

Monetary policy refers to the credit control measures adopted by the central bank of a country to influence the level of aggregate demand for goods and services or to influence the trends in certain sectors of the economy. Monetary policy operates through varying the cost availability of credit. These variations affect the demand for and the supply of credit in the economy, and the nature of economic activities.

Full Employment:- One of the objectives of monetary policy is to 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 they 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, economic growth implies raising the standard of living of the people, and reducing 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.

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, 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.

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 nonmonetized 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.

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, chemicals, electricals, fertilizers , etc, underdeveloped countries have to import capital equipment, machinery, raw materials, spares and components thereby raising their imports.

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.

One of the objective of monetary policy 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 nonmonetized sector and encourage saving and investment for capital formation.

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.

A financial system should be distinguished from a payments system. It can be defined as the set of institutional arrangements through which purchasing power is transferred from one transaction in exchange to another.


Indian financial system performs a crucial role in economic development of India through saving-investment process, also known as capital formation. It is for this reason that financial system is sometimes called the financial market. The purpose of the financial market is to mobilize effectively and allocate the same efficiently among the ultimate users of funds viz investors.


2. 3.

Increase in savings, that is , the resource that would have been normally used for consumption purposes, can be shifted to other development purposes. Mobilization of saving. Investment purpose, which is the production of capital goods.


:- According to G. Crowther it is the collective name given to the various firms and institutions that deal in the various grades of near money  The Indian money market is the market in which short term funds are borrowed and lend.

Money market

Organised market

Un organised

Sub market


Call money market

Commercial banks

Bill market

Certificate of deposit


Call money market:- The Indian money market is not a single homogenous market but it is composed of several sub markets, each one of which deals in particular types of short term credit. One important sub- market of the Indian money market is the call money market, which is the market for very short term funds, also known as money at call and short notice. This market has actually two segments i.e. the overnight market and short notice market. Bill market in India:- The bill market or the discount market is the most important part of the money market where short term bills-normally up to 90 days-ate bought and sold. The bill market is further sub divided into commercial bill market and treasury bill market. The market for commercial bill has not become very popular in India, unlike the London money market where commercial bill are extensively bought and sold i.e. discounted.


c) Acceptance market: The market for the acceptance of trade bills. The main operators in this market are the acceptance houses and the commercial banks. d) Collateral loan market: It is an important section of the money market. It takes the form of loans, over drafts, cash credit. The loan and advance are covered by collaborates like government securities, gold silver stocks of corporation, merchandise etc.

The various institutions in the money market generally includes the following: 1. Central bank : It is naturally to be the leader of all banks. It is the bank, which is entrusted with the task of controlling the issue of money and funds to the market and regulates credit facilities provided by various other institutions. 2. Commercial banks: They play a vital role in the money market. They make advances, discount bills and lend against the promissory notes and the like. They also take help of the market in solving their liquidity problems.

3.Discount houses:- Discount houses are special institutions for rediscounting the bills of exchange. They usually deal in three kinds of bills  The domestic bills  The foreign bills  The government treasury bill 4. Acceptance house:- Acceptance houses are institutions which specialize in accepting bills of exchange. Generally they are merchant bankers. They act as second signatories on the bills of exchange. That is they guarantee the bills of a trader whose financial standing is not known, for making the bill negotiable.

5. Bill brokers:-The bill brokers intimately know their customers and act as intermediaries between the sellers and buyers of bill for a small commission .sometimes , these bill brokers discount bills on their own account.

It is also known as secondary market. It is the market where existing securities are traded. It is an association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities. (securities contract act 1956)


market Evaluation of securities Protection of investor Mobilization of saving Capital formation Economic barometer Regulation of company management Clearing house of information

23 stock exchanges in the country are recognized under securities contract act 1956. 21 are regional ones and 2 are nationalNational Stock Exchange (NSE) and Over The Counter Exchange of India (OTCEI).

NSE was set up in 1993 with IDBI as the Nodal Agency. It operates in two different segment: 1. Wholesale debt market 2. Capital market. The first is concerned with trading in instrument like government securities, PSU bonds, CDs, CPs by corporate entities like banks etc. The second is concerned with equity and corporate debt instruments by corporate and individuals.

OTCEI started its operation in September 1992 with their headquarter in Mumbai. It is jointly promoted by UTI, IDBI, IFCI, LIC, GIC, Canbank Financial Services Ltd. etc. It is for unlisted companies.

Instruments of Monetary Policy

Change in Lending margins

Bank rate


Open market operations

Credit Rationing


Moral Suasion

Cash Reserve Ratio

Direct Controls

Quatitative Instruments
Open Market Operations (OMO):

It means the purchase and sale of securities by the central bank of the country. The OMO is the most powerful and widely used tool of monetary control.
Bank Rate:

Bank rate is the rate at which the central bank rediscounts the bills of exchange presented by the commercial banks. For practical purposes bank rate is the rate which the central bank charges on the loans and advances to the commercial banks.

The Cash Reserve Ratio (CRR):

Cash Reserve Ratio is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank.
Statutory Liquidity Requirement (SLR):

The SLR Is that proportion of the total deposits which commercial banks are required to maintain with them in the form of liquid assets (cash reserve, gold and government bonds) in addition to CRR.

Qualitative Instruments
Credit Rationing: Under this two measures are adopted: 1. Imposition of upper limits on the credit available to large industries and firms. 2. Charging a higher interest rate on bank loans beyond a certain limit.

Change In Lending Margins: The banks provide loans only upto a certain percentage of the value of the mortgaged property. The gap between the value of the mortgaged property and amount advanced is called lending margin.

Moral Suasion:

The moral suasion is a method of persuading and convincing the commercial banks to advance credit in accordance with the directive of the central bank in the economic interest of the country.

Direct controls:

Where all other methods prove ineffective, the monetary, authorities resort to direct control measures with clear directive to the banks to carry out their lending activity in a specified manner.

Highlights of Monetary Policy 2010-2011

The Reserve Bank announces the following policy measures:
The Bank Rate has been retained at 6.0 percent. It has been decided to increase the repo rate from 5.0 per

cent to 5.25 per cent. The reverse repo rate is increased from 3.5 per cent to 3.75 per cent. It has been decided to increase the Cash Reserve Ratio (CRR) of scheduled banks by 25 basis points i.e. from 5.75 percent to 6.0 percent. The SLR is announced 25%.

Limitations Of Monetary Policy

The time lag :

The first and the most important limitation in the effective working of monetary policy is the time lag. i.e. time taken in chalking out the policy action, its implementation and working time.
Problem in forecasting :

The formulation of an appropriate monetary policy requires a reliable assessment of the magnitude of the problem like recession or inflation, as it helps in determining the appropriate policy measures.

Non-banking Financial Intermediaries:

The structural change in the financial market has also reduced the scope of effectiveness of monetary policy.

Under Development of money and capital markets : The effectiveness of monetary policy in less developed countries is reduced considerably because of the underdeveloped character of their capital and money markets.

*Short term lending rate (repo) hiked by 50 bps to 7.25%. *Repo rate to be only effective policy rate to better signal monetary policy stance from now on. *Reverse repo to be fixed 100 bps lower than the repo rate. *Short-term borrowing rate (reverse repo) up by 50 bps to 6.25%. *Cash reserve ratio (CRR) and bank rate left unchanged at 6% each. *Interest rates on savings bank deposits hiked to 4% from 3.5%. *Economic growth projected lower at 8% for FY'12. *WPI inflation projection lowered to 6%. *Objective is to contain inflation by curbing demand-side pressures. *Favours aligning of fuel prices with international crude prices to avert widening of fiscal deficit. *Banks to get a new overnight borrowing window under Marginal Standing Facility at 8.25%. *Likelihood of oil prices moderating significantly is low. *Malegam committee recommendations on MFI sector broadly accepted. *Bank loan to MFIs on or after April 1, 2011, will be treated as priority sector loans.

Based on the assumption of a normal monsoon and crude oil prices averaging US$ 110 a barrel over 2011-12, the baseline projection of real GDP growth for 2011-12 for policy purposes is placed at around 8 per cent. The growth is projected to be in the range of 7.4 per cent and 8.5 per cent in 2011-12 with 90 per cent probability (Chart 1).

Keeping in view the domestic demand-supply balance and the global trends in commodity prices and the likely demand scenario, the baseline projection for WPI inflation for March 2012 is placed at 6 per cent with an upward bias (Chart 2). Inflation is expected to remain at an elevated level in the first half of the year due to expected pass-through of increase in international petroleum product prices to domestic prices and continued pass-through of high input prices into manufactured products.

Graph Indian interest rate RBI - long-term graph

RBI latest interest rate changes

change date july 26 2011 june 16 2011 may 03 2011 march 17 2011 january 25 2011 november 02 2010 september 16 2010 july 27 2010 july 02 2010 april 20 2010

percentage 8.000 % 7.500 % 7.250 % 6.750 % 6.500 % 6.250 % 6.000 % 5.750 % 5.500 % 5.250 %

REVERSE REPO RATE w.e.f. (Since 2005)

29-Apr-2005 26-Oct-2005 24-Jan-2006 8-Jun-2006 25-Jul-2006 8-Dec-2008 5-Jan-2009 5-March-2009 21-Apr-2009 19-March-2010 20-Apr-2010 02-July-2010 27-July-2010 16-Sept-2010 02-Nov-2010 25-January-2011 17-March-2011 03-May-2011 16-June-2011 26-July-2011

5.00 5.25 5.50 5.75 6.00 5.00 4.00 3.50 3.25 3.50 3.75 4.00 4.50 5.00 5.25 5.50 5.75 6.25* 6.50* 7.00*