A. Describe the various instruments of monetary policy and how they are used. B.
ID: 1178417 • Letter: A
Question
A.
Describe the various instruments of monetary policy and how they are used.
B.
Through what channels does monetary policy affect the economy? That is, what are the monetary policy transmission mechanisms? List first them, then clearly describe two of these channels.
Describe the various instruments of monetary policy and how they are used. Through what channels does monetary policy affect the economy? That is, what are the monetary policy transmission mechanisms? List first them, then clearly describe two of these channels.Explanation / Answer
1) One principal instrument used, has been the Bank Rate or Discount Rate i.e., the rate at which RBI lends to the banking system. Through changes in it, the RBI affects the short-term interest rates in the money market, and through it the long-term rates, and through it the level of economic activity in the economy. It also influences the international capital movements: higher rates attract capital inflows and vice versa.
Another important instrument is the open market operations. These operations involve the sale or purchase of government securities. This influence the volume of cash reserves with commercial banks and thus influence the volume of loans and advances they can make to the industrial and commercial sectors. RBI had not used this weapon for many years.
Another device to influence money supply is the Cash Reserve Ratio (CRR). A higher ratio means that the amount of cash available for creating credit is reduced and vice-versa. RBI is empowered to vary the cash reserve requirement between 3 to 15 per cent of net demand and time liabilities to influence the. Volume of cash with the commercial banking system and thus influence their volume of credit.
In addition, the government imposed an obligation on the banks to use a proportion of cash to buy government securities known as Statutory Liquidity Ratio (SLR). This device has been used for long by the government to get bank funds against its securities carrying low rates of Interest.
2)a)
it remains to describe how policy influences the economy. This topic can usefully be divided up between the effects on economic activity, covered in this section, and the effects on inflation, covered in the final section.
In describing the processes by which monetary policy affects the economy, it should be kept in mind that they are far from being purely mechanical in their operation. Predictions about the effects of a policy action are, like economic forecasts generally, always subject to uncertainty. The task of policy is to make decisions on the basis of the best available information, recognising that these uncertainties exist.
b)The credit channel view posits that monetary policy adjustments that affect the short-term interest rate are amplified by endogenous changes in the external finance premium The external finance premium is a wedge reflecting the difference in the cost of capital internally available to firms (i.e. retaining earnings) versus firms' cost of raising capital externally via equity and debt markets. External financing is more expensive than internal financing and the external finance premium will exist so long as external financing is not fully collateralized. Fully collateralized financing implies that even under the worst case scenario the expected payoff of the project is at least sufficient to guarantee full loan repayment. In other words, full collateralization means that the firm who borrows for the project has enough internal funds relative to the size of the project that the lenders assume no risk. Contractionary monetary policy is thought to increase the size of the external finance premium, and subsequently, through the credit channel, reduce credit availability in the economy.
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