Lecture 8

Monetary PolicyWhat is Monetary Policy?

Credit plays an important role in the modern economic system. It is considered as the life blood of modern business. So proper control and regulation of credit is necessary for the economic stability of a country. The primary function of the central bank of a country is to control the money and credit supply in the country according to the development needs of the country. In Pakistan, the State Bank of Pakistan regulates the flow of money in the

1Operation of Banks & Financial Institutions

economy. This management of the flow of money & credit is called monetary policy.

The central bank use strict monetary policy and easy monetary policy according to the circumstances of the economy. If there is inflation in the economy then central bank use strict monetary policy to stabilize the economy, while in case of deflationary gap central bank uses easy monetary policy to maintain the equilibrium in the economy.


According to Professor Spencer:“Monetary Policy is the deliberate

exercise of the monetary authority’s power to induce expansion or contraction in the money supply.”

General Definition of Monetary Policy:“Monetary policy is the management of

the expansion and contraction of the volume of the money in the economy for the attainment of specific objective.”


Inflation:Inflation is the situation of the economy in

which aggregate demand is greater then aggregate supply, prices of the commodities are extermely high, producer earn abnormal profits, investment rate is high, employment rate is high, purchasing power of the people is also high. Supply of money in the market is high, interest rate is low and commercial banks give more loans to the people. In such situation(inflation) the economy is at boom.


Deflation:Deflation is the situation of the economy in

which aggregate demand is less then aggregate supply, unsold stock is placed in the market, producers are facing loss and investment rate is low because of low profits/loss. GDP is low, unemployment rate is high in the economy and due to unemployment people have no purchasing power. Interest rates are also high. Supply of the money in the market is low.


Objectives of Monetary PolicyThe objectives of the monetary policy differ from country to country according to their economic conditions. The major objectives of the monetary policy are as under:

To create the equilibrium in the economy.To stabilize the prices of the commodities.To achieve the full employment without

inflation.To maintain the living standard of people.To encourage the domestic industries. 6Operation of Banks & Financial Institutions

To achieve the steady economic growth.To stabilize the exchange rate & balance of

payment.To bring the equitable distribution of credit.To encourage the comprehensive increase in

production.


Tools of Monetary PolicyThe main tools or weapons or methods of credit control available to the central bank for influencing the level of economic activity in a country are as follows;

1.Quantitative Controls2.Qualitative Controls


Monetary Policy Quantitative Controls Qualitative Controls


1. Quantitative Controls:The methods which are used to control the

total quantity of money supply and bank credit are as under;

i. OMO (Open Market Operations):it is the most important tool which

the central bank of the country uses to influence the money supply. The term open market operation in the wider sense means purchase & sale of govt. securities by the central bank or central bank borrows loan from commercial


bank in order to influence the money supply.Sale of Securities:

When the central bank finds that inflationwind is blowing then the central bank sells

securities or borrow loan from the commercial banks in order to reduce the money supply.

Purchase of Securities:When central bank finds that there is

deflation in the economy then central bank purchases the securites or central bank return the loan borrowed from commercial banks. In


this way money supply moves from central bank to commercial banks, as a result the cash balances of the commercial banks are increased which leads towards lending or credit creation.

ii. Varying Reserve Requirements:Every member bank is required to

keep a certain amount of its total deposits as cash reserve with central bank. A central bank can affect the supply of money and the availability of bank credit in a country by


changing the legal reserve requirment of the commercial banks. If there is a recession/deflation in the economy, the central bank decreases the required reserve ratio of the member bank. It permits banks to lend more money and thereby enlarge the money supply. In case the economy is inflationary, the central bank can increase the reserve requirements of the banks. The lending power of the banks is reduced which ultimately results in decrease of the money supply. 13Operation of Banks & Financial Institutions

iii. Variation in Bank Rate/Discount Rate:Bank rate also known as discount

rate, is the rate at which the central bank of a country provides the facility of giving loan to commercial banks or re-discounts the bills of exchange of scheduled banks. This short term tool of the monetary policy is used to affect not only bank reserves but also credit conditions in the economy as whole.


Increases:if the economy is inflationary and the

central bank wants to restrict bank lending, it raises its bank rate. The borrowing from central bank becomes inattractive for member commercial banks. This increase in bank rate discourages the commercial banks to borrow loan form central bank and resultantly the money supply can be controlled.


Decreases:if there is recession/deflation in the

economy and central bank wants to encourage banks to provide loans in the country, it lowers its bank rate. The borrowing from the central bank becomes attractive and large volumes of loans are taken out by member banks for development purposes. In this way the money supply can be expand.Summing up an increase in the bank rate usually associated with a rise in market


interest rates a general lightening of credit. A decrease in the bank rate tend to be associated with a reduction in market interest rates and an overall easing of credit.

iv. Credit Rationing:This method of credit control is applied by the

central bank in times of financial crisis. The central bank rations the credit of each member bank. It fixes the maximum amount which each member bank can draw by rediscounting bills of exchange. In this way


central bank puts limits for the grant of credit to its member banks.

Increases: if the central bank adopts expansionary

monetary policy the rationing limit of loans increases. Hence money supply also increases.

Decreases: if the central bank adopts contractionary

monetary policy the rationing limit of loan decreases and resultantly the money supply contracts.


v. Interest Rate Policy:The rate of interest at which commercial

banks grant loans against securities according to the instructions of central bank. In case of inflation, the bank interest rate is raised which discourages borrowing, as a result credit contracts. On the other hand if there is deflation, the bank interest rate is lowered which encourages the borrowings as a result credit expands.


2. Qualitative Controls:These methods are used to restrict bank

advances for certain specific purposes. There are general in nature. The detail of these methods is as under;

i. Moral Persuation:The central bank of a country also employs

the instrument of moral caution to influence the total borrowing at the central bank. Moral caution means friendly precaution in the regulation of credit by the monetary authority


to the competitive bankers. It includes policy statements, announcements, or outright appeal to community spirit with the bankers. For instance, if the commercial banks pursuing the policy which the central bank does not like, it can call the meeting of the commercial banks and explain to them the difficulties which the central bank of the country is facing and asking them for the assistance & cooperation which greatly help in achieving a stable economic growth with high level of employment without inflation in the country.


ii. Margin Requirements:Marginal requirement is the difference

between the market value of security and its maximum loan value. For example, if a security has a market value of Rs.100, in case the marginal requirement is 40%, the maximum loan which can be advanced against such security is Rs.60/- An increase in margin requirement reduce the amount which can be borrowed against that security & vice versa. In this way the money supply can be expand or


contract by changing margin requirements.iii. Consumer Credit Regulations:

In this method, the credit controlled by increasing or decreasing the buying power of consumers. If there is inflation, the grant of credit for consumption goods may be banned and in case of deflation a lenient policy about the consumer credit is adopted and supply of money expands. Central bank usually restricts consumer’s credit, so that more funds are available to the industry, agriculture and other sectors. 23Operation of Banks & Financial Institutions

iv. Publicity:Central bank of the country keeps the

nation well informed about the economic conditions through various communication channels, which enables the people to understand the economic condition of the country.

v. Direct Action:if the commercial banks are following a

policy which is inconsistent with the monetary policy of the central bank, it can take direct


actions. Such actions may be in form of refusing to discount the bills of exchange or to impose any penalty if commercial bank(s) fails to follow the prescribed monetary policy of central bank.


Limitations/Difficulties in Controlling Credit

1. Non Cooperation:Different commercial banks do not fully

cooperate, with the central bank due to which central bank cannot achieve its full object.

2. Non-Scheduled Banks:Non-scheduled banks are out of control of

the central bank and they are not bound to follow the policies of the central bank.

3. Self Created Credit Instruments:Only banks do not create credit instruments


rather various businessmen also create their personal credit instruments to settle business dealings and these people are not under control of the central bank.

4. Other Conditions:At the time of getting loan, the

borrowers not only keep in view interest rate but also consider other conditions including %age of down payment, repayment schedule etc. If other conditions are suitable then they get loan even on high rate of interest.


5. No Control on Objects:Central bank cannot control the objects of

spending amount of loan. It means credit can be utilized on unwanted and nonproductive purposes. For example, there is a possibility that loans may be utilized for speculative motive, which is not a progressive element for the economy in any case.

6. Political Conditions:If there is political instability, the business

community transfers its capital to the foreign 28Operation of Banks & Financial Institutions

countries which effects badly on the circulation of credit in the contry.

7. Unorganized Capital Market:The success of monetary policy depends

upon the availability of organized capital market. If the capital market of any country is not organized then the central bank has to face difficulities in controlling the credit.

8. Other Financial Institution:In addition to commercial banks, other

financial institutions like insurance companies,29Operation of Banks & Financial Institutions

and financial corporations play a vital role in import and export. The balance of payment disturbs which leads to the disturbance of credit control measures in the economy.


Role of Central Bank in Developing Economies

The role of central bank is now considerably widened as compare to the traditional regulatory role. Central bank now performs variety of developmental and promotional functions which earlier were regarded as being outside the purview of the central banking. The central bank now builds up a financial structure which helps in mobilizing domestic resources. These resources are then used to finance the developmental programmes in respect to agriculture, trade, industry, through special 31Operation of Banks & Financial Institutions

financial instutions created for this purpose. The main measures which the central bank has taken in improving the conditions of the under-developed economies are as follows:

The central bank itself as the pivot of money market, has taken up the responsibility for the development of an adequate and sound money and capital market in the country. The establishment and spread of financial institutions provides an outlet and an incentive for productive savings. They also increase the amount of funds for capital 32Operation of Banks & Financial Institutions

formation. The central bank thus performs a development and promotional role in the country.

Commercial Bank:The commercial banks are the principal

borrowers and lenders of short term funds in the money market. These banks are now performing a variety of development functions. They are advancing loans to small business and industry and agriculture upto a maximum limit fixed by the central bank of the


country. When the industry and agriculture sector gets supplement in form of advances, they start moving towards prosperity and resultantly the whole economy gets flurish.

Saving Banks:Saving banks are set up to encourage the

habit of saving among small savers. These banks initiate various saving schemes according to the instructions of central bank to mobilze the deposits and then these deposits are invested in government projects.


Assistance to Specialized Financial Institutions:

The central bank, in developing countries provides assistance to specialized financial institutions for enabling them to extend adequate finance to different sectors of the economy. In Pakistan, the State bank of Pakistan gives loan to Zarai Taraqati Bank Ltd Pakistan for financing seasonal agricultural operation and for development of agriculture. The House Building Finance Corporation,


Industrial Development Bank of Pakistan etc gets financial assistance from SBP.

Credit Targets:In order to boost up agricultural and

industrial production, the central bank prescribes loan targets for commercial banks. This step in take in with a view to ensuring adequate flow of bank credit to priority sectors.

Export Finance Scheme:The commercial banks, under the instructions36Operation of Banks & Financial Institutions

of central bank, provides finance to the exporters at the concessional rate. In order to promote the exports in the country which brings the economy on the way to prosperity.

Monetary and Credit Policy:The central bank pursues a monetary

and credit policy in the country which improves market efficiency, stimulates the flow of saving and investment and improves the conditions of the economy in the country.


“Summing up, the central bank plays a big role in the development of under-developed economies and money markets. Its role is not merely regulatory to maintain stability but developmental and promotional activites also.”


Education

Lecture 8