A Report on Monetary Policies & its transmission mechanism
Under the guidance of
Prof. (Dr.) A.K.Mishra
Dean SW, Faculty F...
Executive Summary
Due to the down turn in the economy worldwide and in India. It is imperative to
study and understand the...
Monetary policy is a process by which monetary authority of the country, usually
the Central Bank controls the supply of m...
money in the organization.
Promotion of Exports and Food Procurement Operations: Monetary policy pays
special attention in...
maintain Price Stability, Stable exchange rate, Healthy Balance of
Payment,Financial Stability, Economic Growth, Stable Ex...
buying money market instruments like commercial bills and treasury bills. Increase
in Bank Rate increases the cost of borr...
borrowing and lending of the banks which will discourage the public to borrow
money and will encourage them to deposit. As...
Official Interest Rate
Expectations Money Market Rates
Money, Credit Exchange ratesAsset Prices Bank Rates
Supply and dema...
Issues in Monetary Transmission
For monetary policy to be effective, it is, therefore, essential to have a broad
understan...
where,M=money,r=real interest rate, I=real investment, and Y=real output
By extending the traditional interest rate channe...
The Monetary Policy Instruments
Standing Facilities Open Market Operations Reserve Requirements
Deposit
facility
Marginal
...
Monetary Policy aims to
 Preserve the functioning of the transmission mechanism
 Be forward looking and pre-emptive
 Fo...
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Report on Monetary Policies & its transmission mechanism

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Monetary Policies & its transmission mechanism

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Report on Monetary Policies & its transmission mechanism

  1. 1. A Report on Monetary Policies & its transmission mechanism Under the guidance of Prof. (Dr.) A.K.Mishra Dean SW, Faculty FMS IMIS,Bubaneswar as a part of academic project of Institute of Management and Information Science, Bhubaneswar PGDM (MKTG),Term-III for the core paper Financial Market & Services(FMS C-304) by Gopal Kumar(13DM041) Anurag Guha(13DM040) Utsho Chowdhary(13DM039) Pritish k.Biswal(13DM037)
  2. 2. Executive Summary Due to the down turn in the economy worldwide and in India. It is imperative to study and understand the monetary technicalities. The optimism about Indian economic growth portends well for Indian banks. There are however, challenges in retaining profitability and growth in the next decade. It basically identifies two critical and complex challenges thrown at the economy 1.Monetary policy 2.It's Transmission mechanism This report highlights major facets of monetary policy and the transmission mechanism and articulates suggestive measures for potential success. Table of contents Monetary Policy: Definition & Objective Monetary operations Monetary Transmission Mechanism: Diagram Issues in monetary transmission Monetary transmission channels Conclusion: Key characteristics of a successful monetary policy References Monetary Policy
  3. 3. Monetary policy is a process by which monetary authority of the country, usually the Central Bank controls the supply of money in the economy by exercising its control over interest rates to maintain price stability and achieve high economic growth. In India RBI(Reserve Bank of India) is the central monetary authority. Other Objectives of the monetary policy as stated by RBI are: Price Stability: It implies promoting economic development with considerable emphasis on price stability. The centre of focus is to facilitate the environment which is favourable to the architecture that enables the developmental projects to run swiftly while also maintaining reasonable price stability. Prevailing rates are as follows Rates Prevailing Rate Expected GDP 4.7% 4.9% CPI 6.73% 6.0% WPI 5.8% 5.7% Inflation 9.30% 8.30% Controlled expansion of Bank Credit:One of the important functions of RBI is the controlled expansion of bank credit and money supply with special attention to seasonal requirement for credit without affecting the output. Promotion of Fixed Investment:Goal here is to increase the productivity of investment by restraining non essential fixed investment. Restriction of Inventories: Overfilling of stocks and products becoming out dated due to excess of stock often results is sickness of the unit. To avoid this problem the central monetary authority carries out this essential function of restricting the inventories. The main objective of this policy is to avoid over-stocking and idle
  4. 4. money in the organization. Promotion of Exports and Food Procurement Operations: Monetary policy pays special attention in order to boost exports and facilitate the trade. It is an independent objective of monetary policy. Desired Distribution of Credit: Monetary authority has control over the decisions regarding the allocation of credit to priority sector and small borrowers. This policy decides over the specified percentage of credit that is to be allocated to priority sector and small borrowers. Equitable Distribution of Credit: The policy of Reserve Bank aims equitable distribution to all sectors of the economy and all social and economic class of people. To Promote Efficiency: It is another essential aspect where the central banks pay a lot of attention. It tries to increase the efficiency in the financial system and tries to incorporate structural changes such as deregulating interest rates, ease operational constraints in the credit delivery system, to introduce new money market instruments etc. Reducing the rigidity: RBI tries to bring about the flexibilities in the operations which provide a considerable autonomy. It encourages more competitive environment and diversification. It maintains its control over financial system whenever and wherever necessary to maintain the discipline and prudence in operations of the financial system. Monetary Operations Monetary operations involve monetary techniques which operate on monetary magnitudes such as money supply, interest rates and availability of credit aimed to
  5. 5. maintain Price Stability, Stable exchange rate, Healthy Balance of Payment,Financial Stability, Economic Growth, Stable Exchange Rate.RBI monitors and regulates the monetary policy of the country stabilizes the price by controlling inflation. Open Market Operations:An open market operation is an instrument of monetary policy which involves buying or selling of government securities from or to the public and banks. This mechanism influences the reserve position of the banks, yield on government securities and cost of bank credit. The RBI sells government securities to contract the flow of credit and buys government securities to increase credit flow. Open market operation makes bank rate policy effective and maintains stability in government securities market. Cash Reserve Ratio:Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep with RBI in the form of reserves or balances .Higher the CRR with the RBI lower will be the liquidity in the system and viceversa.RBI is empowered to vary CRR between 15 per cent and 3 per cent. But as per the suggestion by the Narshimam committee Report the CRR was reduced from 15% in the 1990 to 5 per cent in 2002. As of October 2013, the CRR is 4%. Statutory Liquidity Ratio:Every financial institution has to maintain a certain quantity of liquid assets with themselves at any point of time of their Net time and demand liabilities(NDTL). These assets can be cash, precious metals, approved securities like bonds etc. The ratio of the liquid assets to time and demand liabilities(NDTL) is termed as the Statutory liquidity ratio. There was a reduction of SLR from 38.5% to 25% because of the suggestion by Narshimam Committee. The current SLR is 23%. Bank Rate Policy:The bank rate, also known as the discount rate, is the rate of interest charged by the RBI for providing funds or loans to the banking system. This banking system involves commercial and co-operative banks, Industrial Development Bank of India, IFC, EXIM Bank, and other approved financial institutes. Funds are provided either through lending directly or rediscounting or
  6. 6. buying money market instruments like commercial bills and treasury bills. Increase in Bank Rate increases the cost of borrowing by commercial banks which results into the reduction in credit volume to the banks and hence declines the supply of money. Increase in the bank rate is the symbol of tightening of RBI monetary policy. Prevailing Bank Rate is 9%. Credit Ceiling:In this operation RBI issues prior information or direction that loans to the commercial banks will be given up to a certain limit. In this case commercial bank will be tight in advancing loans to the public. They will allocate loans to limited sectors. Few example of ceiling are agriculture sector advances, priority sector lending. Credit Authorization Scheme:Credit Authorization Scheme was introduced in November, 1965 when P C Bhattacharya was the chairman of RBI. Under this instrument of credit regulation RBI as per the guideline authorizes the banks to advance loans to desired sectors. Moral suasion:Moral Suasion is just as a request by the RBI to the commercial banks to take so and so action and measures in so and so trend of the economy. RBI may request commercial banks not to give loans for unproductive purpose which does not add to economic growth but increases inflation. Repo Rate & Reverse Repo Rate:Repo rate is the rate at which RBI lends to commercial banks generally against government securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and increase in Repo rate discourages the commercial banks to get money as the rate increases and becomes expensive.Prevailing repo rate is 8%. Reverse Repo rate is the rate at which RBI borrows money from the commercial banks. The increase in the Repo rate will increase the cost of
  7. 7. borrowing and lending of the banks which will discourage the public to borrow money and will encourage them to deposit. As the rates are high the availability of credit and demand decreases resulting to decrease in inflation.Prevailing reverse repo rate is 7%. Marginal Standing Facility Rate: Under this scheme, Banks are able to borrow up to 2% of their respective NDTL outstanding at the end of second preceding fortnight. The rate of interest on the amount accessed from this facility wef 7th oct 2013 has been fixed at 9%. Transmission Mechanism
  8. 8. Official Interest Rate Expectations Money Market Rates Money, Credit Exchange ratesAsset Prices Bank Rates Supply and demand in goods and labour marketsWage and Price-Setting Domestic Prices Import Prices Price Developments Monetary Transmission Mechanism the process through which changes in monetary policy instruments affect output and inflation. Moreover, the transmission lags are not only long but often also found to be variable. The variability of the lags has been accentuated by the ongoing financial deregulation, liberalization and innovations in a large number of economies.  Reflecting the process of financial liberalization, there have been changes in operating procedures of monetary policy  Like other Emerging Market Economies (EMEs), monetary policy in India has witnessed significant changes in its operating procedures and instruments. A multiple indicator approach has been put in place in lieu of the earlier monetary targeting approach. With gradual deregulation of financial markets and a move towards indirect instruments of monetary management, short-term interest rates have emerged as instruments of conveying the monetary policy stance. At the same time, rigidities in the market rates of interest have blunted the effectiveness of monetary policy actions.
  9. 9. Issues in Monetary Transmission For monetary policy to be effective, it is, therefore, essential to have a broad understanding of these channels and the associated lags. Monetary policy affects output and prices through its influence on key financial variables such as interest rates, exchange rates, asset prices, credit and monetary aggregates. At the same time, changes in the structure of the economy tend to alter the effects of a given monetary policy measure. This requires central banks to continuously reinterpret monetary transmission channels. The recent literature has also focused on the role of transparency in the transmission mechanism. A part of the impetus to greater transparency can be attributed to the framework of inflation targeting followed by a number of economies. A key feature of inflation targeting vis-à-vis the previous regimes is the focus on transparency. However, even central banks that do not follow an inflation targeting regime have increasingly realized that transparency adds to the credibility of their policy actions. Transparency buttresses the credibility of a central bank and this raises the effectiveness of central bank policy actions. Monetary Transmission Channels the channels through which money affects output and prices have been subject to intense debate and widespread research since long. The theoretical underpinnings of direct influence of money supply on the general prices can be traced back to the quantity theory of money (QTM) and there is no denying of this fact except adding structural factors as additional arguments in the price determination. A synthetic framework delineating Channels of Monetary Transmission in Path Diagram The traditional interest rate can be presented as
  10. 10. where,M=money,r=real interest rate, I=real investment, and Y=real output By extending the traditional interest rate channel to foreign exchange and equity markets, the exchange rate channel and the asset prices channels of monetary transmission as discussed in the previous section can be presented in following M ^ => r i => Depreciation = > Net Exports t => Y^ and, M ^= > P e ^ = > Q^ = > l ^ = > Y^ Where Pe=equity price,Q=Tobin’s Q The monetary transmission channel through wealth effect can be depicted as M^ => Pe ^ => Wealth ^ => Consumption Spending ^ => Y ^ the credit channels are broadly categorized as bank lending channel and bank balance sheet channel. The bank lending channel can be presented as, M^ => Bank Deposits^ => Bank Lending^ => 1 ^ => Y ^ Our estimations of path analysis for annual data are based on the path model graphically depicted in the path. In this model, the credit channel operates through the normal Money-* Deposit—* Credit—• Investment—•Output route. The Monetary Policy Instruments
  11. 11. The Monetary Policy Instruments Standing Facilities Open Market Operations Reserve Requirements Deposit facility Marginal Lending facility Main refinancing operations Longer-term refinancing operations Fine-tuning Operations Structural Operations Reserve Base Deposits, Debt securities and money market paper Reserve Ratio For the majority of the items to which the reserve base applies Remuneration Reserve holdings will be remunerated at the rbi’s rate on its main refinancing operations To achieve its primary objective of maintaining price stability, the central bank(rbi) has at its disposal a set of monetary policy instruments. Open Market Operations  Open market operations represent the most important instrument. They serve to steer interest rates,  to manage the liquidity situation in the money market, and  to signal the monetary policy stance Conclusion Key characteristics of a successful monetary policy
  12. 12. Monetary Policy aims to  Preserve the functioning of the transmission mechanism  Be forward looking and pre-emptive  Focus on the medium term  Firmly anchor inflation expectations  Be broadly based * It requires properly functioning money markets if its transmission mechanism is to work. An effective transmission depends on the behaviour of banks and on their willingness to ensure smooth exchanges of liquidity in the interbank market. Dysfunctional money markets can weaken the influence of monetary policy on the outlook for price stability; * The policy needs to be forward-looking and pre-emptive. Changes in policy today will only affect the price level after a number of quarters or years. So a central bank needs to ensure that the impact of the decisions and actions it takes today will maintain price stability in the future; * It should have a medium-term orientation to avoid excessive activism and the introduction of unnecessary volatility into the real economy. Monetary policy cannot prevent some short-term volatility in inflation rates, caused, for example, by changes in international commodity prices; * It should firmly anchor inflation expectations. To that end, a central bank should specify its goal, elaborate and keep to a consistent and systematic method for conducting monetary policy, and communicate clearly and openly. These help it to be credible, which is essential if it is to influence the expectations of businesses and households. * Monetary policy has to be broadly based and take into account all relevant information in order to understand the factors affecting the economy References www.rbi.org.in www.ecb.europa.eu www.investopedia.com www.indiabulls.com www.articles.economictimes.indiatimes.com

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