Monetary Policy is that policy which corrects the situations of excess and deficient demand by regulating interest rate and availability of credit in the economy. Interest rate is the cost of credit, The cost of credit is raised and availability of credit is reduced when excess demand is to be corrected. This is called Dear Money Policy. On the other hand, cost of credit is reduced and availability of credit is increased when deficient demand is to be corrected. This is called Cheap Money Policy.
Components of Monetary Policy :
(1) Repo Rate/ Bank Rate : Both Repo rate and bank rate are the rate at which the central bank lends money to the commercial bank. Repo rate which is used as a policy instrument to correct the situations of excess demand and deficient demand. to correct the situations of excess demand, repo rate is increased. As a follow-up action, the commercial banks raise the market rate of interest (the rate at which the commercial banks lend money to the consumers and the investors).
(2) Open Market Operations : It is the Policy that focuses on increasing and the decreasing the stock of liquidity (or cash balances) with the people, through sale and purchase of securities by the central bank. When cash balances need to be reduced (as during situations of excess demand), the central bank tries to sell securities.
(3) CRR (Cash Reserve Ratio) : It refers to the ratio between 'cash reserves of the commercial banks with the central bank' and their total deposits. Commercial banks are required to maintain minimum CRR, as fixed by the central bank from time to time.
(4) SLR (Statutory Liquidity Ratio) : SLR is the ratio between liquid assets and total deposits of the commercial banks. The commercial banks are required to maintain minimum SLR as fixed by the central bank from time to time.
(5) Margin Requirement : It refers to minimum down payment that the borrowers are required make as a percentage of their total borrowing from the commercial banks. Margin requirement is raised to correct situations of excess demand. Higher Margin requirement acts as a disincentive to borrow.
(6) Moral Suasion : It refers to moral pressure on the commercial banks by the central bank to follow its guidelines. Banks are advised to the liberal in lending during situations of deficients demand, and to be selective in lending during situations of excess demand.
(7) Credit Rationing : Credit rationing means distribution according to prescribed limits for different sectors of the economy. It is introduced to correct situations of excess demand when availability of credit needs to be restricted. Rationing of credit is an instrument of dear money policy. It is not required during situations of deficient demand when the banks are advised to pursue cheap money policy.