Broadly, instruments or techniques of monetary policy can be divided into two categories:
(A) Quantitative or General Methods.
(B) Qualitative or Selective Methods.
A. Quantitative or General Methods:
1. Bank Rate or Discount Rate:
Bank rate refers to that rate at which a central bank is ready to lend money to commercial banks or to discount bills of specified types.
Thus by changing the bank rate, the credit and further money supply can be affected. In other words, rise in bank rate increases rate of interest and fall in bank rate lowers rate of interest.
During the course of inflation, monetary authority raises the bank rate to curb inflation. Higher bank rate will check the expansion of credit of commercial banks. They will be left with less resources which would restrict the credit creating capacity of the bank. On the contrary, during depression, bank rate is lowered, business community will prefer to have more and more loans to pull the economy out of depression. Therefore, bank rate or discount rate can be used in both types of situation i.e. inflation and depression.
2. Open Market Operations:
By open market operations, we mean the sale or purchase of securities. As is known that the credit creating capacity of the commercial banks depend on the cash reserves of the banks. In this way, the monetary authority (Central Bank) controls the credit by affecting the base of the credit-creation by the commercial banks. If the credit is to be decreased in the country, the central bank begins to sell securities in the open market.
This will result to reduce money supply with the public as they will withdraw their money with the commercial banks to purchase the securities. The cash reserves will tend to diminish. This happens in the period of inflation. During depression when prices are falling, the central bank purchases securities resulting in expansion of credit and aggregate demand,
3. Variable Reserve Ratio:
The commercial banks have to keep given percentage as cash-reserve with the central bank. In lieu of that cash ratio, it allows commercial banks to contract or expand its credit facility. If the central bank wants to contract credit (during inflation period) it raises the cash reserve ratio.
As a result, commercial banks are left with less amount of deposits. Their favour to credit is curtailed. If there is depression in the economy, the reserve ratio is reduced to raise the credit creating capacity of commercial banks. Therefore, variable reserve ratio can be used to affect commercial banks to raise or reduce their credit creation capacity.
4. Change of Liquidity:
According to this method, every bank is required to keep a certain proportion of its deposits as cash with it. When the central bank wants to contract credit, it raises its liquidity ratio and vice versa.
B. Qualitative or Selective Methods:
1. Change in Marginal Requirements:
Under this method, the central bank effects a change in the marginal requirement to control and release funds. When the central bank feels that prices are rising on account of stock-piling of some commodities by the traders, then the central bank controls credit by raising the marginal requirements. (Marginal requirement is the difference between the market value of the assets and its maximum loan value). Let us suppose, a borrower pledged goods worth Rs. 1000 as security with a bank and gets a loan amounting to Rs. 800.
Thus marginal requirement is Rs. 200 or 20 percent. If this margin is raised, the borrower will have to pledge goods of greater value to secure loan of a given amount. This would reduce money supply and inflation would be curtailed. Similarly, in case of depression, central bank reduces margin requirement. This will in turn raise the credit creating capacity of the commercial banks. Therefore, margin requirement is a significant tool in the hands of central authority during inflation and depression.
2. Regulation of consumer credit:
During inflation, this method is followed to control excess spending of the consumers. Generally the hire purchase facilities or installment methods are used to reduce to the minimum to curb the expenditure on consumption. On the contrary, during depression period, more credit facilities are allowed so that consumer may spend more and more to pull the economy out of depression.
3. Direct Action:
This method is adopted when some commercial banks do not co-operate with the central bank in controlling the credit. Thus, central bank takes direct action against the defaulter. The central bank may take direct action in a number of ways as under.
(i) It may refuse rediscount facilities to those banks who are not following its directions.
(ii) It may follow similar policy with the bank seeking accommodation in excess of its capital and reserves.
(iii) It may change rates over and above the bank rate.
(iv) Any other strict restrictions on the defaulter institution.
4. Rationing of the credit:
Under this method, the central bank fixes a limit for the credit facilities to commercial banks. Being the lender of the last resort, central bank rations the available credit among the applicants.
Generally, rationing of credit is done by the following four ways.
(i) Central bank can refuse loan to any bank.
(ii) Central bank can reduce the amount of loans given to the banks.
(iii) Central bank can fix quota of the credit.
(iv) Central bank can determine the limit of the credit granted to a particular industry or trade.
5. Moral Persuasion or Advice:
In the recent years, the central bank has used moral suasion also as a tool of credit control. Moral suasion is a general term describing a variety of informal methods used by the central bank to persuade commercial banks to behave in a particular manner. Moral suasion takes the form of Directive and Publicity.
In-fact, moral persuasion is a sort of advice. There is no element of compulsion in it. The central bank focuses on the dangerous consequences of the credit expansion and seeks their co-operation. The effectiveness of this method depends on the prestige enjoyed by the central bank on the degree of co-operation extended by the commercial banks.
Publicity is also another qualitative technique. It means to force them to follow only that credit policy which is in the interest of the economy. The publicity generally takes the form of periodicals and journals. The banks are not kept informed about the type of monetary policy, the central bank regards goods for the economy. Therefore, the main aim of this method is to bring the banking community under the pressure of public opinion.