Monetary Policy

Topics: Monetary policy, Central bank, Inflation Pages: 13 (2506 words) Published: June 19, 2013
Monetary Policy

• The main measures of monetary policy are control of the money supply, credit and interest rates.

• The monetary policy statement in India is announced by the Reserve Bank of India. It specifies the measures that the RBI intends to take to influence such key factors as money supply, interest rates and inflation so as to ensure price stability.

• It also lays down norms for financial institutions like banks. It relates to matters like cash reserve ratio, capital adequacy etc.

Objectives of Monetary Policy

1. Controlled Expansion of Money: This looks after meeting the needs of production and trade and at the same time moderating the growth of money supply to contain the inflationary pressures

2. Sectoral Deployment of Funds: The RBI has determined the allocation of funds as also the interest rates among different sectors. The sectors which have received special attention are core sectors (coal, iron & steel etc), foodgrains, agriculture, small-scale industry etc.

How the Monetary Policy Works?

• The authorities may seek to influence interest rates generally. If the supply of money relative to demand is reduced, the authorities can raise the price of money, i.e. interest rate, with a view to deterring borrowing in general.

• Moreover the authorities can intervene directly to impose an official interest rate that in turn determines all other interest rates.

Difficulties Faced in Money Supply Control-1

• As a result of financial innovation outside the traditional banking system there are limits to regulation of money supply.

1. E.g. this may take the form of credit cards by retail stores which leads to rise in credit or

2. customers being offered 0% interest deals on purchase of cars or furniture, where official interest rate is being circumvented.

Difficulties Faced in Money Supply Control-2

International implications: The openness of national economies to inflows and outflows of foreign currencies makes it difficult for a government to operate domestic monetary policy.

If a country pursuing a policy of domestic credit contraction, leading to higher interest rates, would tend to attract inflows of foreign currencies which serve to increase the exchange value of its currency.

Fiscal Policy

• Just like Monetary Policy, Fiscal Policy too becomes an instrument of demand management that seeks to influence the level and composition of spending in the economy, which affects the level and composition of output, i.e. GDP.

• Fiscal Policy can also affect the supply-side of the economy by providing incentives to work and investment.

• The main measures of fiscal policy are taxation and government expenditure.

How Taxation Works?

• Direct taxes on individuals (income tax) and companies (corporate tax) can be increased if spending needs to be reduced, say for controlling inflation.

• An increase in income tax reduces people’s disposable income and similarly an increase in corporate tax leaves companies with less profit available to pay dividends and to invest.

• Alternatively spending can be reduced by increasing indirect taxes: an increase in value added tax on products in general or an increase in excise duties on particular products such as petrol or cigarettes, will lead to increase in their price, leading to a reduction in purchasing power.

Changes in Government Spending

• The government can use changes in its own expenditure to affect spending levels.

• E.g. a cut in current purchases of products or capital investment by the government again serves to reduce total spending in the economy.

Fiscal Policy and Budget

• Taxation and government expenditure are linked together in terms of the government’s overall fiscal or Budget position:

• Total spending in the economy is reduced by the twin effects of increased taxation and expenditure cuts with the...
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