Monetary policy is adopted, by the monetary authority or the central bank of a country to influence the supply of money and credit by changing interest rate structure and availability of credit. Various monetary measures to control inflation are explained below:
1. Increasing Bank Rate:
Bank rate is the rate at which the central bank lends money to the commercial banks. An increase in the bank rate leads to an increase in the interest rate charged by commercial banks which, in turn, discourages borrowing by businessmen and consumers. This will reduce money supply with public and thus control the inflationary pressure.
2. Sale of Government Securities:
By selling government securities in the open market, the central bank directly reduces the cash reserves of the commercial banks because the central bank must be paid from these cash reserves.
The fall in the cash reserves compels the banks to reduce their lending activities. This will reduce the money supply and hence the inflationary pressures in the economy.
3. Higher Reserve Ratio:
Another monetary measure to check inflation is to increase the minimum reserve ratio. An increase in the minimum reserve ratio means that the member banks are required to keep larger reserves with the central bank. This reduces the deposits of the banks and thus limits their power to create credit. Restrictions on credit expansion will control inflation.
4. Selective Credit Control:
The purpose of selective credit control measures is to influence specific type of credit while leaving other types of credit unaffected.
Such selective measures are particularly important for developing economies in which, on the one hand, there is an increasing need for credit expansion for growth purposes, and, on the other hand, there is also need for checking inflationary tendencies.
In such a situation, selective credit control measures can direct the flow of credit from unproductive and inflation-prone sectors towards the productive and growth oriented sectors. The main selective credit control measures to control inflation are:
(i) Consumer Credit Control:
This method is adopted during inflation to curb excessive spending by consumers. In advanced countries, most of the durable consumer goods, such as, radio, T.V., Fridge, etc.; are purchased by the consumers on installment credit.
During inflation, loan facilities for installment buying are reduced to minimum to check consumption spending.
This is done by (a) raising the initial payment, (b) covering the large number of goods, and (c) reducing the length of the payment period.
(ii) Higher Margin Requirements:
Margin requirement is the difference between the market value of the security and its maximum loan value. A bank does not advance loan equal to the market value of the security, but less.
For example, it may lend Rs. 600 against the security worth Rs.1000; thus the margin requirement in this case is 40%. During inflation, the margin requirement can be raised to reduce the loan one can get on a security.