Instruments of Monetary Policy (2024)

Monetary policy is the policy through which the central bank of any country controls the economy of the country. When the cash demand of a country is estimated, the central bank issues paper money. This circulation of paper money needs to be managed and kept stable, and that is where monetary policies come into play.

This is done because money is a medium of exchange when related to the supply of goods. Thus, the central bank uses various instruments to maintain and contribute to the economic growth of the country.

Instruments of Monetary Policy

There are various instruments used by the central bank to keep a check on the economy of the country. A few of them are as follows:

• Reserve Requirement: The central bank of the country requires that all the other commercial banks keep their cash with it, which they cannot use further for economic or commercial purposes. Thus, all the other banks in the country need to keep a share of their liabilities with the central bank in the form of either cash or deposits. This is done to limit the amount of loan that a commercial bank can lend to the domestic economy, and in turn, limits the supply of money. The idea behind this is that the commercial banks maintain a stable relationship between the money they have lent to the Reserve Bank and the amount of money they are lending to the public.
• Open Market Operations: Central Bank works on behalf of the treasury (fiscal authorities) and buys or sells securities to the other banking authorities or in the open market on behalf of them. Open market refers to the non-banking public. The central bank is directly responsible for the supply of money. When the central bank sells securities, it reduces the supply of reserves, and when it buys the securities that it then redeems, it increases the supply of reserves. This entire process of affecting the supply of reserves to the public is what we call open market operations.
• Interest Rate: When the Reserve Bank lends money to other banks, it makes sure that those banks are financially sound. The Reserve Bank then lends the money to these banks at the most favourable rate. This rate is called MMR (Minimum Rediscount Rate). This MMR sets the bar for the rate regime in the money market. This rate is the affecting factor for the supply of investments, savings, as well as credit.
• Selective Credit Control: When there is a need to influence specific types of credit, this policy comes into play. Changing margin requirements are examples of this type of policy.

Goals of Monetary Policy

The main goal of monetary policies is to keep the price in the market stable as well as promote substantial growth. The RBI Act was amended in May 2016 to provide a base for implementing a flexible inflation targeting framework.

The factors responsible for the failure to achieve the inflation target stated by the central government were as follows:

• The average inflation is less than the lower tolerance level.
• The average inflation is more than the upper tolerance level.

Thus, the goals of the monetary policy include:

• Full Employment: It is an important goal because unemployment causes wastage of potential output.
• Price Stability: This is a policy favoured by both economists and laymen because when the prices fluctuate, they result in unfavourable and unstable economic conditions.
• Economic Growth: Economic Growth is defined as the process by which the real per capita income of the country witnesses growth in the long run.
• Balance of Payments: It has been one of the most important objectives of the monetary policies to maintain the balance of payments since the 1950s.

Conclusion

The development of a country is dependent on its monetary policies and how these policies are implemented. It is absolutely necessary to keep a strong check on the monetary policies. If the supply of money increases in the market, the poor are bound to face suffering and if the money is less than required in the market, the investors have to face suffering.