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Evaluating Monetary Policy (Online Lesson)

Last updated 28 Apr 2020

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In this online lesson, we cover some of the key approaches for evaluating the effectiveness of monetary policy. You may want to take a look at the lesson introducing monetary policy and the lesson for quantitative easing first.

WHAT YOU'LL STUDY IN THIS ONLINE LESSON:

• A review of the main types of macro policy and key aspects of monetary policy
• Evaluating monetary policy and its effectiveness by looking at why the interest rate transmission mechanism may not work in practice
• The need for alternative monetary policy approaches
• Inflation targeting
• Broader evaluation points

Additional teacher guidance is available at the end of this lesson.

Thank you to Peter McGinn and Jon Clark for their contributions to this lesson.

HOW TO USE THIS ONLINE LESSON

Follow along in order of the activities shown below. Some are interactive game-based activities, designed to test your understanding and application of monetary policy. Others are based on short videos, including activities for you to think about and try at home, as well as some extra worksheet-based activities.

If you would like to download a simple PDF worksheet to accompany the video activities, you can download it here: Evaluating Monetary Policy . You can print it off and annotate it for your own notes, or make your own notes on a separate piece of paper to add to your school/college file.

ACTIVITY 1: VIDEO - REVIEW OF THE TYPES OF MACRO POLICY

Test yourself against "The Cube" in this quick review activity of the different types of macro policy.

ACTIVITY 2: VIDEO - MONETARY POLICY KEY TERMS

Before we can address some of the key evaluation points for monetary policy, it's important to make sure that the essential monetary policy terminology is spot on! Check your knowledge in this quick review video.

ACTIVITY 3: GAME - MULTIPLE CHOICE QUESTIONS

Test yourself against the clock with these MCQs on monetary policy.

ACTIVITY 4: VIDEO - BREAKDOWN OF THE TRANSMISSION MECHANISM

For the last decade or so, changes to Bank Rate have not been as effective as they had been in the past. The interest rate transmission mechanism has broken down in parts. This video activity takes you through some of the reasons for this.

ACTIVITY 5: READING AND THINKING TIME - INFLATION TARGETS

From the 1990s onwards, a number of Central Banks decided to introduce inflation targets as part of their monetary policy approach.

For a brief overview of the UK's inflation target, take a look at the Bank of England information here . You can follow this up with a slightly more in-depth explanation of inflation targeting from the IMF here .

Next, take a look at this article from the Federal Reserve Bank of San Francisco on the pros and cons of inflation targeting. You could also read this opinion piece from CNBC , which considers whether inflation targets should be scrapped in light of the impact of COVID-19.

Finally, download this tutor2u resource On Target . On the 2nd page, you will find a series of statements regarding inflation targeting as a monetary policy. Some are advantages of this approach whilst others are disadvantages. Your task is to i) organise the statements into advantages and disadvantages ii) rank those statements from "most convincing" to "least convincing".

ACTIVITY 6: GAME - INFLATION TARGETS

In this Higher or Lower game, build your knowledge of how different economies approach inflation targeting.

ACTIVITY 7: VIDEO - UNCONVENTIONAL MONETARY POLICY

When Central Banks realised that the traditional interest rate transmission mechanism was not going to be as effective as they'd hoped following the Financial Crisis of 2007-2009, they had to turn to some alternative approaches. This video introduces you to some of these unconventional approaches to monetary policy.

ACTIVITY 8: SYNOPTIC THINKING

In your A level exams, you will need to be able to use your economics in a synoptic way i.e. making connections across different aspects and topics in your course. Download this tutor2u Synoptic Assessment Mat to help you practise this skill in relation to monetary policy.

ACTIVITY 9: VIDEO - GENERAL EVALUATION POINTS FOR MONETARY POLICY

In this final video for this lesson, we take you through some of the wider evaluation points for monetary policy.

ACTIVITY 10: DATA RESPONSE

The best way to work out how well you've understood the material in the online lessons on monetary policy is to have a go at some exam-style questions! We've put together a data response set of questions that you could tackle. If you are doing AQA Economics then download this AQA-style data response . If you are doing Edexcel Economics, then download this Edexcel-style data response . If you are following an alternative specification, ask your teacher which of these is the most appropriate for you.

ACTIVITY 11: ESSAY ANALYSIS

An effective way of learning how to write good essays is to read essays that would be awarded high marks in an exam and then analyse the reasons why they would be awarded high marks. You can have a go at this for the following two essays:

• Evaluating the effectiveness of inflation targeting as a tool of monetary policy
• Evaluating the impact of monetary policy on economic performance

Jot down some notes on the key features of these essays, and try highlighting the aspects of the essay that you might not have thought to include yourself if you had tackled that essay title.

EXTENSION READING

The Bank of England has produced a number of reports which aim to compare and contrast different approaches to monetary policy. T his paper focuses on comparing credit easing with quantitative easing, and is worth a read.

This transcript of a speech for the ECB considers why some commentators have regarded recent monetary policy as ineffective, and attempts to explain why they are wrong.

ADDITIONAL TEACHER GUIDANCE

This lesson comprises:

• around 30 minutes of guided video, spread over 5 videos, and supported by an accompanying worksheet
• around 20-25 minutes of student thinking time and activity, spread throughout those 5 videos
• an independent reading and ranking activity on inflation targeting, which could take students anywhere between 15 minutes and 1 hour, depending on their level of involvement
• 2 interactive games testing their application and knowledge of monetary policy
• a synoptic thinking activity (solutions available within the activity download)
• a suggested data response activity
• an essay-based activity, in which 2 example essays on monetary policy are provided (along with some examiner commentary) and students need to consider the strong features of these essays
• extension reading

We anticipate that the "core" of the lesson would take around one hour, with an extra 90 minutes for the written tasks. For the data response activity, there is a choice between an AQA-style and an Edexcel-style data response. Please advise your students which is the most appropriate for them, especially if you follow a different awarding body specification. You can find suggested answers to the AQA DR here and to the Edexcel DR here .

• Monetary policy
• Unconventional Monetary Policy
• Central Bank
• Inflation target
• Quantitative easing (QE)

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Article Contents

I. introduction, ii. the investment multiplier, the marginal efficiency of capital and unemployment, iii. probability, risk, and long-term expectations, iv. monetary policy and the safe interest rate, v. summary and conclusion, keynes's theory of monetary policy: an essay in historical reconstruction.

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Edwin Dickens, Keynes's Theory of Monetary Policy: An Essay In Historical Reconstruction, Contributions to Political Economy , Volume 30, Issue 1, June 2011, Pages 1–11, https://doi.org/10.1093/cpe/bzr001

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Keynes's theory of monetary policy is composed of three concepts—namely, the investment multiplier, the marginal efficiency of capital and the interest rate. By analyzing how these three concepts interact in the short period, Keynes explains why he is opposed to countercyclical monetary policies. And by analyzing how they interact in the long period, he explains why the economy tends to fluctuate around a long-period equilibrium position that is characterized by unemployment. Keynes concludes that the sole objective of the monetary authority should be to use its influence over the interest rate to dislodge the economy from its long-period equilibrium position that is characterized by unemployment and propel it toward a long-period equilibrium position that is characterized by full employment.

Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management ( Keynes, 1936 , p.206).

The paper is organized as follows. In Section II, I use Keynes's concepts of the investment multiplier and the marginal efficiency of capital to specify the long-period equilibrium position of the economy which is characterized by unemployment.

In Section III, in order to explain why the economy fluctuates around a long-period equilibrium position characterized by unemployment, I specify the difference, as well as the relationship, between Keynes's concepts of probability and risk and the orthodox ones.

In Section IV, I use Keynes's concept of the interest rate to explain the effects of monetary policy, both in the short-period and in the long-period.

Lastly, in Section V, I provide a summary and conclusion.

Let N s be the supply of labor and N d the demand for labor, or the actual volume of employment ( n ). We can then define full-employment ( n o ) as N d / N s = 1; unemployment ( n k ) as N d / N s < 1; and the unemployment rate as 1 − n k .

For Keynes (1936 , pp. 25–29 ff. ), n is determined by the aggregate level of output ( Y ) and the productivity of labor ( P ). That is to say, by definition P = Y/N d . Re-arranging terms, N d = Y/P . Substituting into our definition of n , we thus get n = Y/P N s .

Equation (6) is derived from the law of large numbers and incorrectly assumes that the underlying causal structure that determines the outcome of investment projects is known in the same way that the underlying causal structure that determines the outcomes of coin tosses or turns of the roulette wheel is known. In fact, the underlying causal structure that determines the outcome of investment projects is either knowable but unknown or, as Keynes (1937a , b , c ) argues, unknowable. Following Markowitz (1959 , p. 39 ff. ), orthodox economists take this fact into account by interpreting equation (6) in terms of the principle of non-sufficient reason.

According to the principle of non-sufficient reason, if investors do not have a reason to assign different probabilities to a set of possible outcomes, they must assign them equal probabilities. Therefore, if qualms about factors that are knowable but unknown or unknowable undermine the confidence of investors in their calculations of the outcome of prospective investment projects, orthodox economists instruct them to assign equal probabilities to the outcomes they fear may result from these factors, with the sum of assigned probabilities being equal to one. Orthodox economists thus interpret the expected profit ( E o ) in equation (5) as the mathematical mean of the sum of the products of all possible outcomes of investment projects and their probability. They then interpret the risk of investment projects as the variability (or standard deviation), of the sum of the products of all their possible outcomes and their probability, around the mathematical mean.

Equation (9) can be read as ‘proposition a on the hypothesis h · p o has a probability p k ’. Alternatively, it can be read as ‘the conclusion a can be inferred from the evidence h · p o with a probability of p k ’.

If w ( a|h · p o ) = 1, then the hypothesis h · p o implies the conclusion a with certainty. If w ( a|h · p o ) = 0, then hypothesis h implies that the conclusion a is impossible. If 0 < w ( a|h · p o ) < 1, then there is a probability relation of degree p k between a and h · p o .

In short, Keynes's concept of probability ( p k ), as formulated in equation (9), encompasses the orthodox concept of probability ( p o ), as formulated in equation (6), and the relationship between the two is mediated by Keynes's concept of the weight of arguments ( w ).

For Keynes (1921 , p. 77–80), w measures the vague but pervasive sense of inadequacy that investors feel when they compare what they know with what they think they ought to know in order to make informed investment decisions. If w = 1, then the interpretation of equation 6 in terms of the principle of non-sufficient reason has quelled investors’ sense of inadequacy, p o is completely dominate and equation (9), and p k = p o . If 0 < w < 1, then investors do not suppress the fact that setting w equal to one leads to absurdities (see Dickens (2008 , p. 224–225) for an explanation of why), and the factors making the underlying causal structure determining the outcome of investment projects knowable but unknown or unknowable take the form of propositions in h which weigh against p o 's dominance, so that p k < p o .

Even if w = 1, p k is still less than p o once we add Keynes's concept of risk, as formulated in equation (8), to w as a mediating factor between p k and p o , and thereby obtain equation (7). Keynes (1921 , p. 348) formulates equation (7) in such a way that two conditions are met: If p o = 1 and w = 1, then p k = 1; and if p o = 0 and w = 0, then p k = 0. It follows that, if 0 < w < 1 and/or 0 < p o < 1 (so that q = 1 − p o has a value between zero and one), then p k < p o . Of course, p o = m / z = 1 only if there is apodictic certainty about the underlying causal structure that determines the outcome of investment projects, in the way that there is apodictic certainty about the outcome of tossing a two-headed coin—hardly a relevant case to evaluating prospective investment projects.

If p k < p o , then we know from equations (5), (4), (1), and (2), respectively, that E k < E o → I k < I o → Y k < Y o → 1 − n k > 0. In short, if Keynes's concepts of probability and risk are correct, the long-period equilibrium position of the economy is characterized by unemployment.

The monetary authority directly controls the short-term interest rate. 5 With ‘a modest measure of persistence and consistency of purpose,’ Keynes (1936 , p. 204) asserts that the monetary authority can also influence the long-term interest rate. 6 Orthodox economists (see, for example, Ingersoll, 1989 , pp. 173–178) have accepted Keynes's assertion, taking it to mean that the long-term interest rate is the mathematical mean of the sum of the products of all possible outcomes of the short-term interest rate and their probability. For example, the yield on the 10-year bond allegedly equals the mathematical mean of the expected yields on 3-month securities for the next 10 years, plus an illiquidity premium which reflects the orthodox concept of risk. Unfortunately, orthodox economists ignore the difference between Keynes's concepts of probability and risk and the orthodox ones, and reject the classical long-period method, which Keynes uses to distinguish between the long-period equilibrium values of variables and their short-period values. To reconstruct Keynes's theory of monetary policy, these oversights must be rectified.

For Keynes (1936 , pp. 202, 206 and 313–320), the short-period fluctuations of r a around r s are strictly limited to ‘the difference between the[ir] squares’. 9 In contrast, since the stock market determines the actual expected profit ( E a ) in the short-period, the short-period fluctuations of I a and Y a around I k and Y k are unlimited. 10 Therefore, efforts by the monetary authority to stabilize the short-period fluctuations of the economy are futile for two reasons. First, any drastic changes that the monetary authority makes in the short-term interest rate simply cause a more steeply sloped yield curve as r a reaches the limits of its variability around r s . Second, such drastic changes in the short-term interest rate threaten to shatter the confidence of investors in their calculations of E a . If drastic enough, such changes may thus cause a severe recession as investors contemplate trillions of dollars of losses on their bets in the stock market.

If the monetary authority has the discretion to change the short-term interest rate, investors must take into account the possibility that future investment projects, with lower financing costs, will compete against investment projects undertaken today at higher financing costs. As a result, h 2 weighs more heavily than does h 1 against the dominate proposition for undertaking investments projects ( p o ). That is to say, w 1 > w 2 . It follows from equation (15) that p k1 > p k2 → E k1 > E k2 ; and from equation (16) that r s1 < r s2 .

Looking backward, we observe long-run trends shaping economic events. The confidence to undertake investment projects depends upon our ability to project these trends into the future. The problem is that we know these trends are not governed by natural laws but are instead the result of the series of investment projects undertaken by forward-looking investors in the past. In every short-period situation in which such investment projects were undertaken, the long-run trends of the economy would have taken off in a different direction, if those investment projects had not been undertaken.

For this reason, investors take a two-step approach to the evaluation of prospective investment projects. First, they project long-run trends into the future by assigning probabilities to the likelihood of their continuance, and thereby calculate the expected profit ( E o ). 11 Second, they contemplate the degree to which the principle of non-sufficient reason captures their uncertainty about the degree to which knowable but unknown or unknowable factors may cause the future trends of the economy to differ from past ones, and thereby calculate the expected profit ( E k ).

Monetary policy is a factor that has shaped the long-run trends of the economy. It is thus necessary for investors to assign a probability to the likelihood that the monetary authority will continue to act in the same way that it has in the past, and incorporate it into the calculation of E o . If the monetary authority has the discretion to act differently in the future than it has in the past, investors are compelled to contemplate monetary policy itself as a knowable but unknown or unknowable factor that may cause future trends of the economy to differ from past ones, and thus take it into account as a factor that makes E k < E o . If the monetary authority would make a credible commitment to buying and selling at stated prices gilt-edged bonds of all maturities, this element of uncertainty would be alleviated, thereby reducing the difference between E k and E o . The purpose of this paper has been to show that, as a result, the long-period equilibrium position of the economy would be characterized by less unemployment.

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Ricardo and his successors overlook the fact that even in the long period the volume of employment is not necessarily full but is capable of varying, and that to every banking [monetary] policy there corresponds a different long-period level of employment, so that there are a number of positions of long-period equilibrium corresponding to different conceivable interest policies on the part of the monetary authority ( Keynes, 1936 , p.191).

Keynes applies equation (3) to capital assets rather than investment projects, and thereby obtains his concept of the marginal efficiency of capital. As Garegnani (1983) demonstrates, this application is incorrect because it implies that capital is a factor of production that yields a marginal product when plugged into a (aggregate) production function. However, as Pasinetti (1974 , pp. 37–38) demonstrates, equation (3) still applies to investment projects. To make clear that I am using equation (3) in the valid sense of applying to investment projects, I drop the concept of the marginal efficiency of capital in favor of the concept of net present value.

Dickens (2008 , pp. 224–225) draws upon the literature in behavioral finance to explain why the orthodox concept of expected profit ( E o ) leads to absurdities.

The formulation of Keynes's concept of probability ( p k ) in equation (9) differs from its formulation in equation (7) because, at this point in the argument, we are abstracting from the concept of risk, as formulated in equation (8) . As shown below, equation (7) results from the combination of equations (8) and (9) .

This proposition preempts the analysis of the determination of interest rates by the schedule of liquidity preference and the supply of money.

‘The short-term interest rate’ denotes an index of all market yields on high-quality securities of short maturity and ‘the long-term interest rate’ denotes an index of all market yields on high-quality bonds of long maturity. Using such indexes is legitimate because all short-term market yields move in tandem, as do all long-term market yields. However, the short-term interest rate and the long-term interest rate do not move in tandem. Sometimes the yield curve is positively sloped, sometimes inverted, and sometimes flat.

The owners of wealth will then weigh the lack of ‘liquidity’ of different capital equipments … as a medium in which to hold wealth against the best available estimate of their prospective yields after allowing for risk [ E o ]. The liquidity-premium, it will be observed, is partly similar to the risk-premium [understood as the variability (or standard deviation), of the sum of the products of all possible outcomes and their probability, around the mathematical mean] but partly different;–the difference corresponding to the difference between the best estimates we can make of probabilities and the confidence with which we make them. * When we are dealing, in earlier chapters, with the estimation of prospective yield, we did not enter into detail as to how the estimation is made: and to avoid complicating the argument, we did not distinguish differences in liquidity from differences in risk proper. It is evident, however, that in calculating the own-rate of interest we must allow for both ( Keynes 1936 , p.240).

Tobin's q proposes that the expected profit from investment projects, as determined in the stock market ( E a ), influences long-term expectations ( E k ), and thus the aggregate rate of investment undertaken in long-period equilibrium ( I k ). In contrast, as formulated in equation (1 1), E a influences short-term expectations, and thus the pace at which I k is implemented in the short-period.

For example, if the safe long-term interest rate ( r s ) is 4%, then the actual long-term interest rate ( r a ) is limited to a range of 0.04 − (0.04) 2 = 3.84% to 0.04 + (0.04) 2 = 4.16%. If r s is 2%, then r a is limited to a range of 0.02 − (0.02) 2 = 1.96% to 0.02 + (0.02) 2 = 2.04%.

The short-period fluctuations of n a around n k have an upper bound, given by the supply of labor. However, this does not limit the short-period fluctuations of I a and Y a around I k and Y k ; it simply defines the point at which those fluctuations cause what Keynes (1936 , pp.119 and 303) calls ‘true inflation’. In other words, for Keynes, inflation is a short-period phenomenon.

D'Orlando (2005) also argues that probabilistic, as opposed to deterministic, dynamic models are compatible with the classical long-period method.

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Home — Essay Samples — Economics — Political Economy — Monetary Policy

Essays on Monetary Policy

Monetary policy is an important tool used by central banks to manage the money supply and achieve economic goals such as price stability, full employment, and economic growth. It involves the use of interest rates, open market operations, and reserve requirements to influence the level of economic activity. Given its significance in shaping the overall economic landscape, there are numerous topics that can be explored in essays related to monetary policy.

Importance of the Topic

Understanding monetary policy is crucial for individuals, businesses, and policymakers alike. For individuals, it can affect their borrowing and saving decisions, as well as their purchasing power. For businesses, it can impact their investment decisions and access to credit. For policymakers, it is essential for making informed decisions on interest rates and other monetary policy tools to achieve macroeconomic objectives.

Advice on Choosing a Topic

When selecting a monetary policy essay topic, it is important to consider current events and trends in the economy. Some potential areas of focus could include the impact of monetary policy on inflation, the effectiveness of unconventional monetary policies such as quantitative easing, or the role of central banks in financial stability. Additionally, exploring the relationship between monetary policy and other economic variables such as exchange rates, asset prices, and economic growth can provide valuable insights.

Another approach could be to analyze the historical evolution of monetary policy and its impact on different economic periods. This could involve examining the effectiveness of various monetary policy regimes, such as fixed exchange rates versus floating exchange rates, or the implications of different monetary policy rules such as inflation targeting or nominal GDP targeting.

Furthermore, essays could delve into the challenges and limitations of monetary policy in the current global economic environment. This might include discussing the constraints faced by central banks in the aftermath of the 2008 financial crisis, as well as the implications of low and negative interest rates on monetary policy effectiveness.

Monetary policy is a multifaceted topic with a wide range of potential essay topics to explore. Whether delving into contemporary issues, historical perspectives, or theoretical debates, there is no shortage of interesting and relevant subjects to examine. By choosing a well-defined and relevant topic, students and researchers can contribute to the ongoing discourse on monetary policy and deepen their understanding of its impact on the economy. As the economic landscape continues to evolve, the study of monetary policy will remain a crucial area of research and analysis.

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Essay on the Monetary Policy | India | Economics

Here is an essay on the ‘Monetary Policy’ for class 11 and 12. Find paragraphs, long and short essays on the ‘Monetary Policy’ especially written for school and college students.

Essay on the Monetary Policy

Essay # 1. introduction to the monetary policy :.

Monetary policy refers to the steps taken by the Reserve Bank of India to regulate the cost and supply of money and credit in order to achieve the socio-economic objectives of the economy. Monetary policy influences the supply of money the cost of money or the rate of interest and the availability of money. One of the most important functions of Reserve Bank is to formulate and administer a monetary policy. Such a policy refers to the use of instruments of credit control by the Reserve Bank so as to regulate the amount of credit creation by the banks. It also aims at varying the cost and availability of credit with a view to influence the level of aggregate demand for goods and services in the economy.

ADVERTISEMENTS:

D. C. Rowan has defined Monetary Policy as “discretionary act undertaken by the authorities designed to influence (a) the supply of money (b) cost of money or rate of interest and (c) the availability of money”.

Objectives of Monetary Policy :

In India, during the planning period the basic objective of monetary policy has been to meet the requirements of the planned development of the economy.

With this broad and basic objective, the monetary policy has been pursued to achieve the following objectives of the economic policy of the government of India:

(1) To Accelerate the Process of Economic Growth :

One of the twin aims of the economic policy is to accelerate the process of economic growth with a view to raise the national income. The Reserve bank has made the allocation of funds to the various sectors according to the priorities laid down in the plans and requirements of day to day development.

(2) Controlled Expansion :

The second objective is to control the prices and reduce the inflationary pressures in the economy. The monetary policy of the Reserve Bank during the planning period is appropriately termed as that of “Controlled expansion”.

Every economy faces two conflicting interests:

(a) Expansion of money supply to finance the process of economic development.

(b) Control of money supply to check inflationary pressure generated in the economy as a result of vast developmental and non-developmental expenditure.

Thus, controlled expansion of money supply was essential for growth with reasonable price stability in the country.

Essay # 2. Measures Adopted by Reserve Bank for the Monetary Policy :

To achieve the objectives of the monetary policy, the Reserve Bank has adopted the following measures:

(A) Measures for expansion of currency and credit.

(B) Measures for controlling of credit.

These measures are discussed in detail as follows:

A. Measures for Currency and Credit Expansion :

For meeting the developmental needs of the economy the continuous expansion of currency and credit was required during the planning period.

This expansion has been achieved by using the following measures:

1. Revision of Open Market Operations :

In October 1956, the open operations policy of the Reserve Bank was revised and it started giving discriminatory support to the sale and purchase of government securities. Initially, the bank made large purchases of government securities. In the subsequent years the bank’s sale of government securities exceeded its purchases. But this excess sales method was discontinued between 1964 and 1969 with a view to expand currency and credit in the economy.

2. Liberalisation of the Bill Market Scheme:

The Reserve Bank has liberalised the bill market Scheme, as a result, the commercial banks receive additional funds from the Reserve Bank to meet the credit requirements of the borrowers. Since 1957, the Reserve Bank has included the export bills also in the bill market scheme, so as to help the commercial banks to provide credit to exporters also.

3. Financing Facilities to the Priority Sectors :

Even though, the general policy of the Reserve Bank is to control credit expansion, still it continues to provide credit facilities to priority sectors such as small scale industries and cooperatives. The Bank has been providing short term Finances to the rural cooperatives also.

4. Refinancing and Rediscounting Facilities :

The Reserve Bank also follows a policy of selective refinance and rediscount facilities. In the recent years, the banks are permitted to refinance equal to one percent of their time and demand liabilities. This is done at the rate of 10% per annum. Refinance facilities are available for providing food procurement credit as well as export credit. The scheduled banks can also get their bills of exchange, promissory notes and hundis rediscounted with the Reserve Bank, but the maximum duration of these bills should not be more than 3 months.

5. Establishment of Various Financial Institutions :

The Reserve Bank has played the main role in the establishment of various financial institutions in the country, through which the Reserve Bank provides medium term and long term credit facilities for development.

Some of these institutions are:

(i) ICICI—Industrial Credit and Investment Corporation of India.

(ii) IDBI—Industrial Development Bank of India.

(iii) IFCI—Industrial Finance Corporation of India.

(iv) IRCI—Industrial Reconstruction Corporation of India.

(v) SFCs—State Financial Corporations.

(vi) ARDC—Agricultural Refinance and Development Corporation.

(vii) NABARD—National Bank for Agriculture and Rural Development.

6. Deficit Financing :

To continuously increase the supply of money in the country, the Reserve Bank has adopted the system of deficit financing for financing the budgetary deficit of the government.

For this the Reserve Bank has made changes in its reserve requirements and made the reserve system more flexible.

The changes made by the Reserve Bank are:

(i) The proportional reserve system which required keeping of 40% reserves in gold and foreign securities have been dropped by the Reserve Bank.

(ii) The minimum reserve system has been modified by the Reserve Bank. Now the bank need keep only gold worth Rs. 115 crores. The requirement of keeping foreign securities of the value of Rs. 85 crores can be waived during extreme contingencies. Thus, in extreme contingencies the bank needs to keep just Rs. 115 crores of reserves in place of Rs. 200 crores.

7. Anti-Inflationary Fiscal Policy :

In the Seventh five year plan, it was preferred that there should be an anti-inflationary fiscal policy in place of anti-inflationary monetary policy. This plan laid mulch emphasis on the positive, promotional and expansionary role for the monetary policy. In the seventh plan the amount of deficit financing given by the Reserve Bank to the government had been fixed at a minimum level, which was just sufficient to generate the additional money supply needed to meet expected increase in the demand for money. If such a fiscal policy continues, it will relieve the Reserve Bank of its anti-inflationary responsibilities so that it can pay more attention to the provision of credit facilities for the development of trade, industry and commerce in the country.

8. Allocation of Credit :

According to this measure, the allocation of credit will be done in accordance with the priorities laid down in the plans. Still the major part of the credit goes to the public sector through statutory requirements and other means. For the priority sector a certain minimum of credit at concessional rates of interest is ensured through selective credit control and the differential rate of interest scheme. The Reserve Bank does not give credit to the private industries directly. These industries can get credit facilities through the public financial institutions.

B. Measures for Controlling of Credit :

The Reserve Bank of India has the responsibility to ensure that money supply is within manageable limits as unlimited expansion of money and credit results in inflation which ultimately affects the poor.

So, the reserve Bank has been using credit control measures which can be classified into two categories:

(I) General or Quantitative measures

(II) Selective or Qualitative measures

(I) General or Quantitative Measures:

These measures are generally adopted by the Central banks in all the countries. These measures adopted by the Reserve Bank affect the lendable sources of the commercial banks which in turn affect the total volume of the credit and hence the total money supply.

So these measures affect the total quantity of credit and the economy in general. General controls include:

1. Bank Rate:

The traditional definition of Bank Rate says that it refers to the rate at which the Central Bank rediscounts the eligible bills. In broader sense “It refers to the minimum rate at which the central bank provides financial accommodation to commercial banks in the discharge of its functions as the lender of the last resort.”

During inflationary periods, the bank rate is increased so as to increase the rate of interest on borrowings.

A change in discount rate:

(i) Makes the cost of securing funds from RBI cheaper or more expensive

(ii) Brings about changes in the structure of market interest rates and

(iii) Serves as a signal to the money market, business community and the public of the relaxation or restraint in credit policy.

The Reserve Bank has changed the bank rate Several times from 4.5% in 1963 to 10% in 1983 and further to 11% in July 1991. It was 12% w. e. f October 8, 1991. The increase in bank rate was adopted to reduce bank credit and control inflationary pressures. w. e. f. April 29, 1998 the bank rate was 9%. In Oct. 2001 it was 6.5% of in 2002 it comes down to 6 per cent.

2. Open Market Operations:

Open market operations refer to the sale and purchase of securities, foreign exchange and gold by the government. The Central Bank seeks to influence the economy either by increasing the money supply or by decreasing the money supply. To increase money supply, the Central bank purchases government securities from banks and public e.g. If the Reserve Bank buys securities worth Rs. 50 crores from the commercial banks, then the reserves of commercial banks will increase by 50 crores and this money will come in circulation. Conversely, when the central bank sells securities to the banks, the deposits in the banks would get reduced resulting in contraction of credit and reduction in money supply.

In India open market operations are mostly in government bonds because of the absence of Treasury bill market in India. RBI has not used open market operations since long. Since 1991, the enormous inflow of foreign funds into India created the problem of excess liquidity with the banking sector and the Reserve Bank undertook large open market operations. In U.S.A. and U.K., unlike in India, open market operations are mostly in treasury bills. In 2001-2002, RBI sold securities worth Rs. 1,063 crore and purchased worth Rs. 49,068 cr.

3. Cash Reserve Requirements:

Commercial banks in every country maintain a certain percentage of their deposits in the form of balances with the central bank which is known as CRR or Cash Reserve Requirement. If CRR is 10%, for example, the maximum amount a bank can lend is equivalent to 90% of total reserves. The method of CRR is the most direct and effective method of credit control. The more is the excess reserve, the greater is the power of the Reserve Bank to create Credit and lower is the power of the commercial banks to create credit. On the other hand, lower is the excess reserve, the lesser is the power of the Reserve Bank to create credit and larger the power of the commercial banks to create credit.

RBI is empowered to vary the CRR between 3% to 15% of total demand and time liabilities. Since 1973, CRR was 7% and 15% in 1991 and again 14% in 1994. The CRR ratio was cut down to 11% w. e. f. August 29, 1998. This reduction is due to the new liberalised policy of the government.

4. Statutory Liquidity Ratio (SLR):

Apart from Cash reserve requirements (RBI Act 1934) all commercial banks are required to maintain, under sec 24 of the Banking Regulation Act 1949, liquid assets in the form of cash, gold and unencumbered approved securities. This is known as statutory liquidity Ratio and it cannot be less than 25% of their total demand and time deposit liabilities. The Reserve Bank of India is empowered to change this ratio. Accordingly it raised the liquidity ratio from 25% to 38% w. e. f. September 1990.

The two underlying reasons for raising the SLR are:

(i) It helps to check the inflationary pressures in the economy by reducing the capacity of the commercial banks to create credit.

(ii) It makes larger resources available to the government.

In view of the Narsimhan Committee report, the government decided to reduce SLR in stages from 38. 5% to 25%. By the end of December 1996, the effective SLR came down to 27%. It has been reduced to 25% in 2002.

5. Refinance Policy:

Refinance given by the Reserve Bank to the Commercial banks affects their credit but this system is changed from time to time to allow or disallow flow by banks. Over the years effectiveness of refinance policy has come down because dependence of commercial banks on Reserve Bank of India for refinance has come down except in case of subsidised refinance of agricultural and rural credit.

(II) Selective or Qualitative Controls:

This control refers to regulations of credit for specific purposes or branches of economic activity. Selective credit controls are considered to be useful supplement to general credit regulations.

Under section 21 and 35-A of Banking Regulation Act 1949, the Reserve Bank has powers to control advances by banks regarding:

(a) The purpose for which advances may or may not be made.

(b) The margins to be maintained in respect of secured advances.

(c) The maximum amount of advance to any borrower.

(d) The maximum amount upto which guarantees may be given by the banking company on behalf of any firm, company etc. and

(e) The rate of interest and other terms and conditions for granting advances.

The Reserve Bank of India has generally adopted the following techniques of selective credit control since 1956 onwards:

1. Regulation of Marginal Requirements on Loans:

The Reserve Bank fixes the minimum marginal requirements on loans for purchasing or carrying securities. Margin is the difference between the market value of the security and the amount lent by the banks against these securities. The basic aim of this method is to restrict the use of credit to purchase or carry securities by the speculators. Minimum requirements of loan is the percentage value of the security which cannot be borrowed or lent or in other words, it is the maximum value of loan which a person can get from the banks against the securities.

The changes in margin requirements regulate and control the demand for speculative credit. These margins are 20% to 100%. The Reserve Bank can control credit by increasing the margins and expand credit by reducing the margin requirements.

2. Regulation of Consumer Credit:

To check the inflationary pressures in the economy, another method of selective credit controls is the regulation of consumer credit. This credit is generally given to the consumers for the purchase of durable goods. The consumer credit schemes which are adopted by the banks require that a certain percentage of the consumer durable goods are paid by the consumer in cash. The balance amount is financed by the bank through bank credit which is re-payable in monthly installments over a period of time. The Reserve Bank can control credit by changing the total amount which can be borrowed by the consumer for the purchase of consumer durable goods and/or the maximum period over which the installments can be extended.

The Reserve Bank can control credit by increasing the down payment and reducing the number of installments. On the other hand, it can expand credit by reducing the down payment and increasing the number of installments.

3. Rationing of Credit:

Rationing of credit is another technique of selective credit control. Under this method, the Reserve Bank fixes the quota for member banks as well as their limits for the payment of bills. The Quota system was first introduced in 1960. If the member banks seek more loans than the quota which is fixed for them, they will have to pay higher rate of interest to the Reserve Bank than the prevailing bank rate.

Rationing of credit is both quantitative as well as qualitative method of credit control. If rationing is done with respect to the total amount of loan, it will be a quantitative control. But if rationing fixes the maximum ceilings for specific categories of loans and advance, it becomes qualitative in nature.

4. Credit Authorisation Scheme (CAS):

Credit Authorisation Scheme, as a selective credit control, was introduced by the Reserve Bank in November 1965. Under this scheme, the commercial banks had to seek authorisation from the Reserve Bank before sanctioning any fresh limit of Rs. 1 crore or more to any single party. The amount of this limit has been changed from time to time. This limit was raised to Rs. 6 crore with effect from April 1986. Since July 1987, this scheme has been liberalised to allow large amount of loans to meet genuine demands of production sector without the prior sanction of the Reserve Bank. However, in such cases, a system of post sanction scruting called Credit Monetary Arrangements (CMA) has been introduced by the Reserve Bank.

The main purpose of CAS is to keep a close watch on the flow of credit to the borrowers. It requires that the banks should tend to large borrowing concerns on the basis of credit appraisal and actual requirements of the borrowers.

5. Directives:

Under this method, the Reserve bank makes extensive use of selective credit controls and issues directives to the commercial banks.

Since 1956, the following directives have been issued by the Reserve Bank:

(i) The first such directive was issued by the Reserve Bank on May 17, 1956 to restrict advances against paddy and rice. Later on, so many other commodities of common use were also included in this list.

(ii) The State agencies, such as the Food Corporation of India and State Trading Corporation have been exempted from the use of selective credit controls.

This method can help a lot in credit regulation and can be quite effective if properly used and implemented by the monetary authorities of the country.

6. Moral Persuasion:

The Reserve Bank has been using moral persuasion as a selective credit control measure. Periodical letters are issued by RBI to banks urging them to exercise control over credit in general or advances against particular commodities or unsecured advances. Regular meetings and discussions are also held by the Reserve Bank with commercial banks to impress upon them the need for their cooperation in the effective implementation of the economic policy.

Essay # 3. Evaluation of the Monetary Policy:

The twin objectives of the monetary policy of the Reserve Bank had been to (1) accelerate the process of economic growth and to (2) control the inflationary pressures in the economy. Though, the Reserve Bank has been extensively using various credit control methods, but it has not been able to bring stability to the economy of the country.

Major failures and limitations of the monetary policy of the Reserve Bank are as discussed below:

1. Minor and Restricted Role in Economic Development:

The monetary policy has not been given an active and crucial role in the economic development of the country. Rather, it has been assigned only a minor role in the expansion and development of the Economy. The Reserve Bank has been assigned a very minor and restricted role that is to see that the economic development of the country is not hampered because of the non-availability or inadequacy of funds.

2. Lack of Coordination between Monetary and Fiscal Policies:

There is lack of coordination between the monetary policy of the Reserve Bank and the fiscal policy of the government of India. The five year plans emphasised that there should be proper coordination between the fiscal policy particularly relating to deficit financing and the Reserve Bank Credit Policy relating to commercial banks. To maintain a reasonable balance between aggregate demand and aggregate supply, it was necessary to limit the deficit financing to a reasonable level and to have a bank credit policy which cooperates with the policy of deficit financing. In reality, the Reserve Bank has been monetising the increasing budgetary deficit which in turn leads to a less effective monetary policy. As the proper integration between the monetary and fiscal policies could not be achieved due to lack of serious efforts, our basic objectives of growth and price stability could also not be achieved.

3. Imbalance in Credit Allocation:

Another limitation of our monetary policy has been imbalance in the allocation of credit. Even though agriculture and small scale industries are given priority in the five year plans, still relatively less credit is diverted towards these sectors. After the nationalisation of the banks, some efforts have been made by the commercial banks to provide credit to these priority sectors; but the efforts are not sufficient. These sectors remain dependent mainly upon private resources for their financial needs.

4. Unsatisfactory Role of Capital Market:

Another drawback of our monetary policy lies in the unsatisfactory and limited role of the capital market. The distribution of credit in the market is not based on the efficiency and profitability of the enterprises demanding funds. The present scenario is that the public financial institutions are raising the resources at lower than the market price to finance investments in private industries. Now there is a strong need to enlarge the Capital Market. This can be done by encouraging both the public and private enterprises to seek much larger support from the capital market. Funds should be provided to the enterprises on the basis of their capacity and credit worthiness.

5. Excessive Budgetary Deficit and Government Borrowings:

Another reason for the failure of monetary policy in India has been the impact of excessively growing budgetary deficit and large scale government borrowings. The main reason for developing excessive budgetary deficit was to maintain high level of plan outlays and to promote investment in the economy. But the results have been contrary. The high level of deficit financing has created excessive monetary demands which have further led to inflationary pressures in the economy of the country.

6. Excessive Increase in Bank Credit to the Commercial Sector:

The Reserve Bank has provided excessive credit to the Commercial banks, which is another cause of the failure of the monetary policy. This excessive credit was provided to promote growth and investment in the country, to provide liberal and concessional credit to the priority sector and to give preferential treatment to the government agencies and the private sector. All this has led to a large expansion of money supply in the economy.

7. Limited Role in Curbing the Inflationary Pressures:

The monetary policy of the Reserve Bank has played only a limited role in curbing the inflationary pressures in the economy. It has not succeeded in achieving the objectives of economic growth with stability.

The general and selective measures adopted by the Reserve Bank are effective only if the inflation is caused due to expansion of bank credit. If inflation is caused due to deficit financing or shortage of goods, these measures will not prove to be effective. The average rate of money supply during the plans has been 15% p. a. whereas the average rate of growth of domestic product is just 4%. This disproportionate increase is a major factor in the inflationary pressures of the economy.

8. Increased Liquidity of Commercial Banks:

After the nationalisation of the banks, their liquidity position has improved. As a result of nationalisation, there has a rapid growth of banking industry. The commercial banks have increased mobilisation of savings as well as increased growth of deposits. Now they do not have to depend upon the Reserve Bank for their financial needs. The Reserve Bank may increase the CRR or the SLR but the commercial banks do not get affected much. They can grant as much loans as are required without resorting to the Reserve Bank. This has also reduced the effectiveness of the monetary policy.

9. Existence of Black Money:

Another limitation of monetary policy in India is the existence of black money which limits the working of the monetary policy. The black money is not recorded since the borrowers and lenders keep their transactions secret. As a result, the supply and demand of money do not remain as desired by the monetary policy.

10. Underdeveloped Money Market:

The underdeveloped money market of our country limits the coverage as well as the efficient working of the monetary policy. The Indian money market consists of organised as well as unorganised money market. The monetary policy cannot reach the unorganised money market thus the desired results cannot be achieved.

In short, the monetary policy of the Reserve Bank suffers from many limitations. It requires improvements in many directions.

Essay # 4. Suggestions/Recommendations of the Chakravarty Committee on Monetary Policy:

The Committee to review the working of the monetary system was appointed by the Reserve Bank of India in 1982 with Prof. Sukhmoy Chakravarty as the chairman. The Committee submitted its report in 1985.

The following were the terms of reference of this committee:

(i) To critically review the structure and operation of the Monetary System, in the context of the basic objectives of planned development.

(ii) To assess the interaction between monetary policy and Public debt Management in so far as they have a bearing on the effectiveness of monetary policy.

(iii) To evaluate the various instruments of monetary and credit policies.

(iv) To recommend suitable measures for improving the effectiveness of monetary policy.

The following were the main recommendations of the committee:

1. Price Stability :

The committee had strongly emphasised that price stability, in the broadest sense, should be the objective of the monetary policy. The committee suggested that average annual increase in the wholesale price index should not be more than 4%. To achieve this objective measures had to be adopted to control both the aggregate demand and aggregate supply of money. For achieving this target the government should aim at improving the output level and the Reserve Bank should control the reserve money and money supply.

2. Non-Inflationary Financing of Plans :

The committee expressed its concern over the increase in government deficits, despite the rise in savings rate. In this context it stressed that deficit financing measured in terms of governments’ recourse to credit from Reserve Bank, should not exceed safe limits.

The plans should be financed in non-inflationary manner with the help of the following measures:

(i) Tapping the Savings of the public in greater measure.

(ii) Realising higher savings from public sector enterprises.

(iii) Improving efficiency in revenue gathering and expenditure functions.

3. Monetary Targeting :

The committee observed that the major cause of substantial increase in the money supply since 1970 has been the rise in the Reserve Bank credit to the government, as reflected in the high degree of monetisation of the debt. In this regard the committee recommended that the target for the growth of money supply in a year should be set within a range. It should be reviewed in the course of the year to accommodate revisions, if any keeping in view growth in output and the price situation. Monetary targeting is an aggregative concept which lends clear direction to the monetary policy instruments.

4. Co-Ordination of Monetary and Fiscal Policies :

The committee suggested that to coordinate monetary and fiscal policies, the concept of “Budgetary deficit” should be redefined.

The present policy does not provide a clear picture of the monetary impact of the fiscal operations because:

(i) It does not cover the rise in Reserve Bank’s holding of dated securities which has a monetary impact.

(ii) The deficit is related to only the changes in the level of Treasury bills outstanding.

(iii) It does not distinguish between an increase in the Reserve Bank’s holding of treasury bills which has a monetary impact and the absorption of the Treasury bills by the public which does not have a direct monetary impact.

Hence, there should be suitable modification in the definition of the budgetary deficit.

5. Interest Rate Policy :

The committee made the following recommendations regarding the policy of rate of interest:

(i) The banks should have greater freedom in the determination of their rates of interest. This would prevent unnecessary use of credit which presently is possible due to low rate of interest.

(ii) Concessional rates should be used in a very selective manner that to as a distributive device.

(iii) The interest rates on bank rates should be positive after adjusting the inflation. This will encourage small savers.

(iv) The interest rates should reflect the real cost of long term loans for industrial projects. This will discourage those projects which are basically not viable.

6. Credit Planning :

The committee recommended the need for Credit-Budgeting to achieve desired sectorial credit allocation in line with plan priorities. It suggested the need to support quantitative credit controls with a price rationing mechanism in the context of excess demand for credit. The committee also suggested a reduction in the importance of cash credit in bank lending and greater resort to financing through loans and bills.

7. Restructured Money Market :

The committee suggested that the money market in India should be restructured to make it more efficient. The monetary system of the economy should be restructured in such a way that the Treasury bill market, the call money market, the commercial bill market are able to play an important role in the allocation of short term resources with minimum transaction cost and minimum delay. The committees stressed that improvement in productivity in all aspects of banking operations was to be pursued by banks as an important management objective. As regards the traditional non-banking financial intermediaries, the committees suggested that beyond a suitable cut off point, these should also be under a legal obligation to obtain license.

8. Priority Sector Lending :

To make the priority sector lending more effective, the committee suggested the need for organisational reorientation and effective communication and monitoring. In this area, credit delivery system should be strengthened, so that sufficient and timely credit is made available to this sector.

9. Role of Reserve Bank for the Conduct of Monetary Policy :

The committee was of the view that the Reserve Bank should have adequate powers and authority to match its responsibility to supervise and control functioning of the Monetary System.

The committee gave the following suggestions in this regard:

(i) The Reserve Bank should not depend too much on any single instrument of monetary policy.

(ii) The regulatory measures should be adopted early and slowly so that effects of these measures are not too drastic and create hardship to the specific sectors.

(iii) The creation of reserve money should be kept within limits.

(iv) The developmental institutions should get their working funds from sources other than the Reserve Bank and the Bank should provide only a secondary support to these institutions.

The government has accepted the recommendations of the Chakravarty committee and these are now being implemented.

Related Articles:

• Monetary Policy of Reserve Bank of India (RBI)
• Monetary Policy and Fiscal Policy of India
• Instruments of Monetary Policy
• Monetary-Fiscal Policy Link (With Diagram) | Economics

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Economics Monetary Policy Essay (Rojina Parchizadeh)

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Evaluate the effectiveness of the RBA’s expansionary monetary policy in achieving economic objectives in the Australian economy. Intro: The Reserve Bank of Australia’s (RBA) use of expansionary monetary policy to countercyclically stimulate growth at a sustainable level has been moderately effective in the past. Monetary policy has successfully achieved the economic objectives of economic growth to a relatively high extent, maintaining low unemployment, inflation and a sustainable rate of economic growth through its Domestic Market Operations (DMOs) which influence the cash rate in the overnight money market. However, it has been unhelpful to the goal of maintaining a fair distribution of wealth and income whilst not being useful for the objective of external stability. In more recent years, as interest rates become increasingly low, expansionary monetary policy has diminished in its effectiveness, raising questions on the policy mix required to achieve economic objectives

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Economics Gr. 11 T1 W6: MACROECONOMICS: ECONOMIC SYSTEMS

Economics Grade 11 Term 1 Wk.6: MACROECONOMICS: ECONOMIC SYSTEMS

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