Unit - V Monetary Policies. Dr.U.Ramesh pdf

Unit - V Monetary Policies. Dr.U.Ramesh pdf

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  1 Unit V: MonetaryPolicies Monetary Policy Objectives and Instruments of Monetary policy– Limitations of monetary policy- Monetarism and Keynesianism – Comparison - Supply side policies. MONETARY POLICY: Monetary policy refers to the process by which the central bank of a country, such as the Reserve Bank of India (RBI), manages the supply of money, availability of credit, and interest rates to achieve specific economic objectives. It is a key tool for maintaining economic stability and promoting growth. Types of Monetary Policy: 1. Expansionary Monetary Policy: Increases the money supply and lowers interest rates to stimulate economic growth, usually during a recession. 2. Contractionary Monetary Policy: Decreases the money supply and raises interest rates to control inflation. THE OBJECTIVES OF MONETARY POLICY: The objectives of monetary policy aim to achieve economic stability, growth, and development. These objectives are dynamic and depend on the economic conditions of a country. Below are the key objectives of monetary policy: 1. Price Stability  Maintain stability in the general price level by controlling inflation and deflation.  Ensures that inflation does not erode purchasing power or destabilize the economy. 2. Economic Growth  Support sustainable economic development by ensuring adequate credit flow to productive sectors.  Encourages investment, production, and employment generation. 3. Employment Generation  Strive to achieve full employment, which is considered an essential indicator of economic health.  In line with the Keynesian approach, monetary policy can influence job creation through credit availability. 4. Control of Inflation and Deflation  Prevent high inflation, which affects the cost of living, and avoid deflation, which discourages investment and production.  Maintain a balance between supply and demand of goods and services. 5. Exchange Rate Stability  Stabilize the value of the domestic currency in the foreign exchange market.  Prevents excessive fluctuations in exchange rates, which can impact foreign trade and investment. 6. Regulation of Money Supply  Control the circulation of money in the economy to ensure it aligns with economic activity.  Avoid excessive liquidity, which can lead to inflation, or liquidity shortages, which can hinder growth. 7. Balance of Payments (BoP) Stability  Help maintain equilibrium in the balance of payments by influencing foreign trade and capital flows. 8. Promote Financial Stability
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  2  Ensure thestability and soundness of the financial system by regulating credit flow and interest rates.  Prevent financial crises caused by excessive speculation or market imbalances. 9. Redistribution of Income and Wealth  Promote equity by influencing credit flow to priority sectors such as agriculture, small industries, and weaker sections of society. INSTRUMENTS OF MONETARY POLICY: Monetary policy is implemented through various instruments that can broadly be classified into two categories: quantitative (general) instruments and qualitative (selective) instruments. These instruments are used by the central bank to regulate the supply of money and credit in the economy. I. Quantitative Instruments Quantitative instruments influence the overall supply of money and credit in the economy. They include: 1. Bank Rate  The rate at which the central bank lends long-term funds to commercial banks.  An increase in the bank rate discourages borrowing, reducing money supply, while a decrease encourages borrowing. 2. Repo Rate  The rate at which the central bank lends short-term funds to commercial banks against government securities.  Lowering the repo rate encourages borrowing by banks, increasing liquidity in the economy, while raising it reduces liquidity. 3. Reverse Repo Rate  The rate at which the central bank borrows funds from commercial banks.  It is used to absorb excess liquidity from the banking system. 4. Cash Reserve Ratio (CRR)  The percentage of a bank’s total deposits that must be kept with the central bank.  Increasing the CRR reduces the funds available for banks to lend, reducing money supply, and vice versa. 5. Statutory Liquidity Ratio (SLR)  The percentage of a bank’s total deposits that must be maintained in the form of liquid assets (e.g., gold, cash, government-approved securities).  It ensures the liquidity and solvency of banks and regulates credit flow. 6. Open Market Operations (OMO)  The buying and selling of government securities in the open market by the central bank.  Buying securities injects money into the economy, while selling securities reduces money supply. 7. Marginal Standing Facility (MSF)  A facility that allows banks to borrow overnight funds from the central bank in case of emergencies. II. Qualitative Instruments Qualitative instruments are used to regulate credit flow to specific sectors or industries and influence the use of credit. They include: Credit Rationing
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  3  Restricts theamount of credit available to certain sectors deemed unproductive or speculative, while promoting priority sectors like agriculture and small industries. Moral Suasion  A persuasive method where the central bank requests or advises banks to follow desired credit policies, rather than mandating them. Margin Requirements  Regulates the minimum margin (borrower’s contribution) for loans against securities or assets. Adjusting margin requirements can control speculative credit. Direct Action  The central bank can take direct actions like imposing penalties or restrictions on banks that fail to comply with its guidelines. Consumer Credit Regulation  Controls credit granted to consumers by regulating the terms of purchase (e.g., down payment, maximum loan tenure). Publicity  The central bank publishes periodic reports to influence public opinion and guide banks’ behavior. LIMITATIONS OF MONETARY POLICY: 1. India’s Liquidity Challenges Post-2016 Demonetization o Explore how monetary policy measures taken by the Reserve Bank of India (RBI) were delayed in their impact on credit and growth. 2. Japan’s Liquidity Trap during the Lost Decade o Understand why Japan’s monetary policy failed despite near-zero interest rates. 3. India’s NBFC Crisis of 2018 o Analyze how the crisis affected the effectiveness of RBI’s liquidity measures and impacted credit flow. 4. Conflict between Monetary and Fiscal Policy in India (Post-1991 Economic Reforms) o Examine how fiscal deficits limited the impact of RBI’s monetary tightening. 5. India’s Rupee Depreciation in 2018 o Look into how global factors such as oil prices and capital outflows influenced monetary policy. 6. Turkey’s Currency Crisis (2021-2022) o Explore how political interference in monetary policy caused economic instability. COMPARISON BETWEEN MONETARISM AND KEYNESIANISM: Aspect Monetarism Keynesianism Origin Developed by Milton Friedman in the 20th century. Developed by John Maynard Keynes in the 1930s. Core Belief Economic stability is achieved by controlling the money supply. Economic stability is achieved through government intervention in demand. Focus Emphasis on long-term economic Focus on short-term
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  4 Aspect Monetarism Keynesianism growthand price stability. fluctuations in economic activity and employment. Role of Money Money supply is the primary determinant of economic activity. Money plays a secondary role; aggregate demand is more critical. Government Role Minimal government intervention; free markets self-correct. Active government intervention is necessary to manage demand. Monetary Policy Monetary policy is the key tool to control inflation and stabilize the economy. Monetary policy is effective only to some extent; fiscal policy is more important in certain situations. Fiscal Policy Fiscal policy (government spending and taxation) has limited or no role in managing the economy. Fiscal policy is crucial to stimulate demand during recessions. View on Inflation Inflation is always a monetary phenomenon, caused by excessive growth in the money supply. Inflation can result from both demand-side and supply-side factors, including cost-push inflation. Unemployment There is a natural rate of unemployment (Non-Accelerating Inflation Rate of Unemployment - NAIRU); attempts to reduce unemployment below this rate will lead to inflation. Unemployment is primarily due to insufficient demand, and government spending can reduce it. Economic Cycles Business cycles are caused by erratic monetary growth. Business cycles are caused by fluctuations in aggregate demand. Self-Correction The economy is self-correcting in the long run; markets tend to equilibrium. The economy may not self- correct quickly and can remain in a prolonged slump without intervention. Key Theories - Quantity Theory of Money (MV = PY). - Emphasis on controlling money supply to stabilize the economy. - Keynesian Cross Model. - Importance of government spending (multiplier effect) to boost demand. Policy Recommendations Focus on controlling money supply and interest rates to manage the economy. Use fiscal stimulus (government spending and tax cuts) to boost demand during downturns. Criticism of the Other Keynesian policies cause inflation and government inefficiency. Monetarist policies ignore the importance of fiscal measures in tackling unemployment and demand shocks. Notable Supporters Milton Friedman, Anna Schwartz. John Maynard Keynes, Paul Samuelson.
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  5 Key Example ofApplication 1. Monetarism: o The 1980s policies under Paul Volcker (US Federal Reserve Chairman), where tight monetary policy was used to control inflation in the United States. 2. Keynesianism: o The New Deal programs in the 1930s during the Great Depression, where large-scale government spending boosted demand and reduced unemployment. MONETARY SUPPLY-SIDE POLICIES AND FISCAL SUPPLY-SIDE POLICIES: Comparison with Fiscal Supply-Side Policies Aspect Monetary Supply-Side Policies Fiscal Supply-Side Policies Objective Increase the economy’s productive capacity by improving the availability of credit and lowering borrowing costs. Increase productive capacity through government investments in infrastructure, tax incentives, and reducing regulatory burdens. Tools Used Interest rates, open market operations, reserve requirement changes, targeted lending programs. Government spending on infrastructure, tax cuts for businesses, subsidies, deregulation. Impact on Economy Focus on financial conditions, aimed at fostering investment by reducing borrowing costs. Focus on direct economic activities, aimed at stimulating production and job creation through government projects. Speed of Impact Long-term effects, especially when aiming to foster investment in industries. Medium to long-term effects, depending on the effectiveness of government projects. Impact on Employment Primarily affects business investment, which indirectly leads to job creation through increased production. Direct impact through government- funded projects that create jobs, and tax incentives for businesses to hire more. Government Involvement The central bank (e.g., the RBI or Federal Reserve) plays a key role in shaping the policy. Direct government involvement through fiscal policy decisions (e.g., national budgets, tax reforms). Economic Stimulus Primarily through credit availability, ensuring businesses can expand and invest. Direct economic stimulus through government spending and subsidies aimed at specific sectors. Examples of Fiscal Supply-Side Policies 1. United States (1980s Reaganomics) o The Reagan administration implemented major tax cuts for corporations and individuals to increase investment and labor supply. The government also reduced regulations, making it easier for businesses to operate and invest. o Impact: The policy resulted in long-term economic growth and a lower unemployment rate but also led to rising budget deficits and income inequality. 2. India (2016-2020) o Corporate Tax Cuts:
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  6 In 2019, theIndian government slashed corporate tax rates to attract foreign investment and boost production. This was a supply-side fiscal measure to make India a more attractive investment destination. o Atmanirbhar Bharat (Self-Reliant India) Under this initiative, the Indian government increased spending on infrastructure, boosted local manufacturing, and provided incentives for industries to produce domestically. This fiscal policy was designed to enhance India’s self-sufficiency and increase its manufacturing capacity. 3. United Kingdom (Thatcher’s Supply-Side Reforms, 1980s) o Deregulation of Industries: The Thatcher government introduced policies to reduce the role of government in the economy, privatized state-owned enterprises, and lowered taxes. o Impact: The UK experienced significant economic growth during the 1980s, but at the cost of increased inequality and unemployment in certain sectors. Conclusion: Monetary vs. Fiscal Supply-Side Policies  Monetary supply-side policies focus on improving the financial environment for businesses by making credit cheaper and more accessible, fostering investment and growth over the long term.  Fiscal supply-side policies involve direct government actions, such as tax incentives, subsidies, and infrastructure spending, that aim to stimulate production and employment more immediately.