2.1.3 Instruments of monetary policy
The instruments or tools of monetary policy are of two types
Qualitative and Quantitative in nature.
Qualitative control includes change in margin requirements,
regulation of consumer credit, moral persuasion, publicity, direct action.
Quantitative control includes open market operations, the
reserve ratio, the discount rate, Foreign Exchange Interventions.
Monetary policy guides the Central bank's supply of money in
order to achieve the objectives of price stability (or low inflation rate),
full employment, and growth in aggregate income.
The instruments of monetary policy used by the Central bank
depend on the level of development of the economy, especially its financial
sector (Federal Reserve System and Monetary Policy, 1979).
The commonly used instruments are:
1. Reserve Requirement
The monetary authority exerts regulatory control over banks.
Monetary policy can be implemented by changing the proportion of total assets
that banks must hold in reserve with the central bank. Banks only
maintain a small portion of their assets as cash available for
immediate withdrawal; the rest is invested in illiquid assets like mortgages
and loans.
By changing the proportion of total assets to
be held as liquid cash, the Federal Reserve changes the availability
of loan able funds. This acts as a change in the money supply. Central
banks typically do not change the reserve requirements often
because it creates very volatile changes in the money supply
due to the lending multiplier.
2. Open Market Operations
The Central bank buys or sells ((on behalf of the Fiscal
Authorities (the Treasury)) securities to the banking and non-banking public
(that is in the open market).
One such security is Treasury Bills. When the Central bank
sells securities, it reduces the supply of reserves and when it buys (back)
securities-by redeeming them-it increases the supply of reserves to the Deposit
Money Banks, thus affecting the supply of money.
3. Lending by the Central bank
The Central bank sometimes provide credit to Deposit Money
Banks, thus affecting the level of reserves and hence the monetary base.
4. Interest Rate
The Central bank lends to financially sound Deposit Money
Banks at a most favorable rate of interest, called the minimum rediscount rate
(MRR). The MRR sets the floor for the interest rate regime in the money market
(the nominal anchor rate) and thereby affects the supply of credit, the supply
of savings (which affects the supply of reserves and monetary aggregate) and
the supply of investment (which affects full employment and GDP).
5. Direct Credit Control
The Central bank can direct Deposit Money Banks on the maximum
percentage or amount of loans (credit ceilings) to different economic sectors
or activities, interest rate caps, liquid asset ratio and issue credit
guarantee to preferred loans. In this way the available savings is allocated
and investment directed in particular directions.
6. Moral Suasion
The Central bank issues licenses or operating permit to
Deposit Money Banks and also regulates the operation of the banking system. It
can, from this advantage, persuade banks to follow certain paths such as credit
restraint or expansion, increased savings mobilization and promotion of exports
through financial support, which otherwise they may not do, on the basis of
their risk/return assessment.
7. Prudential Guidelines
The Central bank may in writing require the Deposit
Money Banks to exercise particular care in their operations in order that
specified outcomes are realized.
Key elements of prudential guidelines remove some discretion
from bank management and replace it with rules in decision making.
8. Exchange Rate
The balance of payments can be in deficit or in surplus and
each of these affect the monetary base, and hence the money supply in one
direction or the other. By selling or buying foreign exchange, the Central bank
ensures that the exchange rate is at levels that do not affect domestic money
supply in undesired direction, through the balance of payments and the real.
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