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Unit 13: Macro Economic Policies: Monetary Policy

3. The objectives of monetary policy are always in conflict with each other. Notes
4. Monetary policy is the most significant factor in explaining the slow rates of economic
growth in our national economies.

13.2 Instruments of Monetary Policy

To achieve the above objectives, modern central banks have several instruments of monetary
policy. One is the open market operations. Expansionary monetary policy requires purchasing
of government securities in the open market by the central banks. This will augment the supply
of base or reserve money. This increase in reverse money enables banks to increase deposit
money and hence money stock. Because the banks are required to maintain reserves of only a
fraction of their demand and time deposit liabilities, the expansion of the money stock which
can result from an increase in reserves is a multiple of the increase in the reserves.
A contractionary monetary policy involves selling government securities by central bank in the
open market. The reserve money will decrease and the reduction in reserve money will eventually
result in reduction in money stock.
Broadly instruments or techniques of monetary policy can be divided into two categories:
1. Quantitative or general techniques

2. Qualitative or selective techniques

13.2.1 Quantitative or General Techniques

1. Bank Rate or Discount Rate: Bank rate refers to that rate at which a central bank is ready
to lend money to commercial banks or to discount bills of specified types. Thus by changing
the bank rate, the credit and further money supply can be affected. In other words, rise in
bank rate increases rate of interest and fall in bank rate lowers rate of interest. During the
course of inflation, monetary authority raises the bank rate to curb inflation. Higher bank
rate will check the expansion of credit of commercial banks. They will be left with fewer
reserves, which would restrict the credit creating capacity of the bank. On the contrary,
during depression, bank rate is lowered, business community will prefer to have more
and more loans to pull the economy out of depression. Therefore, bank rate or discount
rate can be used in both type of situation is inflation and depression.

2. Open Market Operations: by open market operations, we mean the sale or purchase of
securities. It is known that the credit creating capacity of the commercial banks depend on
the cash reserves of the bank. In this way, the monetary authority (Central Bank) controls
the credit by affecting the base of the credit-creation by the commercial banks. If the credit
is to be decreased in the country, the Central Bank begins to sell securities in the open
market. This will result to reduce money supply with the public as they will withdraw
their money with the commercial banks to purchase the securities. The cash reserves will
tend to diminish. This happens in the period of inflation. During depression, when prices
are falling, the central bank purchases securities resulting expansion of credit and aggregate
demand also increases and prices also rise.
3. Variable Reserve Ratio: The commercial banks have to keep given percentage as
cash-reserve with the central bank. In lieu of that cash ratio, it allows commercial bank to
contract or expand its credit facility. If the central bank wants to contract credit (during
inflation period) it raises the cash reserve ratio. As a result, commercial banks are left with
fewer amounts of deposits. Their power to credit is curtailed. If there is depression in the
economy, the reserve ratio is reduced to raise the credit creating capacity of commercial

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