Monetary policy refers to actions taken by central banks to affect monetary conditions and financial variables to promote economic goals. It uses tools like open market operations, reserve requirements, and interest rates to influence the money supply and cost of credit. During recessions, monetary policy aims to stimulate demand by increasing money supply and lowering rates. During inflation, it aims to reduce spending by tightening money supply or raising rates. The objectives are economic stability, price stability, and growth.

1. Prof. S. Maitra,
iasstudymat.blogspot.com

2. What is Monetary Policy?
 The term monetary policy refers to actions taken by
central banks to affect monetary magnitudes or other
financial conditions.
 It is concerned with the changing the supply of
money stock and rate of interest for the purpose of
stabilizing the economy at full employment or
potential output level by influencing the level of
aggregate demand.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 2

3. Monetary Policy during recession
At times of recession monetary
policy involves the adoption of
some monetary tools which tends
to increase the money supply and
lower interest rate so as to
stimulate aggregate demand in
the economy.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 3

4. Monetary Policy during inflation
At the time of inflation
monetary policy seeks to
contract aggregate spending
by tightening the money
supply or raising the rate of
return.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 4

5. Three objectives
To ensure the economic stability at full
employment or potential level of
output.
To achieve price stability by controlling
inflation and deflation.
To promote and encourage economic
growth in the economy.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 5

6. Tools of Monetary Policy
Bank rate policy
Open market operations
Changing cash reserve ratio
Undertaking selective credit
controls.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 6

7. Bank Rate Policy
 Bank rate is the minimum rate at which the central
bank of a country provides loan to the commercial
bank of the country.
 Bank rate is also called discount rate because bank
provide finance to the commercial bank by
rediscounting the bills of exchange.
 When general bank raises the bank rate, the
commercial bank raises their lending rates, it results
in less borrowings and reduces money supply in the
economy.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 7

8. Limitations
Well organized money market
should exist in the economy. It
is not present in India
It is useful during the times of
inflation but it does not fullfil its
purpose during the time of
recession or depression.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 8

9. Open Market Operations
 It means the purchase and sale of
securities by central bank of the
country.
 It is useful for the developed
countries.
 The sale of security by the central
bank leads to contraction of credit and
purchase there of to credit expansion.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 9

10. Limitations
 When the central bank purchases the securities the cash
reserve of member bank will be increased and vice
versa.
 The bank will expand and contract credit according to
prevailing economic and political circumstances and not
merely with reference to their cash reserves.
 When the commercial bank cash balance increase the
demand for loan and advance should increase. This may
not happen due to economic and political uncertainty.
 The circulation of bank credit should have a constant
velocity.
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11. What is CRR?
 CRR means Cash Reserve Ratio.
 Banks in India are required to hold a certain proportion of their
deposits in the form of cash. However, actually Banks don’t hold
these as cash with themselves, but deposit such cash with Reserve
Bank of India (RBI). This minimum ratio (that is the part of the total
deposits to be held as cash) is stipulated by the RBI and is known as
the CRR or Cash Reserve Ratio.
 Thus, When a bank’s deposits increase by Rs100, and if the cash
reserve ratio is 6%, the banks will have to hold additional Rs 6 with
RBI and Bank will be able to use only Rs 94 for investments and
lending / credit purpose. Therefore, higher the ratio (i.e. CRR), the
lower is the amount that banks will be able to use for lending and
investment.
 This power of RBI to reduce the lendable amount by increasing the
CRR, makes it an instrument in the hands of a central bank through
which it can control the amount that banks lend. Thus, it is a tool used
by RBI to control liquidity in the banking system.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 11

12. What is CRR?
 Consequent upon amendment to RBI act in 2006, RBI can
prescribe Cash Reserve Ratio (CRR) for scheduled banks
without any floor rate or ceiling rate ( Before this enactment, the
Reserve Bank could prescribe CRR for scheduled banks between 3
per cent and 20 per cent of total of their demand and time liabilities).
 RBI uses CRR either to drain excess liquidity or to release funds
needed for the growth of the economy from time to time. Increase in
CRR means that banks have less funds available and money is
sucked out of circulation. Thus we can say that this serves duel
purposes i.e.(a) ensures that a portion of bank deposits is kept with
RBI and is totally risk-free, (b) enables RBI to control liquidity in the
system, and thereby, inflation by tying the hands of the banks in
lending money
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 12

13. What is SLR?
 Every bank is required to maintain at the close of
business every day, a minimum proportion of their
Net Demand and Time Liabilities as liquid assets in
the form of cash, gold and un-encumbered approved
securities. The ratio of liquid assets to demand and
time liabilities is known as Statutory Liquidity Ratio
(SLR). RBI is empowered to increase this ratio up to
40%. An increase in SLR also restrict the bank’s
leverage position to pump more money into the
economy.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 13

14. Repo Rate
 Repo (Repurchase) rate is the rate at
which the RBI lends shot-term money to
the banks against securities. When the
repo rate increases borrowing from RBI
becomes more expensive. Therefore, we
can say that in case, RBI wants to make it
more expensive for the banks to borrow
money, it increases the repo rate; similarly,
if it wants to make it cheaper for banks to
borrow money, it reduces the repo rate

03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 14

15. Reverse Repo Rate
 Reverse Repo rate is the rate at which banks park
their short-term excess liquidity with the RBI. The
banks use this tool when they feel that they are stuck
with excess funds and are not able to invest
anywhere for reasonable returns. An increase in
the reverse repo rate means that the RBI is ready to
borrow money from the banks at a higher rate of
interest. As a result, banks would prefer to keep
more and more surplus funds with RBI.

03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 15

16. Repo Rate signifies the rate at
which liquidity is injected in the
banking system by RBI, whereas
Reverse repo rate signifies the
rate at which the central bank
absorbs liquidity from the banks

03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 16

17.  The policy announcements on 03/05/2011,
indicates that now repo rate has become the only
independent variable policy rate, marking a shift
from earlier method of calibrating various policy
rates separately. The reverse repo rate -- the rate
at which RBI borrows – will be kept 100 basis
points lower than the repo rate. On the other
hand Marginal Standing Facility (MSF) rate will
be kept 100 basis points higher than the repo
rate.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 17

18. Marginal Standing Facility
 Under this scheme, Banks will be able
to borrow upto 1% of their respective
Net Demand and Time Liabilities". The
rate of interest on the amount accessed
from this facility will be 100 basis
points (i.e. 1%) above the repo rate.
This scheme is likely to reduce volatility
in the overnight rates and improve
monetary transmission. This facility has
become effective from May 9, 2011

03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 18

19. Expansionary Monetary Policy
 Problem: Recession and unemployment
 Measures:
 (1) Central bank buys securities through open market
operation
(2) It reduces cash reserves ratio
(3) It lowers the bank rate
 Money supply increases  Investment
increasesAggregate demand increases Aggregate
output increases by a multiple of the increase in
investment
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 19

20. Tight Monetary Policy
 Problem: Inflation
 Measures: (1) Central bank sells securities through open
market operation
 (2) It raises cash reserve ratio and statutory liquidity
(3) It raises bank rate
(4) It raises maximum margin against holding of stocks of
goods
 Money supply decreases Interest rate raises
Investment expenditure declines
Aggregate demand declines Price level falls
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21. Sources of Monetary Mismanagement
Variable time lags concerning the
effect of money supply on the
national income.
Treating Interest rate as the target
of monetary policy for influencing
investment demand for stabilizing
the economy.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 21

22. Role of Monetary Policy in
Economic Growth
 Monetary policy and savings.
 Monetary policy and investment.
 Cost of credit..
i) Monetary policy and public
investment.
ii) Monetary policy and private
investment.
iii)Allocation of investment funds.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 22

23. Monetary Policy of RBI
 In recent years starting from the mid-nineties
promoting economic growth is being given greater
emphasis in monetary policy of RBI.
 Three sub-periods:
Monetary policy of controlled expansion(1951-1972).
Monetary policy in the pre-reforms
period(1972-1991) .
Monetary policy in the post-reforms
period(1991-2011).
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 23

24. Monetary Policy of Controlled
Expansion
 Reserve bank’s responsibility in the circumstances is
mainly to moderate the expansion of credit and
money supply in such a way as to ensure the
legitimate requirements of industry and trade and
curb the use of credit for unproductive and
speculative purposes.
 To ensure controlled expansion, RBI used the
instruments:
 Changes in bank rate
Changes in cash reserve ratio
Selective credit control
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 24

25. Monetary Policy in the pre
Reform Period (1972—1991)
Price situation worsened during
the years of 1972- 1974. to
contain inflationary pressures RBI
further tightened its monetary
policy.
It is similar to tight monetary policy
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 25

26. Easy and Liberal Monetary
Policy
 Liberal monetary policy adopted for
encouraging private sector since
1996.
 Two instrument for monetary
management BY RBI since 1996:
 Reactivation of bank rate.
 Repo rate system .
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 26

27. Repo Rate System
 It is introduced through which RBI can add to
liquidity in the banking system. Through repo
system RBI buys securities from the bank and
there by provide funds to them.
 Repo refers to agreement for a transaction
between RBI and banks through which RBI
supplies funds immediately against government
securities and simultaneously agree to
repurchase the same or similar securities after a
specified time which may be one day to 14 days.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 27

28. Liquidity Adjustment
Facility(LAF)
 It is the another instrument of monetary
policy from June 2000 to adjust on a daily
basis liquidity in the banking system.
 Through LAF, RBI regulates short-term
interest rates while its bank rate policy
serves as a signaling device for its
interest rate policy in the intermediate
period.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 28

29. Movements in Key Policy Rates in India
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 29

30. Latest Rates
 Bank Rate
 9.50% (w.e.f. close of business of 13/02/2012) .
 Increased from 6.00% to 9.50% which was continuing sinc

 Cash Reserve Ratio (CRR)
 5.50% (wef 28/01/2012) - announced on 24/01/2012
Decreased from 6.00% to 5.50% which was continuing sin
 Statutory Liquidity Ratio (SLR)
 24%(w.e.f. 18/12/2010)
Decreased from 25% which was continuing since 07/11/20

03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 30

31. Latest Rates
 Repo Rate under LAF
 8.50% (w.e.f.25/10/2011)
 Increased from 8.25% which was continuing since 16/09/2011

 Reverse Repo Rate under LAF *
 7.50% (w.e.f. 25/10/2011)
 Increased from 7.25% which was continuing since 16/09/2011

 *Reverse Report rate was an independent rate till 03/05/2011. Howeve
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 31

32. Neutral interest rate
 “Neutral interest rate”, as a concept, generally
refers to the level of interest rate at which
monetary policy stance is neither expansionary
nor contractionary. Policy stance can be deemed
“neutral” when the real interest rate reaches a
level that is consistent with full employment of
resources over the medium-term, and hence full
capacity output and price stability.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 32

33. Neutral interest rate
 The concept of natural rate of interest was first
introduced into economics by the Swedish
economist Knut Wicksell in 1898. This rate,
theoretically, essentially relates to:
 (i) the rate of interest that equates saving with
investment;
 (ii) the marginal productivity of capital, and
 (iii) the rate of interest that is consistent with
aggregate price stability.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 33

34. Neutral interest rate
Although natural and neutral rates of interest are
used interchangeably, there are major conceptual
differences between the two. Moreover, while the
former emerges in the market and is not directly
observable, the latter essentially is an empirical
approximation used in practice for conduct of
monetary policy. Thus, the neutral rate of interest is
useful as an important benchmark for the actual
conduct of monetary policy and also market analysis
of monetary policy stance.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 34

35. Liquidity Management Measures taken by the RBI
in 2010--11
Event:
 End-May 2010: Larger than
anticipated collection for 3G/ BWA
spectrum in addition to advance tax
outflow resulted in migration of
liquidity to central government’s cash
balance account with the Reserve
Bank
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 35

36. Liquidity Management Measures
taken by the RBI in 2010--11
Measures:
 For the period May 28, 2010-July 2, 2010, SCBs were:
 (i) Allowed to avail additional liquidity support under the
LAF to the extent of up to 0.5 per cent of their Net
Demand and Time Liabilities NDTL (for any shortfall in
maintenance of SLR arising out of availing of this facility,
banks were allowed to seek waiver of penal interest).
 (ii) Given access to second LAF (SLAF) on a daily basis.
 With the persistence of deficit liquidity conditions,
measure (i) was extended up to July 16, 2010 and
 measure (ii) up to July 30, 2010.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 36

37. Liquidity Management Measures
taken by the RBI in 2010--11
Event:
 End-October 2010: Frictional liquidity
pressure due to autonomous factors
compounded by banks’ high CRR
requirement (since the fortnight
ended October 22, 2010 had seen a
large increase in NDTL)
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 37

38. Liquidity Management Measures
taken by the RBI in 2010--11
Measures:
 (i)The Reserve Bank conducted special SLAF on October 29
and November 1, 2010, a special two day repo auction under
the LAF on October 30, 2010, and allowed waiver of penal
interest on shortfall in maintenance of SLR (on October 30-31,
2010) to the extent of 1.0 per cent of NDTL for availing
additional liquidity support under the LAF.
 (ii) The Reserve Bank extended these liquidity easing
measures further and conducted SLAF on all days during
November 1-4, 2010 and extended the period of waiver of
penal interest on shortfall
 in maintenance of SLR ( to the extent of 1.0 per cent of NDTL)
for availing additional liquidity support under the LAF till
November 7, 2010.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 38

39. Liquidity Management Measures
taken by the RBI in 2010--11
 (iii) The Reserve Bank re-started purchase of
government securities under its open market operations
(OMO) from November 4, 2010.
 (iv) On November 9, 2010, the Reserve Bank
reintroduced daily SLAF and extended the period of
waiver of penal interest on shortfall in maintenance of
SLR to the extent of 1.0 per cent of NDTLfor availing
additional liquidity support under the LAF till December
16, 2010.
 (v) On November 29, 2010, the Reserve Bank extended
the daily SLAF and allowed additional liquidity support to
the SCBs under the LAF to the extent of up to 2.0 per
cent of their NDTL till January 28, 2011.
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 39

40. Liquidity Management Measures
taken by the RBI in 2010--11
Event:
Mid-December 2010:
Continued build up in
government balances on
account of third quarterly
advance tax collections
03/20/12 ICSA 2012 GS Indian Economics/Prof. S.Maitra 40

41. Liquidity Management Measures
taken by the RBI in 2010--11
Measures:
 In the mid-Quarter Review of December 2010, the
Reserve Bank:
 (i) Reduced the SLR of SCBs from 25 per cent of NDTL
to 24 per cent with effect from December 18, 2010. Given
the permanent reduction in the SLR, additional liquidity
support of 1.0 per cent of NDTL under the LAF would be
available from December 18, 2010 till January 28, 2011.
 (ii) Announced conduct of OMO auctions for purchase of
government securities for an aggregate amount of
Rs.48,000 crore in the next one month (staggered as
purchases of Rs.12,000 crore per week).
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