Discuss the instruments of monetary policy also discussed how monetary policy can be used to control inflation.

Q. Discuss the instruments of monetary policy (Dec'13). How monetary policy can be used to control inflation?

The statutory liquidity requirement (SLR), as a monetary policy instrument, has experienced infrequent changes in Bangladesh. Past evidence shows that reduction in SLR produced positive impact on bank credit and investment especially prior to the 1990s. In recent times, changes in SLR and cash reserve requirement (CRR) helped to reduce inflation to some extent in some years. Since the 1990s, Bangladesh Bank has used open market operations (OMOs), more frequently rather than changes in the Bank Rate and SLR as instruments of monetary policy in line with its market oriented approach. In this context, it should be noted that lately Bangladesh depends mostly on the money market as the channel for monetary transmission rather than changes in reserve requirements. The CRR and SLR for scheduled banks are used only in situations of drastic imbalance resulting from major shocks. The effectiveness of SLR in bringing about desired outcomes, however, depends on appropriate adjustments of other indirect monetary policy instruments such as repo and reverse repo rates.

Repo Rate: The repo rate also known as Repurchase Agreement is the rate at which the banks borrow from the Central Bank. It becomes typical for the banks to borrow from the central bank if there is an increase in the repo rate. Generally used to control the amount of money in the market, repo rate is usally a short-term measure which is used for short-term loans.

Reverse Repo: The Federal Open Market Committee adds reserves to the banking system and withdraws them after a specified period of time. So, reverse repo drains reserves initially and adds them back later. Hence, it can be used as a tool for stabilizing interest rates with the Federal Reserve using it in the past to adjust the Federal funds rate to match the target rate.

Monetary policy can be used to control inflation: The primary job of the Central Bank is to control inflation while avoiding a recession. It does this with monetary policy. To control inflation, the Central Bank must use contractionary monetary policy to slow economic growth. If the GDP growth rate is more than the ideal of 2-3%, excess demand can generate inflation by driving up prices for too few goods.

The Central Bank can slow this growth by tightening the money supply, which is the total amount of credit allowed into the market. The Central Bank action reduces the liquidity in the financial system, making it becomes more expensive to get loans. This slows economic growth and demand, which puts downward pressure on prices.