Page 259 - DECO502_INDIAN_ECONOMIC_POLICY_ENGLISH

Unit 20: Indian Financial System: Money Market and Monetary Policy

Another factor that matters in determining the scope and the effectiveness of the monetary policy is Notes
how developed and integrated is the capital-market. Some instruments of monetary control (bank
rate and cash reserve ratio) work through the capital market. Where capital market is fairly developed,
monetary policy affects the level of economic activities through the changes in the capital market. It
works faster and more effectively in an economy with a fully developed financial market. Incidentally,
a developed financial market is one which has the following features : (i) there exists a large number
of financially strong commercial banks, financial institutions, credit organizations, and short-term
bill market, (ii) a major part of financial transactions are routed through the banks and the capital
markets, (iii) the working of capital sub-markets is inter-linked and interdependent, and (iv)
commodity sector is highly sensitive to the changes in the capital market. Monetary weapons like
bank rate and cash reserves ratio work through the commercial banks. Therefore, for the monetary
policy to have a widespread impact on the economy, other capital sub-markets must have a strong
financial link with the commercial banks.

Instruments of Monetary Policy
The instruments of monetary policy refer to the economic variables that the central bank is empowered
to change at its discretion with a view to controlling and regulating the supply of and demand for
money and the availability of credit. The instruments are also called ‘weapons of monetary control.’
Samuelson and Nordhaus call them ‘The Nuts and Bolts of Monetary Policy.’ Monetary instruments
are generally classified under two categories :
(i) General credit control measures, and
(ii) Selective credit controls.
The General Credit Control Measures
The general measures of monetary control include the monetary weapons that aim at controlling the
aggregate supply of and demand for money, given the objective of the monetary policy. As noted in
the previous chapter, general credit control measures, also called as traditional measures of monetary
control are following.
(i) Bank rate
(ii) Cash Reserve Ratio (CRR), and
(iii) Open Market Operations
In addition to these traditional measure of monetary control, Reserve Bank of India has introduced
an extra-ordinary measure, named Statutory Liquidity Ratio (SLR) to facilitate the government
borrowing from the banks. We describe here briefly the meaning and working of these monetary
measures. While discussing these aspects, brief references will be made to the RBI approach. A detailed
discussion follows in the forthcoming section.
(i) Bank Rate Policy : ‘Bank rate’ is the rate at which central bank lends money to the commercial
bank and rediscounts the bills of exchange presented by the commercial banks. The RBI Act
1935 defines ‘bank rate’ as the “standard rate at which (the bank) is prepared to buy or
rediscount bills of exchange or other commercial papers eligible for purchase under this
Act.” The RBI rediscounts only the government securities, approved bills and the ‘first class
bills of exchange.’ When commercial banks are faced with shortage of cash reserves, they
approach the central bank to borrow money for short term or get their bills of exchange
rediscounted. It is a general method of borrowing by the commercial banks from the central
bank, the ‘lender of the last resort’. The central bank rediscounts the bills presented by the
commercial bank at a discount rate. This rate is traditionally called bank rate. Thus, bank rate is
the rate which central bank charges on the loans and advances made to the commercial banks.
The central bank can change this rate—increase or decrease—depending on whether it wants
to expand or reduce the flow of credit from the commercial banks. When it wants to increase
the credit creation capacity of the commercial banks, it reduces the discount rate and when it
decides to decrease the credit creation capacity of the banks, it increases the bank rate. This
policy action by the central bank is called the bank rate policy.

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