ECONOMIC POLICY

Economic policies

Economic policy refers to the actions that government takes in the economic field.

It covers the system for setting levels of taxation, government budgets, money supply and interest rates .

Most factors of economic policy can be divided either into fiscal policy or monetary policy.

Economic policies are…

Industrial policy 1991Monetary policy Recent EXIM policy 2002-2007Fiscal policy

Monetary policy

Monetary policy is an integral part of the overall economic policy of the govt. and in modern times it plays an important role in the analysis of the problems of economic stability and economic growth.

Monetary policy includes all those measures which affects the total volume and value of money in the economy.

Objectives

The nature and objectives of monetary policies in underdeveloped and developing countries like India are basically different from what they are in the developed countries.

The major problem of the developing countries is not economic stability but economic growth.

These countries suffers from low income level, low level of employment and low capital information.

Monetary policy in these countries therefore, has to work for raising the level of income and providing more employment.

The main objective of monetary policy , thus is to accelerate the rate of economic growth and to act as an agent of economic growth.

Maintaining stability in the domestic price level and stability in exchange rate are important pre-requisites for achieving maximum growth rate.

The major objectives of the monetary policies are :

1) to promote capital formation and provide finance for the economic development.

2) to regulate the bank credit 3) to encourage the monetisation in the economy

and to coordinate different sectors of the money market.

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4) to achieve growth with stability.5) to maintain equilibrium in the balance of

payments.

To promote capital formation and provide finance for economic development

A major objective of the monetary policy is to provide the needed finance for the rapidly growing sectors of the economic sectors of the economy.

Monetary policy has to be so geared as to meet the financial requirements of the developing segments of the economy.

This aspect of providing finance for economic development is known as the positive or “promotional role ” of the monetary policy.

To regulate the bank credit

Here the objective is to regulate the volume of bank credit in the economy in a manner that it does not result either overexpansion or undue contraction.

This implies effective control over the lending policies of the commercial banks.

This aspect of regulating bank credit is known as the regulatory role of monetary policy.

To encourage monestisation in the economy and to coordinate different sector of money market

the third objective of the monetary policy is to accelerate the process of monetisation of the economy because now it has come to be realized that the existence of the non-monestised sector is obstructive to rapid economic growth.

similarly , the existence of the unorganized sector is lacuna in the Indian money market because it reduces the effectiveness of monetary policy.

To achieve economic growth with stability

A developing economy like India is very easily exposed to the generation of inflationary pressures.

It has now come to be widely accepted that inflation is not conductive but obstructive to the process of economic growth.

The objective of the monetary policy therefore , should be to contain inflationary pressure and attain economic growth with stability.

To maintain equilibrium in the balance of payments

Developing countries generally face balance of payments difficulties at least in the initial stages of development because of high import bill and low growth rate of exports.

By using the direct method of exchange control

like bank rate , monetary policy can play important role in correcting the disequilibrium in the balance of payment.

Tools of monetary policy

Monetary policy in India is generally implemented by the central bank of the country.

As the regulations and control of currency is concerned , there is practically no difficulty because the central bank has the sole right to issue currency notes and therefore can regulate the same;

In order to regulate the volume of credit it uses:

(1) General method of credit control or quantitative method of credit control.

(2) Selective method of credit control or Qualitative method of credit control

General method of credit control

General method of credit control aims at influencing the total volume of credit in the economy without any regard to use for which it is put .

General method of credit control includes..

Bank Rate Policy

Open market operation

Variations in the Reserve

Ratio

Bank Rate Policy

Bank rate is the rate at which the central bank of the country is willing to discount first class bills of exchange and advance loans against approved securities to the commercial bank.

It is also known as “lending rate ” or “discount rate” of the central bank.

Bank rate affects both the cost and availability of the credit.

Modus operandi of the bank rate

If the commercial bank are pursuing an expansionist credit policy, which the central bank considers the harmful for the economy , then in such situation the central bank will raise its bank rate.

With an increase in bank rate commercial bank too will raise the lending rates , because they have to pay higher rate to borrow from the central bank. Besides other interest rates in the market will also go up.

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This will naturally lead to rise in the cost of bank credit leading ultimately to reduced borrowing from the side of trade , commerce and industry.

Thus a rise in the cost borrowing will result in contraction of credit.

Conditions for the success of Bank Rate Policy

The following are the main conditions for the successful operations of bank rate policy :

(1) There should be a close relationship between bank rates and rates of interest prevailing in the money market.

(2) The structure of economy must be elastic enough so that any change in bank rate must lead changes in the structure of wages , prices and costs.

(3) The country should have a well developed and well organised money market.

Bank Rate Policy In India

The bank rate policy has been defined in section 49 of the Reserve Bank of India Act 1934 , as ,

“the standard rate at which it is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under this act.”

It may be mentioned that the reserve bank as a part of its monetary policy to control credit has been making use of bank rate , repo rate and reverse repo rate policy.

REPO (repurchase ) rate is the rate at which the RBI lends short term money to the bank against securities.(current 6.5%)

Reverse repo rate is the rate at which the RBI borrows from banks.(current 6%)

At 1935 BOD had fixed bank rate as 3.5%

Since then till this day , the reserve bank has changed the bank rate 30 times of which 17 occasions it has been raised the bank rate while on 13 occasions it has been reduced the bank rate.

The last change in the bank rate was made in April,2012 when it was fixed as 9.0% and since then till July 2012 the bank rate has been maintained @ 9.0% level.( current bank rate is 7% 29/9/2015)

ANTI-INFLATIONARY MEANS ANY POLICY A CENTRAL BANK OR OTHER AGENCY TAKES TO REDUCE INFLATION RATE.

Bank rate policy in India has been used by and large , as integral part of anti-inflationary policy and it is also mentioned that changes made in bank rate were less frequent.

Anti inflationary includes thing like to cut down money supply , price control raising interest rate

Evaluation Of Bank Rate Policy

(1) the efficacy of the bank rate as a policy of instrument depends essentially upon the commercial bank dependence on the reserve bank for funds and influence it wields on other interest rate.

(2) There is virtual absence of a well organised and well -coordinated money market in the country . The Indian Money Market has been characterised by its dichotomy into modern banking system and the indigenous banking system.

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(3) the non-availability of eligible short terms assets for rediscount in adequate quantity makes the bank less effective.

(4) the predominance of the currency over credit and the habit of keeping surplus cash reserve over and above the minimum legal requirements by the commercial banks also reduce the need for seeking financial accommodation from the reserve bank.

(5) in the context of inflationary situation , when profit expectations are high , a rise in the bank rate and consequent rise in the interest rates hardly act as a deterrent for the businessmen. It has been said that borrowings during times of inflation are interest inelastic.

Repo rate and reverse repo rate

Apart from bank rate the RBI is using repo rate and reverse repo rate as instrument to regulate the money supply in the economy and thereby maintain monetary stability.

REPO (repurchase ) rate is the rate at which the RBI lends short term money to the bank for short period. (current 6.5%)

The repo rate which was 5% prior to April 2010 was progressively increased to 8.50% in October 2011.

This was done to control inflationary pressure in the economy .

Then it reduced to 8% in April 2012 and since July 2012 it was maintained at the level of 8%. Then it reduced to 7.25% since June 2015 and currently its 6.50%.

Reverse repo rate is the rate at which the RBI borrows from banks. It is the bench- mark in the money market.

April 2010 it was 3.5% raised to 7.50% in October 2011 and then to 8% then it reduced to 7% in 2012 and currently it is 6%.

(B) Open Market Operation

To regulate the flow of money in the economy , another tool is open market operation.

Here RBI regulates the flow of money by purchasing and selling the securities.

In inflationary situation RBI issues securities that will be purchased by people or financial institutions that again reduces the money supply in the economy.

The same as with in deflation RBI purchases the securities from open market it again increases money supply in the economy . Thus RBI raises economic stability.

Cash Reserve Ration

Every commercial banks requires to keep certain amount of cash reserve with them as decided by the RBI.

Change in CRR also changes credit creation capacity of commercial banks.

CRR and credit creation capacity are having inverse relationship.

In the case of inflation RBI increases the % of CRR.

It means commercial banks are required to keep more amount as a cash reserve. It reduces the credit creation capacity of commercial banks. That again reduces the flow of cash in the economy.

On the other hand , RBI reduces the % of CRR that again increases the credit creation capacity of the commercial banks and the flow of cash in the economy that raises the economic stability.

Qualitative Credit Control Tools

When RBI wants to regulate the flow of cash of selected areas or field , RBI uses qualitative or the selective credit control tools.

(A) MARGIN REQUIREMENT : generally commercial

banks provides financial resources against securities. But commercial banks do not provide the financial resources equals to market value of the securities.

But commercial banks provide financial resources of certain % of securities by keeping certain % of

margin to be on the safe side. In case of inflation RBI increases margin requirements and decreases in the situation of deflation.

(B) Regulation of consumer credit: generally commercial

bank provides financial resources for different purposes in the form of consumer credit.

In case of inflation commercial banks cut off the finance provided for the different purposes and may extend the limit in the case of deflation.