Instruments of Monetary Policy

These include the tools or approaches which the monetary authorities can use to seek to achieve the objective of monetary policy. Instruments of monetary policy are classified into two:

  • Quantitative instruments
  • Qualitative instruments


The quantitative instruments which are usually impartial and impersonal operate mainly by influencing the cost, volume, and availability of reserves and hence the supply of credit.

Their effects are of general nature and so, cannot be used effectively to regulate the use of credit in a particular sector of the credit market. The quantitative instruments are hereunder discussed:

Open Market Operations (OMO):

These involve the sale or purchase of government securities in the money market to curtail or expand respectively, the quantity of money available in the economy.

The monetary authorities sell securities to reduce bank reserves and increase money supply.

When they purchase the securities the reverse becomes the case. But it should be noted that the extent to which this instrument is effective, is a function of the level of development and operation of the financial market.

Bank/ Discount/Rediscount Rate:

This is the rate at which the central Banks of Nigeria discount “First Class” or “Bank” bills. This is also said to be the rate of interest which the Central Bank of Nigeria, being the lender of the last, resort, charge the commercial banks on loans extended to them.

When the Central Bank wants to increase liquidity and investment in the economy, it reduces the bank rate.

This consequently, leads to a reduction in commercial banks interest on loans; thereby making borrowing more attractive and as such, expansion in liquidity and investment.

And to reduce liquidity and investment, the central bank raises the bank rate. Borrowing becomes less attractive; hence low liquidity, low level of investment and reduced aggregate demand.

It is noteworthy to say that in the developing countries, many commercial banks experience excess liquidity and this hinders the growth of rediscounting of bills.

 Under such circumstances even if the bank rate is raised to squeeze the credit market, the commercial banks may not be obliged to raise their interest rates and neither the cost nor the availability of credit will be affected.

Also, it may be pointed out that rediscounting is not a regular feature of the central banks in the developing countries like Nigeria.

Reserve Requirements/Required Reserve Ratios:

The commercial banks by this policy are required, legally as in statutory cash reserve ratio, to keep a certain reserve amount usually expressed as a percentage of their total deposits with the central bank.

The ratio can be increased or decreased in line with the desired economic objectives. Increasing the ratio is contractionary and decreasing it is expansionary.

The reserve requirements can take any of the following forms: statutory cash reserve ratio, liquidity ratio and cash reserve requirements.

  • Statutory Cash Reserve Ratio

By this the commercial banks are legally required to maintain a specified cash reserve ratio with the central bank. The ratio can be increased or decreased depending on the economic objectives – whether contractionary or expansionary.

  • Liquidity Ratio

This is the ratio or proportion of all the liquid assets of a commercial bank which is required to keep with the central bank. Such liquid assets may include cash, bills and government securities. This ratio can be varying rather than fixed.

  • Variable Cash Reserve Ratio

This refers to the varying cash reserves or balances held by banks with the central banks. Such deposits are often a certain proportion of the banks deposit liabilities.

The use of variable reserve ratio by the central bank of the developing countries is popular on the following ground.

First, the effects of the instrument are more drastic and immediate than those of the open market operations and the rediscount rate, without adverse repercussions on the prices of government securities.

Here the central bank raises the reverse ratios of the commercial banks to enforce a tight money policy.

Secondly, in a situation of excess liquidity in the commercial banks, a rise in the bank rate or an increase in the sales of securities may not be enough to mop up the excess liquidity.

So it is necessary to use a more direct weapon like variable reserve ratio.

However, it has been suggested that the effects of variable reserve ratio are discriminatory. This is because a change in the reserve ratio by the central bank will influence the credit-creating capacity of the commercial banks.

But the non-bank financial intermediaries will not be affected as they do not maintain any deposit with the central banks.

Also, while some commercial banks may be enjoying excess liquidity others may not. Obviously those which do not maintain excess liquidity will be more affected than those that did.

Special Deposits:

 By this instrument the commercial banks are required to hold, over and above the legal minimum cash reserves, a specified percentage of their deposits in government securities. The main aim is to regulate bank lending.


The qualitative instruments or selective control instruments are those monetary tools which seek primarily to regulate the demand for credit for specific uses.

That is to say that they influence the volume and direction of credit into those sectors of the economy which necessitate economic development. They include moral suasion and selective credit control.

Moral Suasion:

This is a method whereby the central bank appeals to the conscience of the commercial banks, requesting them to behave in a particular manner for the attainment of identified general objectives.

The central bank may let the banks to see the need for an expansionary or contractionary credit measure.

Moral suasion is supposed to work voluntarily but sometimes the fear of the central bank’s might and authority compels the bank to comply. This is because a total refusal may attract the wrath of the authorities.

Selective Credit Control:

These are monetary policy mechanism whereby the central bank gives direct instruction to the banks on the cost and volume of credit to specified sectors of the economy depending on their assumed importance. The control includes:

  • Credit Ceiling
  • Sectorial Allocation of Credit
  • Differential Discount Rates

Credit Ceiling:

By this approach the percentage of credit from total deposit liabilities is pegged for the lending banks.

Sectorial Allocation of Credit:

This means extension of more or all credits to favoured sector of the economy at a particular point in time. This is a form of credit rationing or sectorial credit discrimination.

Differential Discount Rates:

Differential discount rates can be used in a selective way. The central bank can charge a rate lower or higher than the bank rate to encourage or discourage expansion of sectors, branches or specific types or form of activities.

The central bank can apply different types of eligibility rules for rediscounting different types of bills.

For example, the central bank may wish to favour the growth of export and therefore, will apply lenient eligibility criteria for rediscounting the bills which would make credit available to the export sector.

Also, in countries where hoarding of essential goods, to create scarcity and reap large profits is rampant, the central bank in order to discourage such a situation; can charge a higher than the standard rate for rediscounting bills created against inventory holdings.

It must however, be maintained that selective credit control can only be successful if it is used as an integral part of a “package deal” programme of the central bank.

The experience of the use of selective credit controls in many developing countries has so far suggested that its isolated use is unlikely to achieve much. 

But as a mechanism for the allocation of credit to the priority sectors, its use has gained some remarkable success.

Suggested Posts:

Leave a Comment

Your email address will not be published. Required fields are marked *