Quantitative instruments of monetary policy

Quantitative Instruments of Monetary Policy

What do you mean by monetary policy?

Table of Contents

Monetary policy is the process by which the monetary authority of a country, like the central bank or currency board, controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.

The central bank uses several instruments of monetary policy, referred to as monetary variables at its discretion, to regulate the credit availability and liquidity (money supply) in a manner that controls inflation and at the same time stimulates the growth of the economy. The instruments of monetary policy are also called as “weapons of monetary policy”.

Central banks use monetary policy to determine how much money they will create in order to achieve price stability (or low inflation), full employment, and economic growth. A change in demand for money relative to supply requires a spending adjustment as money is a medium of exchange. In order to achieve the goals it does not control, some of the variables that the Central Bank controls are adjusted, such as the monetary aggregate, interest rate, or exchange rate. Depending on the economy, especially its financial sector, the Central Bank uses different monetary policy instruments.

Quantitative Instruments are also known as General Tools of Monetary Policy. This type of instrument relates to the Quantity or Volume of money. They are also known as General Tools for credit control or Quantitative Tools of credit control. Their purpose is to regulate or control the overall level of bank credit in the economy. The indirect nature of these tools makes them useful for influencing the quantity of credit in the country. Increasing the Statutory Liquidity Rate (SLR) will decrease liquidity, and reducing it will increase it.

The following are the important Quantitative instruments of monetary policy.

What are the qualitative instruments of monetary policy?

Quantitative instruments of monetary policy focuses on:

a) Bank Rate Policy(BRP)

The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at which the central bank (i.e RBI) rediscounts bills and prepares of commercial banks or provides advance to commercial banks against approved securities.

The Bank Rate affects the actual availability and the cost of the credit. Any change in the bank rate necessarily brings out a resultant change in the cost of credit available to commercial banks.

The efficiency of the bank rate as a tool of monetary policy depends on the existing banking network, interest elasticity of investment demand, size and strength of the money market, international flow of funds, etc.

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With reference to Trade-Related Investment Measures (TRIMS), which of the following statements is/are correct?

(1) Quantitative restrictions on imports by foreign investors are prohibited.
(2) They apply to investment measures related to trade in both goods and services.
(3) They are not concerned with the regulation of foreign investment.

Select the correct answer using the code given below:

(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3

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The correct answer for the given question is Option (c) 1 and 3 only.

Answer Explanation

Foreign investors are prohibited from importing goods via trade-related investment measures. As a result, statement 1 is correct. TRIMs require members to report their existing tariffs that are in violation of the agreement to WTO Council for Trade in Goods. TRIMs allow international firms to operate more easily within foreign markets by restricting the preference for domestic firms. The Federal Emergency Management Agency and the Department of Industrial Policy and Promotion (DIPP) manage foreign investment as such. Therefore, statement 3 holds true.

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The money multiplier in an economy increases with which one of the following?

(a) Increase in the Cash Reserve Ratio in the banks.
(b) Increase in the Statutory Liquidity Ratio in the banks
(c) Increase in the banking habit of the people
(d) Increase in the population of the country

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The correct answer for the given question is Option (c) Increase in the banking habit of the people.

Answer Explanation

The money multiplier in an economy can be increased by increasing people’s banking habits. The bank can lend the money it receives from a short-term deposit account to someone else minus the reserve requirement. Ownership of money remains with the depositor, but the money generated through loans is based on that money. Even though the new amount is not backed by physical currency, its value increases when a second borrower deposits funds received from the lending institution. The increase in the Cash Reserve Ratio in banks, the increase in the Statutory Liquidity Ratio in banks, and an increase in the population will not result in an increase in the money multiplier.

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b) Open Market Operation(OMO)

Open market operation is the most important instrument of monetary policy. It refers to purchase or sale of government securities, short term as well as long term, at the initiative of the central bank, as deliberate credit policy. These Bonds and securities are purchased or sold from or to the commercial banks and the general public in the country.

The OMO is used to wipe out a shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc.

c) Change in Reserve Ratio

The commercial banks are required to keep a limited percentage of their deposits by law with the central bank. The central bank charges the ratio according to the need of controlling the credit. When prices are rising and there is a need to control them, the central bank sells securities.

The reserves of commercial banks are reduced and they are not in a position to lend more to the business community.

d) Credit Rationing

This instrument of monetary policy is applied only in times of financial crises. The bank can collect by re-discounting bill of exchange when credit is rationed by fixing the amount. This method of controlling credit can be justified only as a measure to meet exceptional emergencies because it is open to serious abuses.

There can be a danger, the rationing may not be satisfactory and the central bank may abuse the power by giving preferential treatment to favorite customers.

Management Notes

Quantitative Instruments of Monetary Policy – 4 Key Instruments | Macroeconomics