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RBIs
Monetary
Policy
DR B K MUKHOPADHYAY
presents
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PolicyBank Money
Banks create money by writing an accounting voucher Debit. Loan A/c
Credit Customers Deposit A/c
Amount of loan credited in Deposit A/c is rarely withdrawn in cash as most
payment are made by cheques on another bank account.
(Deposit) money thus created keeps circulating within the banking systemas book entries
Banks do not need you to deposit cash to give a loan. Loans are self-
funding
It needs cash deposit only meet the probabilistic event of cash being
withdrawn The banking system needs very little cash injection from outside, especially
if banks are willing to lend among themselves freely
Banks are mainly in business of creating money; much less in that of
savings intermediation
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Bank Money
If acceptance of (cash) deposits is seen as
similar to buying cash; and making loans as
selling cash, then banks are in the business of
short-selling cash Greater the credit creation higher the cash-short
position (leverage)
Credit creation makes financial system fragile
CRR and SLR act as margin money with a
centralized clearing house and limits the
capacity of banks to roll over the same cash for
making loans
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Bank Money
Bank credit is repayable
Bank credit is money + anti-money
For sustaining demand over a period of time
fresh credit > repayment
Leading to inexorably increasing debt to GDP
ratio
Excessive credit can be inflationary, and oftenresults in asset inflation
Central banks have a strong motivation to to limit
bank credit beyond whats considered safe
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Central Bank (sovereign) Money
Does not increase leverage in the financial
sector
Results in long term and often permanent
money creation & increase in demand Results in creating liquidity in the economy
Strong inflationary bias
Central banks creates money when govt.borrows from it
Controlling inflation requires restriction on deficit
monetization
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The need for more money
Expanding economy needs expansion in
money
Excessive bank money (credit) leads to
financial fragility and asset booms
Excessive central bank money leads to
inflation
Constraining either can affect growth
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Conflicted objectives of the
central banks How much bank money and sovereign
money should be created so as to
Promote credit creation for increasing
demandRestrain credit creation for financial stability
Promote deficit monetisation for demandmanagement (i.e. when credit creation has
not been successful in promoting demand)Restrain deficit monetisation to control
inflation
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Twin policy tools of central bank
Monetary policy:
Dealing with money creation and the
proportion of bank money and sovereign
money in the total money
Prudential regulations:
Mitigating the effects of leverage resulting
from banks credit creationEnsuring overall financial stability
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Objectives of Monetary Policy
Developed Economies Australia: Stability of the currency, maintenance of full
employment and economic prosperity and welfare.
Canada:Low and stable inflation.
ECB:Price stability primary objective. Without prejudice to the
objective of price stability, also support the general economicpolicies with a view to contributing to a high level of employment and
sustainable and non-inflationary growth.
Japan:Price stability and to ensure the stability of the financialsystem.
New Zealand: Maintaining a stable general level of prices. UK:Monetary stabilitymeaning stable prices and confidence in
the currencyand financial stability.
USA:Maximum employment, stable prices and moderate long-terminterest rates.
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Objectives of Monetary Policy
Developing Economies
China:Stability of the currency and thereby promote economicgrowth.
India:Price stability, credit availability, growth, financial stability
Indonesia:Achieve and maintain currency stability by maintaining
monetary stability and by promoting financial system stability.
Malaysia:Safeguard the value of the currency, promote monetarystability and a sound financial structure and influence the credit
situation to the advantage of the country.
Mexico:Price stability. Russia:Stability of currency, development of banking system and
efficient settlement system.
South Africa:Financial stability.
Thailand:Maintain monetary stability
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The basis of monetarism
Fishers quantity equation
Money value of transactions = Quantity of money x
Velocity of Money
Nominal GDP = Quantity of Money x
Velocity of Money
Velocity of money constant Globally, money stock has expanded much faster than
output
Velocity of money describes a U curve (?)
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Declining velocity of money
A safe conclusion: velocity of money is notconstant
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Interest rate as policy target
The decline of money stock and the rise of interest rateas operating targets of monetary policy
Emergence of Taylor like rules
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RBIs mandate
RBI Acts states the rationale of the
establishment of RBI in following terms:
"to regulate the issue of Bank Notes and
keeping of reserves
with a view to securing monetary stability
in India and generally to operate thecurrency and credit system of the country
to its advantage".
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RBIs Framework of Monetary
Policy
Instruments
CRR/SLR
Liquidity Adjustment Facility
RBI refinance rates
Open Market Operations
Moral suasion
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RBIs Framework of Monetary
Policy
Operating targets
Level of cash reserves
Short term interest
rates Intermediate targets
Monetary/credit
targets
Exchange rate
Long term interest rate
Final Objectives
Price Stability
Output
Financial Stability Studies show 6-24
months lag in
attaining the final
objectives
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RBIs Annual Policy
Announced in April of the corresponding
financial year
Reviewed in
July (first quarter)
October (mid-term)
January (third quarter)
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RBIs Annual Policy (2009-10)
Mid-term Review Section I
Macroeconomic and Monetary Developments
Section II
Stance of the monetary policy
Section III
Policy measures
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Macroeconomic and Monetary
Developments
World
Economic
Outlook
revised thegrowth
projections
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Macroeconomic and Monetary
Developments
Mixed signals from the US
Much lower contraction of the economy in the2ndquarter (0.7% as against 6.4% in Q1)
Home prices are stabilisingUnemployment rose to 9.8% and expected to
rise further
Weak signals from Europe
Rising unemployment (9.6% as of Aug. 2009)
Unabated economic contraction in Q2 (4.8%)
However output appears to be stabilising
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Macroeconomic and Monetary
Developments
Inflation
Rebound in commodity prices, steady crude
prices and rally in gold prices
However CPI in most advanced and EMEs
remained low/negative (except India)
Financial Markets
Share prices have bounced back
Fall in credit offtake mainly due to tightening
of credit standards by banks
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Macroeconomic and Monetary
Developments
Domestic
outlook
Lower than
forecasted
growth but
signs of
recovery
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Macroeconomic and Monetary
Developments
Agriculture
Deficient rainfall
Low agricultural output hasdisproportionate impact on overalleconomic prospects
Higher food prices lower sense of well-
beingInter-sectoral supply demand linkages
High stock of food grains with publicagencies
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Macroeconomic and Monetary
Developments
Industry
Recovery in basic, intermediate and
consumer durables
Capital and non-durable consumer goodsshowing modest recovery
Services
Lower growth
Trade related services showing negative
growth, reflecting contraction in trade
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Macroeconomic and Monetary
Developments
Demand Components of GDP
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Macroeconomic and Monetary
Developments
Inflation
WPI was negative till June-August, 2009;
1.21% as at 10 Oct 2009
Sharp divergence in CPI and WPI
Different weights
CPI leads WPI
2008 inflation and 2009 inflation are fordifferent reasons
Vegetables 59.3%, Tea 30.7%, Sugar 25.3%
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Macroeconomic and Monetary
Developments
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Macroeconomic and Monetary
Developments
Fiscal situation
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Macroeconomic and Monetary
Developments
Govt. borrowings
Net borrowings in 2008-09 increased by 143%
Net borrowings in 2009-10 increased by 34%
Net borrowings increased in 2009-10 by 226% from2007-08
RBI front loaded the borrowings for 2009-10 in
order to complete the borrowing programme in a
non-disruptive manner 80.4% of the borrowing already completed
Aided by reduction in CRR
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Macroeconomic and Monetary
Developments
RM lower due to reduction in CRR
M3higher due to increase in net bank credit to
Government (as against increase in bank credit to
commercial sector and foreign exchange assets)
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Macroeconomic and Monetary
Developments
Bank credit
Non-food credit declined
Slow down in credit demand from manufacturing
sector
Slow down in sanction of retail credit
Lower oil prices have led to lower borrowing oil
companies
Sharp decline in credit by private sector and foreignbanks
Rise in banks investment in mutual funds
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Macroeconomic and Monetary
Developments
Interest rate Decline in interest rates across the term structure
Trend in interest rates
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
Oct-
08
Nov-
08
Dec-
08
Jan-
09
Feb-
09
Mar-
09
Apr-
09
May-
09
Jun-
09
Jul-
09
Aug-
09
Sep-
09
Oct-
09
Call Money
CBLO
Market Repo
CD rate
CP rate
91-D TB
10-Yr-Gsec
BPLR of PSBs
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Macroeconomic and Monetary
Developments
BOP Greater decline in imports than exports
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Stance of the Monetary Policy
Keep a vigil on the trends in inflation
Monitor the liquidity situation closely and
manage it actively to ensure that credit demands
of productive sectors are adequately met while
also securing price stability and financial stability
Maintain a monetary and interest rate regime
consistent with price stability and financial
stability, and supportive of the growth process
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Measures
Bank rate unchanged at 6%
Repo and reverse repo unchanged at 4.75%and 3.25%
CRR unchanged at 5% SLR hiked back to 25%
Special refinance facilities withdrawn, exportrefinance reduced to 15% of o/s export credit
Special repo facilities discontinued A Financial Stability Unit set up in RBI
Repo in corporate bonds to be started
Permission for centralized credit derivatives
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Measures
STRIPs launched
Banks to maintain CRR for CBLO
PLR to give way to BLR
State Coop Banks and Central Coop Bankto obtain banking license by 2012
RRBs to bring their CRAR to 9% by 2012
Financial inclusion: list BCs expanded Priority Sector Lending Certificates
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Measures
Banks to maintain at least 70% provision
against NPAs
Effective governance of compensation
Adjustment of compensation for all types of
risk
To be symmetric with risk outcomes, and to
be sensitive to the time horizon of risks