Monetory policy


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Monetory policy

  1. 1. Module 3Thursday, January 24, 2013 NVK 1
  2. 2.  Monetary policy is the process by which the government, central bank or monetary authority of a country controls (i) the supply of money (ii) availability of money (iii) cost of money or rate of interest in order to attain a set of objectives oriented towards the growth and stability of the economyThursday, January 24, 2013 NVK 2
  3. 3.  To ensure a stable currency value Price stability Economic stability or full employment Rapid economic growth Balance of payments equilibrium Greater equality in distribution of income & wealthThursday, January 24, 2013 NVK 3
  4. 4.  To maintain continuously low rate of interest To create a continuous market for government securities To provide credit at differential rate of interestThursday, January 24, 2013 NVK 4
  5. 5.  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.Thursday, January 24, 2013 NVK 5
  6. 6.  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.Thursday, January 24, 2013 NVK 6
  7. 7.  It depends mainly on two factors 1. level of monetized economy 2. level of development of capital marketThursday, January 24, 2013 NVK 7
  8. 8. Expansionary policy expansionary policy increases the total supply of money in the economy used to combat unemployment in a recession by lowering interest rates.Contractionary policy contractionary policy decreases the total money supply involves raising interest rates in order to combat inflation increasing interest rates slows the economy by making funds more expensive to firms, and promotes consumer savings which decreases revenues by firms.Thursday, January 24, 2013 NVK 8
  9. 9.  Open market operations Bank rate Variable reserve ratioThursday, January 24, 2013 NVK 9
  10. 10.  Open Market Operations involve buying (outright or temporary) and selling of government securities by the central bank, from or to the public and banks.Thursday, January 24, 2013 NVK 10
  11. 11. Open-Market Operations Buying Securities From commercial banks... Bank gives up securities RBI pays bank Banks have increased reserves From the public... Public gives up securities Public deposits check in bank Banks have increased reservesBuying increases the money supply and lowers ratesThursday, January 24, 2013 NVK 11
  12. 12.  Selling Securities To commercial banks... RBI gives up securities Bank pays for securities Banks have decreased reserves To the public... RBI gives up securities Public pays by check from bank Banks have decreased reservesSelling decreases the money supply and increases ratesThursday, January 24, 2013 NVK 12
  13. 13.  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.Thursday, January 24, 2013 NVK 13
  14. 14.  Raising the Reserve Ratio  Banks must hold more reserves  Banks decrease lending  Money supply decreases Lowering the Reserve Ratio  Banks may hold less reserves  Banks increase lending  Money supply increasesThursday, January 24, 2013 NVK 14
  15. 15.  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.Thursday, January 24, 2013 NVK 15
  16. 16. Instruments1. Discount Rate (Bank Rate)2.Reserve Ratios Operating Target3. Open Market Operations • Monetary Base • Bank Credit Intermediate • Interest Rates Target •Monetary Aggregates(M3) Ultimate •Long term Goals interest rates •Total Spending • Price Stability Etc. Thursday, January 24, 2013 NVK 16
  17. 17.  Credit Rationing Change in lending margins Moral Suasion Direct ControlsThursday, January 24, 2013 NVK 17
  18. 18. MONETARY POLICY AND EQUILIBRIUM GDP Sm1 Sm2 Sm3 Investment Demand Real rate of interest, i 10 10 8 8 6 6 Dm 0 0 Quantity of money demanded and supplied Amount of investment, i AS If the Money Supply Increases to Stimulate the Economy… Interest Rate Decreases Price level P3 Investment Increases P2 AD & GDP Increases P1 AD3(I=$25) with slight inflation AD2(I=$20) Increasing money supply AD1(I=$15) continues the growth –Thursday, January 24, 2013 Real domestic output, GDP NVK but, watch Price Level. 18
  19. 19.  Time lag 1. Recognition lag 2. Action lag 3. Effect lag Problem in forecasting Non Banking financial Intermediaries Under development of money and Capital MarketsThursday, January 24, 2013 NVK 19
  20. 20. Thursday, January 24, 2013 NVK 20