The Millennium University

Assignment on: Monetary Policy & Short Notes

Submitted To:
MD. Ashraf Ali
Assistant Professor & Course Co-ordinator
MBA Program
The Millennium University

Submitted By:
MD. Kawsar Ahmmed
ID. 113BBA0022
Batch: 24th
Program: BBA
Department of Business Administration
The Millennium University

Submission Date: 27th September, 2016

Define monetary policy
Monetary policy is how central banks manage liquidity to create economic growth.
Liquidity is how much there is in the money. That includes credit, cash,
checks, and money market mutual funds. The most important of these is credit.
That includes loans, bonds, and mortgages.

After having explained the objectives we shall explain role of monetary policy in
promoting economic growth in a developing country like India. In the end we will
explain monetary policy of reserve Bank of India in different periods of planned
development, especially soft interest and liberal credit policy adopted by Reserve
Bank of India since 1996. 

Objectives of Monetary Policy

The primary objective of central banks is to manage inflation. The second is to

reduce unemployment, but only after they have controlled inflation.

The U.S. Federal Reserve, like many other central banks, has specific targets for
these objectives. It seeks an unemployment rate below 6.5%. The Fed said the
natural is between is between 4.7% and 5.8%. It wants the core inflation rate to be
between 2.0% and 2.5%. It seeks healthy economic growth. That's a 2-3% increase
in the annual Gross Domestic Product.

The following are the principal objectives of monetary policy:

1. Full Employment:

Full employment has been ranked among the foremost objectives of monetary
policy. It is an important goal not only because unemployment leads to wastage of
potential output, but also because of the loss of social standing and self-respect.

2. Price Stability:
One of the policy objectives of monetary policy is to stabilize the price level. Both
economists and laymen favor this policy because fluctuations in prices bring
uncertainty and instability to the economy.
3. Economic Growth:
One of the most important objectives of monetary policy in recent years has been
the rapid economic growth of an economy. Economic growth is defined as “the
process whereby the real per capita income of a country increases over a long
period of time.”

4. Balance of Payments:

Another objective of monetary policy since the 1950s has been to maintain
equilibrium in the balance of payments.

5. Exchange stability:

It must be noted that if there is instability in the exchange rates, it would result in
outflow or inflow of gold resulting in unfavorable balance of payments. Therefore,
stable exchange rates play a key role in international trade. Thus, it is clear from
this fact that: the main objective of monetary policy is to maintain stability in the
external equilibrium of the country. In other words, they should try to eliminate
those adverse forces which tend to bring instability in exchange rates.

6. Neutrality of money:

The main aim of the monetary authority is not to deviate from the neutrality of
money. It means that quantity of money should be perfectly stable. It is not
expected to influence or discourage consumption and production in the economy.

7. Credit control:

To control credit, government uses tools like bank rate policy, open market
operation, statutory liquidity ratio (SLR) and cash reserve ratio (CRR).

8. Reduction in equality and wealth:

Inequality in income and wealth due to right of private property and law of
inheritance is the common feature of capitalist and mixed economy. As a result, the
society is divided into two classes- rich and poor. Poor class is generally exploited
by rich class. The objective of monetary policy is to reduce the inequalities of
income and wealth.
9. Creation and expansion of financial institution:

A major objective of monetary policy in a developing country is to speed up the

process of economic development by improving the currency to provide large
credit facilities and to mobilize savings of productive purposes. The monetary
authority can help in establishment and expansion of banks and institutions in
urban and rural areas.

Advantage of Monetary Policy

1. Expansionary monetary policy makes it possible for more investments come

in and consumers spend more.
With the banks lowering the interest rates on mortgages and loans, more business
owners will be encouraged to expand their businesses since they are more available
funds to borrow with interest rates that they can afford. On the other hand, prices
of commodities will be lowered and the buying public will have more reason to
buy more consumer goods. In the end, companies will profit while their customers
are able to afford what they need like basic commodities, property and services.

2. Lowered interest rates also lower mortgage payment rates.

Another advantage of monetary policy in relation to lowered rates is that it also
affects the payments home owners need to meet for the mortgage of their homes.
Reduced mortgage fees will leave home owners more money to spend. Also, they
will be able to settle their monthly payments regularly. This is a win-win situation
for merchandisers, creditors and property investors as well.

3. It allows the Central Bank to apply quantitative easing.

The Federal Reserve can make use of this policy to print or create more money
which enables it to purchase government bonds from banks. The end result is
increased cash reserves in banks and also monetary base. This also leads to
reduced interest rates and more money for the bank to lend its borrowers.
4. It promotes predictability and transparency.
Supporters say that policymakers are obliged to make announcements that are
believable to business owners and the consumers when it comes to the type of
monetary policy to be expected in the coming months for it to be a success,

What are the limitations of monetary policy?

Monetary policy is the process by which the monetary authority of a country

controls the supply of money with the purpose of promoting stable employment,
prices, and economic growth. Monetary policy can influence an economy but it
cannot control it directly. There are limits as to what monetary policy can
accomplish. Below are some of the factors that can make monetary policy less
effective.

i.Large non-monetized sector:

There is a large non-monetized sector which hinders the success of monetary

policy in such countries. People mostly live in rural areas where barter is practiced.
Consequently, monetary policy fails to influence this large segment of the
economy.

ii. Undeveloped money and capital markets:

The money and capital markets are undeveloped. These markets lack in bills,
stocks and shares which limit the success of monetary policy.

iii. Large number of NBFLs:

Non-bank financial intermediaries like the indigenous bankers operate on a large

scale in such countries but they are not under the control of the monetary authority.
The factor limits the effectiveness of monetary policy in such countries.
iv. High liquidity:

The majority of commercial banks possess high liquidity so that they are not
influenced by the credit policy of the central bank. This also makes monetary
policy less effective.

v. Foreign banks:

In almost every underdeveloped country foreign owned commercial banks exist.

They also render monetary policy less effective by selling foreign assets and
drawing money from their head officers when the central bank of the country is
following a tight monetary policy.

vi. Small bank money:

Monetary policy is also not successful in such countries because bank money
comprises a small proportion of the total money supply in the country. As a result,
the central bank is not in a position to control credit effectively.

vii. Money not deposited with banks:

The well-to-do people do not deposit money with banks but use it in buying
jeweler, gold, real estate, in speculation, in conspicuous consumption, etc. Such
activities encourage inflationary pressures because they lie outside the control of
the monetary authority.

On account of these limitations of monetary policy in an under-developed country,

economists advocate the use of fiscal policy along-with it.
What are the tools/instruments of monetary policy?
To accomplish its monetary policy objective, the central bank can use a mix of
direct and indirect policy tools to influence the supply and demand money.

Direct policy tools:

These tools are used to establish limits on interest rates, credit and lending. These
include direct credit control, direct interest rate control and direct lending to banks
as lender of last resort, but they are rarely used in the implementation of monetary
policy by the Bank.

 Interest rate controls:

The Bank has the power to announce the minimum and maximum rates of
interest and other charges that domestic banks may impose for specific types of
loans, advances or other credits and pay on deposits.

 Credit controls:

The Bank has the power to control the volume, terms and conditions of domestic
bank credit, including installment credit extended through loans, advances or
investments.

 Lending to domestic banks:

The Bank may provide credit, backed by collateral, to domestic banks to meet
their short-term liquidity needs as lender of last resort.
 

Indirect policy tools:

Used more widely than direct tools, indirect policy tools seek to alter liquidity
conditions.

 Reserve requirements:

The Bank uses reserve requirements to limit the amount of funds that domestic
banks can use to make loans to its customers. Domestic banks are required to
hold a proportion of customers’ deposits in approved liquid assets. An increase
in the reserve ratios should reduce domestic banks’ lending and, therefore, the
 demand for hard currency, while a decrease should yield the opposite effect.

 Secondary reserve requirement: 

It is a certain percentage of domestic banks’ deposit liabilities that is to be held

in approved liquid assets. It should be freely and readily convertible into cash
without significant loss, free from any charge, lien or encumbrance.
Cash reserve requirement:

It is also called primary reserve requirements. It is a percentage of domestic

banks’ average deposit liabilities that must be held at the Bank in a non-interest
bearing account. Cash reserves are a component of the secondary reserve
requirements.

Open market operations:

The conduct of open market operations refers to the purchase or sale of

government securities by the Bank to the banking and non-banking public for
liquidity management purposes. When the Bank sells securities, it
reduces domestic banks’ reserves (monetary base), and when it buys securities, it
increases banks’ reserves.

Characteristics of Monetary Policy?

Monetary policy is effective when it meets the issuing agency's goals for its effect
on the economy. In the United States, the Federal Reserve handles money and
credit tactics, with the stated goals of promoting maximum employment, keeping
prices stable and securing moderate long-term interest rates.

1. Traditional Approach

Traditionally, the Federal Reserve has relied on three main approaches to influence
the economy: open market operations, the discount rate and reserve requirements.

2. Open Market Operations

The Federal Reserve influences monetary policy by buying and selling securities in
the open market. The historic goal has been to adjust the reserve balances to keep
the federal at the desired target. If the rate is close to the target -- which was near-
zero for an extended period beginning in 2008 -- the Fed will continue down the
same path.
3. The Discount Rate
The discount rate represents the interest charged banks on loans they receive from
their regional Federal Reserve Bank lending facility. This in turn influences other
interest rates, increasing its effect on the economy. Lowering the discount rate
encourages businesses and consumers to take out loans because it's cheaper to
borrow money. Raising the rate has the opposite effect and can cool off an
economy perceived to be in danger of overheating.
4. Reserve Requirements
The Fed's Board of Governors uses reserve requirements to mandate how much of
its deposits banks must set aside, either in their own branches or at a Reserve Bank.
Decreasing the reserve requirements increases the amount a bank can lend;
increasing them does the opposite.

SHORT NOTES

Money Supply

In economics the money supply or money stock, is the total amount of monetary

assets available in an economy at a specific time. Money supply is the entire stock
of currency and other liquid instruments circulating in a country's economy as of a
particular time. Also referred to as money stock, money supply includes safe
assets, such as cash, coins, and balances held in checking and savings accounts that
businesses and individuals can use to make payments or hold as short-term
investments.

Interest Rate

Interest rate is the amount charged, expressed as a percentage of principal, by

a lender to a borrower for the use of assets. Interest rates are typically noted on
an annual basis, known as the annual percentage rate (APR). The assets borrowed
could include, cash, consumer goods, large assets, such as a vehicle or building.
Interest is essentially a rental, or leasing charge to the borrower, for the asset's use.
In the case of a large asset, like a vehicle or building, the interest rate is sometimes
known as the "lease rate". When the borrower is a low-risk party, they will usually
be charged a low interest rate; if the borrower is considered high risk, the interest
rate that they are charged will be higher.

An interest rate is often expressed as an annual percentage of the principal. It is

calculated by dividing the amount of interest by the amount of principal. From
a consumer's perspective, the interest rate is expressed as annual percentage
yield (APY) when the interested is earned, for example, from a savings account or
a certificate of deposit. When the interest is paid, for example, for a credit card,
a mortgage, or a loan, the interest rate is expressed as annual percentage
rate (APR). Anyone can lend money and charge interest, or hold deposits and pay
interest.

Bank Rate

Bank rate, also referred to as the discount rate in American English, is the rate of

interest which a central bank charges on the loans and advances to a commercial
bank. The bank rate is known by a number of different terms depending on the
country and has changed over time in some countries as the mechanism used to
manage the rate have changed.

Bank rates influence lending rates of commercial banks. Higher bank rate will
translate to higher lending rates by the banks. In order to curb liquidity, the central
bank can resort to raising the bank rate and vice versa. 

Managing the bank rate is method by which central banks affect economic activity.
Lower bank rates can help to expand the economy by lowering the cost of
funds for borrowers, and higher bank rates help to reign in the economy when
inflation is higher than desired.

Clearing House

A clearing house is a financial institution that provides clearing and

settlement services for financial and commodities derivatives and securities
transactions. It is an intermediary between buyers and sellers of financial
instruments. Further, it is an agency or separate corporation of a futures
exchange responsible for settling trading accounts, clearing trades, collecting and
maintaining margin monies, regulating delivery, and reporting trading data.
Clearing houses act as third parties to all futures and options contracts, as buyers to
every clearing member seller, and as sellers to every clearing member buyer.

Interest Rate Cap

An interest rate cap is a type of interest rate derivative in which the buyer receives
payments at the end of each period in which the interest rate exceeds the
agreed strike price. An example of a cap would be an agreement to receive a
payment for each month the LIBOR rate exceeds 2.5%.

It is actually a series of European interest call options (called caplets), with a

particular interest rate, each of which expire on the date the floating loan rate will
be reset. At each interest payment date the holder decides whether to exercise or let
that particular option expire. In an interest rate cap, the seller agrees to compensate
the buyer for the amount by which an underlying short-term rate exceeds a
specified rate on a series of dates during the life of the contract. Interest rate caps
are used often by borrowers in order to hedge against floating rate risk.

Interest Rate Floor

An interest rate floor is a derivative contract in which the buyer receives payments
at the end of each period in which the interest rate is below the agreed strike price.

Floors are similar to caps in that they consist of a series of European interest put
options (called caplets) with a particular interest rate, each of which expire on the
date the floating loan rate will be reset. In an interest rate floor, the seller agrees to
compensate the buyer for a rate falling below the specified rate during the contract
period. A collar is a combination of a long (short) cap and short (long) floor, struck
at different rates. The difference occurs in that on each date the writer pays the
holder if the reference rate drops below the floor. Lenders often use this method to
hedge against falling interest rates.

Inflation

In economics, inflation is a sustained increase in the general price level of goods

and services in an economy over a period of time. When the price level rises, each
unit of currency buys fewer goods and services. Consequently, inflation reflects a
reduction in the purchasing power per unit of money – a loss of real value in the
medium of exchange and unit of account within the economy.

“Inflation means that your money won’t buy as much today as you
could yesterday.”

Central banks attempt to limit inflation, and avoid deflation, in order to keep

the economy running smoothly.

Deflation

Deflation is defined as a decrease in the general price level.

In economics, deflation is a decrease in the general price level of goods and
services. Deflation occurs when the inflation rate falls below 0% (a
negative inflation rate). Inflation reduces the real value of money over time;
conversely, deflation increases the real value of money – the currency of a national
or regional economy. This allows one to buy more goods and services than before
with the same amount of money. Basically deflation is a negative inflation rate.