Monetary Policy

Regulating money supply in the economy in order to promote growth and ensure price stability is monetary policy. Monetary policy is the responsibility of Central Bank (RBI in India).

Central and Commercial Bank

Commercial Bank accepts deposit and lends a part of it to make profit. Central Bank controls commercial banks, issues currency notes, controls credit and money supply, acts as banker to the government and manages foreign exchange position of the country.

Control of money supply

Without adequate money supply, an economy cannot function But too much money causes price instability and inflation. So fine tuning money supply is an important task. Central Bank is to do this regulating act.

What is money
Money is the abode of purchasing power Its main characteristic is universal acceptability as a medium of exchange. Currency has this feature. Cheques drawn on demand deposits of commercial banks also have this feature. So money is currency + demand deposit.

Creation of money supply

When part of demand deposit is lent, more purchasing power is created. Demand depositor can buy with cheque and agent who borrows part of demand deposit can also buy. So lending actually creates money i.e. purchasing power. This is called credit creation.

Credit control
As more credit means more money, Central Bank may have to reduce credit during inflation. Similarly during recession central bank has to increase credit. Central Bank does this by controlling the lendable fund in the hands of commercial banks.

Credit creation
We know that banks have to maintain a reserve ratio, fixed by central bank. This leads to a multiplied credit creation. Suppose A bank gets INR 1000 from central bank through open market purchase. Assume reserve ratio is 10%. Then A Bank lends 900. This money is deposited to bank B, which lends INR 810. Now purchasing power in the economy is 900 + 810 = 1710

Credit Creation
This process now goes on, as follows. 1000+900+810+729.. Purchasing power increases because the initial depositor holds his purchasing power but who gets the loan out of this deposit also can buy with the loan. If the above series goes on indefinitely we get Initial deposit (1000)X (1/CR)=INR 10000

Money Supply Function

M=C+D M = Money, C = Currency and D = Demand Deposit. R = bD R = Reserve, b = R/ D = Reserve Ratio. C = kD, k = Currency deposit ratio. M = kD + D = (1+k)D R + C = bD +kD = (b +k)D M =[(1+k)/(b+k)](R+C) = mH

Money Supply Function

M =[(1+k)/(b+k)](R+C) = mH H = High power money or monetary base M = Money multiplier. Money multiplier falls if k or b rises. That is, money multiplier falls if people hold more currency or commercial banks maintain more reserves.

Need for control of money supply

The above result shows that a money multiplier operates in the economy. So if price rises at a high rate on account of excess money supply, central bank will curtail the loan giving power of the commercial banks. This will adversely affect the banks profitability.