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Monetary policy


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monetary policy

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Monetary policy

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