Monetary policy refers to the control of credit and the total liquidity. This policy is also known as central bank policy on credit control. Control of the money supply is very important for a country’s economic growth. If there is excess supply of money, then the result will be inflation while tight control over money can cause depression and unemployment. Therefore monetary policy is implemented to achieve various objectives such as achieving price stability, increase job opportunities, stimulate economic growth, achieving reciprocating currency and increased investment. Monetary policy is carried out by the central bank and uses different methods for this purpose. These are classified into two types and are given below.
Bank rate refers to the speed at which the central bank’s rediscount bills of exchange. In other words, is the rate of interest loans from the central bank advances to commercial banks. In the case of rising inflation the central bank the bank rate, because commercial banks have to increase interest rates. Due to increasing demand interest rate for loans from commercial banks and reduces the money supply shrinks country. Thus, inflation is under control. As regards the rate is reduced by another bank in case of depression that results in the reduction of interest rate and money supply in the country increases.
Open Market Operations
When the central bank buying or selling government securities in the open market, as the exchange of values is called open market operation. If the Fed wants to reduce money supply in the country to sell government bonds to commercial banks and individuals. In this way the amount of cash to people and commercial banks is reduced because the commercial banks to reduce the number of loans as demand shrinks people’s goods and services. Likewise if the Fed wants to increase the supply of money going to buy government securities because the amount of cash commercial banks and increasing people.
Changes in the Reserve Ratio
Each member bank keeps a percentage of total deposit in the central bank is called cash reserve ratio. Central Bank uses a reserve ratio to increase or decrease the money supply in the country. For example, if the Fed wants to reduce the money supply increases the reserve ratio, because it leaves less amount of cash commercial banks to lend. Due to lower lending the money supply decreases along with the demand for goods and services that results in the control of inflation. Similarly central bank can increase the money supply by reducing reserve requirements.
Central Bank credit rationing used to set the maximum credit limit allowed for each and every one of the commercial banks. This means that the central bank sets the credit limit of each commercial bank and not give credit to them beyond that limit. Every time the Fed wants to decrease the money supply decreases the limit to which can give loans to member banks. Similarly central bank can increase the money supply to increase the credit limit.
Change in the Margin Requirement
Each commercial bank has to maintain a margin ever extending loans against security. This means that the loan amount is below the actual value of security. For example, the real security value is 100 and the loan amount is 85, therefore need margin is 15%. Central Bank may increase or decrease the money supply by changing the margin requirements. For example, if the Fed wants to reduce the supply of money can do so by increasing margin requirements. This amount decreases in loans.
Consumer Credit Regulation
Consumer credit facility refers to the act of selling consumer goods on credit to people. The method is used by the government or central bank to implement certain regulations on goods sold on credit. If the Fed wants to increase the supply of money can do so by adopting a lenient policy on credit for the purchase of consumer goods. Similarly, the central bank can reduce the supply of money by placing restrictions on consumer credit.
In some cases morally persuade the central bank and requests from commercial banks to indulge in this kind of economic activities which are against the interests of the country. Usually, advice and guidance to member banks to adopt a particular policy for loans and to refrain from giving themselves loans for speculative purposes.
Central Bank also publishes details of its policies and important information about assets and liabilities, credit and business, etc situation of commercial banks. This helps commercial banks, as well as the general public aware of the monetary needs of the country. Central Bank reveals some important information about commercial banks so that people know about the various activities of commercial banks and can be protected against any potential losses in the future.
Direct action is a last resort through which the central bank carries out direct action against the bank is not acting in accordance with central bank policy. In case of direct action that the central bank may impose fine and penalty and may refuse to give loans to commercial banks. Such a pressure keeps the commercial banks against lending activities not allowed.