Monetary Policy is the policy of the central bank of a country to regulate and control money supply and credit in the economy.
(i) Bank rate : Bank rate is the rate of interest charged by the central bank on loans given to the commercial banks. In a situation of excess demand leading to inflation, central bank raises bank rate. This raises cost of borrowing which discourages commercial banks to borrow from the central bank. Raising bank rate forces the commercial banks to raise their lending rate of interest to consumers and investors. Thus, makes credit costlier. As a result, demand for loans falls or vice-versa.
(ii) Open Market Operations: It refers to the sale and purchase of government securities and bonds in the open market by the central bank. Sale of securities by central bank brings flow of money to central bank from commercial banks thereby restricting their lending capacity. During inflation, central bank sells Government securities to commercial banks which lose equivalent amount of cash reserve thereby affecting their capacity to offer loans. This absorbs liquidity from the system. As a result, there is a fall in investment and aggregate demand. Thus, it is an effective measure to control credit.
(iii) Cash Reserve Ratio (CRR) : It is the ratio of bank deposits that a commercial bank must keep as reserve in cash with the central bank. It is compulsory for each commercial bank. When there is an inflationary situation, central bank raises the rate of CRR thereby making the banks to keep more cash reserve with RBI which curtails the lending capacity of commercial banks. Opposite takes place at the time of recursion. In this way, the central bank keeps control on the flow of money in an economy.