Monetary Policy-meaning & analytics, Its operating framework and policy instruments

1. MONETARY POLICY
CA Shilpi Taparia

2. MONETARY POLICY-MEANING
 Use of Monetary instruments by Central Bank to
regulate the availability, cost & use of money and
credit to promote economic growth.
 To regulate Demand for & Supply of Money with
the Public & flow of credit
 It is in the nature of Demand side Macro Economic
policy & works by stimulating or discouraging
investment & consumption spending on goods and
services

3. OBJECTIVES OF MONETARY POLICY
 General objectives include:
1. Maintenance of economic growth
2. Ensuring an adequate flow of credit to the
productive sectors
3. Sustaining a moderate structure of interest rates
to encourage investments
4. Creation of an efficient market for govt. securities
5. Maintenance of price stability (controlling
inflation)
6. Achieving high level of economic growth
7. Maintenance of full employment

4. ANALYTICS OF MONETARY POLICY
Monetary Policy intend to impact macro-economic
variables such as aggregate demand, quantity of
money & credit, interest rates, etc.
It influences the Price level & National Income
through mainly 4 mechanisms:-
 The interest rate channel
 The exchange rate channel
 The quantum channel (eg. Money supply & credit)
 The asset price channel (via equity & real estate prices)

5.  Interest rate channel:
Increase in Interest rates
Increases cost of capital & real cost of
borrowings for firms
Households face high borrowing cost, cut
back on their purchases of Homes & other
durable goods
Decline in Aggregate Demand results in fall in
Output & employment
& Vice-Versa

6.  Exchange Rate Channel
Works through expenditure switching between
Domestic & Foreign Goods
Appreciation of Domestic Currency makes
Domestic produced goods more expensive to
Foreign produced goods. It results in Net Exports
to fall; corresponding domestic output and
employment also fall and Vice-Versa.

7.  Quantum Channel:
Basically, there are two distinct credit channels –
Bank Lending channel – An open market operation
may lead to increase or decrease in supply of bank
reserves, which will in turn increase or decrease
Banks’ lending firms .
Balance Sheet Channel – Increase or Decrease in
interest rates will relatively increase or decrease
firm’s cost of capital and the same interest rates
also works to rise or fall in capitalized value of
assets, thereby impacting Balance Sheet of a Firm.

8.  Standard Asset Price Channel:
Rise or fall in interest rates will relatively make
Debt or Equity attractive.
Increase in short term interest rates will make Debt
more attractive to investors leading to fall in equity
prices which will further impact on consumption of
households, output & employment.
& Vice-Versa

9. OPERATING PROCEDURE
 Operating framework relates to all aspects of
Implementing of Monetary Policy including:
choosing operating target i.e. the variable (inflation)
that monetary policy can influence
choosing intermediate target i.e. the variable
(economic stability) that central bank can hope to
influence through operating target
choosing policy instruments or the tools that a central
bank can use to influence money market & credit
conditions and pursue its monetary objectives

10. OPERATING INSTRUMENTS
 Cash Reserve Ratio
 Fraction of total net demand & time liabilities
(NDTL) of a schedule commercial bank which it
should maintain with RBI as Cash Deposit.
 No interest is paid by RBI on such deposit
 Failure of bank to meet such requirement would
attract penalty
 Higher the CRR, lower the liquidity in the economy
& vice-versa
 Current CRR rate in India is 4%

11.  Statutory Liquidity Ratio
 All commercial banks should maintain a certain
percentage (currently 18.50%) of their total NDTL
in one of the following forms:
Cash
Gold, or
Investments including T-bills, Securities issued by
Govt. under Market borrowing Programme & Market
Stabilization scheme, State development loans issued
by state govt. & any other specified instruments.
 Changes in SLR majorly influence the availability of
resource in the banking system for lending.

12.  Liquidity Adjustment Facility
 Central Bank provides liquidity to banks during
shortage through its Discount window.
 In LAF facility, Banks can borrow via Discount
window against collateral of securities like
commercial bills, govt. securities, treasury bills or
other eligible papers
 Currently RBI provides financial facility through
repo/reverse repos under LAF facility
 Banks can also park their excess funds with RBI
under this facility.

13. Repo Rate Reverse Repo Rate
RBI charges when funds
borrowed by Banks (5.15%)
Commercial banks charges
when funds borrowed by
RBI(4.9%)
Banks have to pay high rate of
interest against amount
borrowed and controls excess
liquidity from the markets
Banks are offered high gains
and economic system is
injected with liquidity
Involves selling of securities to
RBI & a fixed rate is charged
while repurchasing in future
Transferring of funds from one
bank account to RBI account
It controls inflation It controls money supply in
market
It helps to deal with deficiency
of funds
It helps to deal with liquidity
in the market

14.  Marginal Standing Facility
Facility under which commercial banks can borrow
additional amount of loan from RBI over & above
what is available to them under LAF facility by
dipping into their SLR upto a limit at a penal rate of
interest.
Minimum amount which can accessed is Rs.1 crore
MSF would be the last resort for banks once they
exhaust with all borrowing options.
MSF rate being a penal rate automatically gets
adjusted to a fixed % above repo rate
MSF rate is presently aligned with Bank Rate

15.  Bank Rate
Under section 49 of the RBI Act 1934, Bank rate-
“Standard Rate at which the RBI is prepared to buy
or re-discount bills of exchange or other
commercial paper eligible for purchase under the
Act.”
In general terms, Bank Rate is the rate of interest
charged by RBI for providing loans to the banking
system. It is currently aligned with the MSF
rate(5.65%).

16.  Market Stabilization Scheme:
It was introduced in 2004. It refers to monetary
policy intervention by RBI to withdraw excess
liquidity or money supply by selling securities in the
economy, by selling govt. bonds.
It is used when there is high liquidity in the system
The issued securities are govt. bonds or Market
Stabilization Bonds.
Securities are originally owned by Govt. though sold
by RBI as banker to the govt.
The Securities issued are bought by financial
institutions.

17.  Open Market Operations
Market operations conducted by RBI by way of sale
or purchase of govt. securities to or from the
market with an objective to adjust rupee liquidity
conditions in the market.
When RBI feels excess liquidity in the market, it
sells securities against rupees.
When liquidity conditions are tight , RBI buys
securities from the market, thereby releasing
liquidity in the economy.