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Monetary policy


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  • 1. Monetary Policy RBI and Monetary Policy in India
  • 2. Monetary Magnitudes
    • M 1 = Currency with public+
    • Demand deposits with banks+ Other Deposits with RBI
    • M 2 = M 1 + Post Office Deposits
    • M 3 = M 1 + Time Deposits with Banks
    • M 4 = M 3 + Total Post Office Deposits
  • 3. Growth of M 3 and Differential Contribution of Components
    • Source: RBI-Macroeconomic and Monetary Developments: Third Quarter Review 2005-06
  • 4. What is Monetary Policy?
    • The term monetary policy refers to actions taken by central banks to affect monetary magnitudes or other financial conditions.
    • Monetary Policy operates on monetary magnitudes or variables such as money supply, interest rates and availability of credit.
    • Monetary Policy ultimately operates through its influence on expenditure flows in the economy.
    • In other words affects liquidity and by affecting liquidity, and thus credit, it affects total demand in the economy.
  • 5. Credit Policy
    • Central Bank may directly affect the money supply to control its growth.
    • Or it might act indirectly to affect cost and availability of credit in the economy.
    • In modern times the bulk of money in developed economies consists of bank deposits rather than currencies and coins.
    • So central banks today guide monetary developments with instruments that control over deposit creation and influence general financial conditions.
    • Credit policy is concerned with changes in the supply of credit.
    • Central Bank administers both the Credit and Monetary policy
  • 6. Aims of Monetary policy
    • MP is a part of general economic policy of the govt.
    • Thus MP contributes to the achievement of the goals of economic policy.
    • Objective of MP may be:
    • Full employment
    • Stable exchange rate
    • Healthy BoP
    • Economic growth
    • Reasonable Price Stability
    • Greater equality in distribution of income & wealth
    • Financial stability
  • 7. Price Stability: The Dominant Objective
    • There is convergence of views in developed and developing economies, that price stability is the dominant objective of monetary policy.
    • Price stability does not mean complete year-to-year price stability which is difficult to attain.
    • Price stability refers to the long run average stability of prices.
    • Price stability involves avoidance of both inflationary and deflationary pressures.
  • 8.
    • Price Stability contributes improvements in the standard of living of people.
    • It promotes saving in the economy while discouraging unproductive investment.
    • Stable prices enable exports to compete in international markets and contribute to the strengthening of BoP.
    • Price stability leads to interest rate stability, and exchange rate stability (via export import stability).
    • It contributes to the overall financial stability of the economy.
  • 9. Operation of Monetary Policy
    • Instruments
    • Discount Rate
    • (Bank Rate)
    • 2.Reserve Ratios
    • 3. Open Market
    • Operations
    • Operating
    • Target
    • Monetary Base
    • Bank Credit
    • Interest Rates
    • Intermediate
    • Target
    • Monetary
    • Aggregates(M3)
    • Long term
    • interest rates
    • Ultimate
    • Goals
    • Total Spending
    • Price Stability
    • Etc.
  • 10. Instruments of Monetary Policy
    • Variations in Reserve Ratios
    • Discount Rate (Bank Rate)
    • (also called rediscount rate)
    • Open Market Operations (OMOs)
    • Other Instruments
  • 11. Variations in Reserve Ratios
    • Banks are required to maintain a certain percentage of their deposits in the form of reserves or balances with the RBI
    • It is called Cash Reserve Ratio or CRR
    • Since reserves are high-powered money or base money, by varying CRR, RBI can reduce or add to the bank’s required reserves and thus affect bank’s ability to lend.
  • 12. Discount Rate (Bank Rate)
    • Discount rate is the rate of interest charged by the central bank for providing funds or loans to the banking system.
    • Funds are provided either through lending directly or rediscounting or buying commercial bills and treasury bills.
    • Raising Bank Rate raises cost of borrowing by commercial banks, causing reduction in credit volume to the banks, and decline in money supply.
    • Variation in Bank Rate has an effect on the domestic interest rate, especially the short term rates.
    • Market regards the increase in Bank rate as the official signal for beginning of a tight money situation.
  • 13. Open Market Operations (OMOs)
    • OMOs involve buying (outright or temporary) and selling of govt securities by the central bank, from or to the public and banks.
    • RBI when purchases securities, pays the amount of money by crediting the reserve deposit account of the seller’s bank, which in turn credits the seller’s deposit account in that bank.
  • 14.
    • Monetary policy also known as Money and Credit Policy:
    • It concerns itself with the supply of money as also credit to economy
    • Till 1998-99:It was announced twice in a year:Oct….for Oct..March….to coincide with busy season
    • April…for April to Sept…to coincide with lean season of agri.With decline in agri. And rise in industrial credit since 1999-2000 in April RBI makes an annual policy statement and a review in Oct.
  • 15.
    • Since 1951 and till 1990s….
    • Two sets of objectives pursued…
    • a)controlled expansion of money
    • b)sectoral deployment of funds
    • Done keeping in mind plan priorities
    • Special attention…
    • Core industries (coal, iron, steel and engg.)
    • foodgrains (rice, wheat etc.)
    • priority sectors ( agri., SSI)
    • weaker sections of population
  • 16. In general, the interaction between monetary and fiscal policy occurs To control inflationary or deflationary impact of fiscal policy For instance, a substantial multi-year rise in the deficit need not cause an increase in inflation was demonstrated in USA: Between 1979-85……budget deficit rose from 2.7% of GDP to 5.1% of GDP……national debt rose from 26% of GDP to 36% of GDP
    • However, GDP price inflation fell from 8.2 % to 3.2%
    • This due to a tough anti-inflationary monetary policy pursued by the Federal Reserve.
  • 17.
    • In India, for instance, In 90s…
    • growth of economy remain primary aim
    • control of inflation urgent concern
    • (91….double digit….17%)
    • 8th (92-97)…aimed at achieving trend rate of inflation 5%
    • MP of 90s favored…process of stabilization and structural adjustment initiated in 91
  • 18.
    • Various measures used by RBI include:
    • Rate of interest (or price of money)
    • Quantity or supply of money
    • Access to or demand for money
    • One imp. Instrument is bank rate or discount rate..
    • Rate at which RBI lends to the banking system…
    • Through it: short term interest
    • long term rates
    • level of economic activity
    • international capital inflows
    • Second imp. Instrument is sale or purchase of govt. securities
    • (by sale of securities banks’ resources reduce and vice versa
  • 19.
    • Third imp. Instrument…
    • Cash Reserve Ratio: Banks’ Cash Holding/Total Deposit Liabilities
    • Fourth Imp. Instrument is Statutory Liquidity Ratio(SLR)…
    • RBI imposes an obligation on banks to buy govt. Securties (of
    • Low interest rates)(25% at present)
    • To achieve the objective of sectoral deployment of credit..
    • Direct (Quantity)…
    • Reserve ratios
    • Quantitative controls on RBI lending to banks and commercial sector
    • Quantitative credit controls
    • Indirect Instruments… administrative setting of various interest rates:
    • e.g. RBI lending
    • commercial bank lending
    • deposits
  • 20.
    • In 1960s .. Emphasis was on indirect measures with little variation
    • in reserve ratios
    • In1970s… Emphasis shifted to direct approaches and persisted since then
    • Shift from indirect to direct measures was prevalent more
    • due to rising deficit or inflation
    • Monetary instrument in India, both direct and indirect, operate
    • Through administrative controls or fiat
    • The crisis like droughts, oil crisis in 1966,1969, 1973 were dealt with effectively by cutting down domestic credit
  • 21.
    • One of the main problem area in the monetary policy
    • lie with the Exogenous element in reserve money.
    • Reserve money comprise of:
    • Increased RBI lending to govt. (relates to fiscal deficit)
    • Increased RBI lending to commercial banks
    • Growth of net foreign exchange of RBI
    • RBI can control only b) by prescribing high SLR
    • Monetary control has been reasonably successful
    • in spite of rising Fiscal deficit because of aggressive use of the reserve ratios
    • In a sense reserve ratios have not been genuinely
    • monetary policy Instrument but rather acted as fiscal
    • policy instrument