Monetary and Credit Policy

and Business Environment

Courtesy

School of Management, NIT Rourkela

MBA (Finance) and Ph.D (Finance Management)

Lectures

Objectives of Study

To understand the concept monetary policy

To know the objectives of monetary policy

To know how it is implemented and

operationalized

To know what mechanism influences the different

sectors of an economy.

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Introduction

Monetary policy is the process by which monetary

authority of a country, generally a central bank

controls the supply of money in the economy

It control over interest rates in order to maintain

price stability and achieve high economic growth.

In India, the central monetary authority is the

Reserve Bank of India (RBI). is so designed as to

maintain the price stability in the economy.

3

Objectives of Monetary Policy

Objectives of Monetary

Policy

Price Stability

Credit availability and

economic growth

Exchange Rate Stability

Financial Stability

4

Price Stability

Sustained economic

growth requires capital

formation

It depends on level of

saving

It needs low and stable

inflation

It creates conducive

environment for saving, investment and growth

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Credit Availability and Economic

Growth

6

Underut ilisation

of capacit

y

Idle resourc

es

Unempl oyment

Overall recessi

on

Excess of

demand fuelling inflation

Promotes sustained economic growth by

Minimizing fluctuations in business activity

Fine-tuning credit availability and Money supply in concurrence with

growth requirements

• Restricting credit and money supply when total demand for goods and services raises prices to unsustainable levels

• Expanding when deficiency of money threatens the underutilization of resources

Expansion in productive capacity

Sustained economic Growth

A sustained increase in per capita income

Corresponding increase inthe demand for goods and services, Produced through

enhanced capacity

Exchange Rate Stability

Stabilizing the value of domestic currency vis-a-vis foreign currency as changes in exchange rates

A large destabilizing impact on an inflow of trade and capital flows, as well as on inflation,

employment and output

The exchange rate also affects the balances sheet of the residents by affecting their transactions in

foreign currency.

7

Financial Stability

It implies• Uninteruppted financial transactions

• Confidence in the financial system amongst all the participants

• Absence of volatility in the financial markets

A weak and unstable financial system leadsto financial crisis and adversely affecting thefunctioning of the economy.

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Financial Stability

9

facilitate the trade. It is an independent objective of monetary policy.

Promotion of Exports and Food Procurement Operations

• Monetary policy pays special attention in order to boost exports and

• The aim here is to increase the productivity of investment by restraining nonessential fixed investment.

Promotion of Fixed Investment

idle money in the organization

money market instruments etc.

Restriction of Inventories and stocks

• Overfilling of stocks and products becoming outdated due to excess of stock often results in sickness of the unit. To avoid this problem the central monetary authority carries out this essential function of restricting the inventories. The main objective of this policy is to avoid over-stocking and

To Promote Efficiency

• It is another essential aspect where the central banks pay a lot of attention.• It tries to increase the efficiency in the financial system and tries to

incorporate structural changes such as deregulating interest rates, ease operational constraints in the credit delivery system, to introduce new

Reducing the Rigidity

• RBI tries to bring about the flexibilities in the operations which provide a considerable autonomy.

• It encourages more competitive environment and diversification.• It maintains its control over financial system whenever and wherever

necessary to maintain the discipline and prudence in operations of the financial system.

Types of Monetary Policy

Expansionary Contractionary Countercyclical Discretionary

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Instruments of Monetary

Policy

Quantitative (General)

Direct Instruments

Cash ReserveRatio

Indirect Instruments

Bank rate

Open market Operations

Outright

Repo/Reverse Repo

Qualitative (selective)

Priority sector lending

Differential interest rates

Margin requirements

Restrictions on bills

rediscounting

Moral suasion

11

Types of Open Market

Operations

Outright

Sale and purchase of government securities

Repo Rate

Sale and purchase of government securities with an agreement to buyback or resell

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Monetary Policy, Economic Growth

and Business Environment

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It can maintain balance between monetary demandand supply of goods and can also supply money insuch way as consistent with supply of goods andservices

It can create an atmosphere in which a high rate ofsaving and investment would be generated.

It minimizes fluctuations in business activity andprices and creates stability for growth.

It influences the rate of interest and investment andthe use of credit in most productive channel in theeconomy

It expands credit and when it is not necessary , itrestricts the flow of credit. It creates saving institutionsand mobilizes the savings of community towards

productive investment.

Use of Monetary Policy during

Inflation

Reduce money supply and bring it down to the rate at which output is

growing in the economy

Increase bank rate to reduce the borrowing

spree from banks

Increase cash reserve ratio of commercial

banks

Raise minimum legal reserve requirements

Help banks practise open market sale of securities so that liquidity level of

the economy comes down.

Use selected creditc

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ontrols to discouragecredit flow to unwanted

sectors and encourage itto desirable productive

sectors.

Use of Monetary Policy during

Recession/Depression

Increase the money supply to increase the level of income and

liquidity in the economy.

Reduce bank rate to encourage borrowings

from banks

Decrease the cash reserve ratio of

commercial banks to give them more

liquidity

Reduce minimum legal reserve requirements

Helps banks practise open market purchase

of securities so that the liquidity level of

the economy goes up

Use selected credit controls to encourage

credit flow to every productive sector of

the economy.

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Monetary operations: Open Market

Operations

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An open market operation is an instrument of

monetary policy which involves buying or selling

of government securities from or to the public and

banks.

This mechanism influences the reserve position

of the banks, yield on government securities and

cost of bank credit.

The RBI sells government securities to control the

flow of credit and buys government securities to

increase credit flow.

Open market operation makes bank rate policyeffective and maintains stability in governmentsecurities market.

Cash Reserve Ratio

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Cash Reserve Ratio is a certain percentage of

bank deposits which banks are required to keep

with RBI in the form of reserves or balances.

Higher the CRR with the RBI lower will be the

liquidity in the system and vice versa. RBI is

empowered to vary CRR between 15 percent and

3 percent.

But as per the suggestion by the Narsimham

committee Report the CRR was reduced from

15% in the 1990 to 5 percent in 2002. As of

September 2014, the CRR is 4.00 percent.

Statutory Liquidity Ratio

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Every financial institution has to maintain a

certain quantity of liquid assets with themselves

at any point of time of their total time and demand

liabilities.

These assets have to be kept in non cash form

such as G-secs precious metals, approved

securities like bonds etc.

The ratio of the liquid assets to time and demand

liabilities is termed as the Statutory liquidity ratio.

There was a reduction of SLR from 38.5% to 25%

because of the suggestion by Narshimam

Committee. The current SLR is 2.1 5%(.w.e. f 03/02/15.)

Bank Rate Policy

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The bank rate, also known as the discount rate, is therate of interest charged by the RBI for providing fundsor loans to the banking system.

This banking system involves commercial and co-operative banks, Industrial Development Bank ofIndia, IFC, EXIM Bank, and other approved financialinstitutes.

Funds are provided either through lending directly orrediscounting or buying money market instrumentslike commercial bills and treasury bills. Increase inBank

Rate increases the cost of borrowing by commercialbanks which results into the reduction in credit volumeto the banks and hence declines the supply of money.

Increase in the bank rate is the symbol of tightening ofRBI monetary policy. As of 3 February 2015, the bankrate is 8.75%.

Credit Ceiling

In this operation RBI issues prior information or

direction that loans to the commercial banks will

be given up to a certain limit.

In this case commercial bank will be tight in

advancing loans to the public.

They will allocate loans to limited sectors.

Few example of ceiling are agriculture sector

advances, priority sector lending.

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Credit Authorization Scheme

Credit Authorization Scheme was introduced in

November, 1965 when P C Bhattacharya was the

chairman of RBI.

Under this instrument of credit regulation RBI as

per the guideline authorizes the banks to advance

loans to desired sectors.

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Moral Suasion

Moral Suasion is just as a request by the RBI to

the commercial banks to take so and so action

and measures in so and so trend of the economy.

RBI may request commercial banks not to give

loans for unproductive purpose which does not

add to economic growth but increases inflation.

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Repo Rate

Repo rate is the rate at which RBI lends to

commercial banks generally against government

securities.

Reduction in Repo rate helps the commercial

banks to get money at a cheaper rate and

increase in Repo rate discourages the

commercial banks to get money as the rate

increases and becomes expensive.

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Reverse Repo Rate

Reverse Repo rate is the rate at which RBI

borrows money from the commercial banks.

The increase in the Repo rate will increase the

cost of borrowing and lending of the banks which

will discourage the public to borrow money and

will encourage them to deposit.

As the rates are high the availability of credit and

demand decreases resulting to decrease in

inflation.

This increase in Repo Rate and Reverse Repo

Rate is a symbol of tightening of the policy.

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RBI’s Different Rate,2015Bank Rate-9.50%

• RBI lends to the commercial banks through its discount window to help the banks meet depositor’s demands and reserve requirements for long term. The Interest rate the RBI charges the banks for this purpose is called bank rate.

Repo Rate-7.50%

• The rate at which RBI lends money to commercial banks in the event of any shortfall of funds to control inflation

Reverse Repo Rate-6.50%

• If the borrower of the funds is RBI, it is termed as reverse repo transaction.

• The rate at which RBI absorbs money from the system.

Marginal Facility Rate-9.50 %

• The rate at which banks can borrow overnight from RBI.

• Introduced in the monetary policy of RBI for the year 2011-2012.

• The MSF is pegged 100bps or a % above the repo rate.

• Banks can borrow funds during considerable shortfall of liquidity.

• Introduced by RBI to regulate short-term asset liability mismatches

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Monetary Policy Framework

Instrument s

• Reserve requirements

• Official interest rates

• Open market operations

• Direct controls

Operating Targets

• Short Term Money market rates

• Bank Reserves

• Monetary Base

Intermediat e Targets

• Long Term interest rates

• Asset prices

• Monetary / credit aggregates

• Exchange rates

Final Goals

• Price stability

• Long Term growth

• Business Cycle Stabilization

• Financial Stability

Tactical Decisions Strategic Decisions

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Implications for Business Managers

Business Units

Financial Intermediaries

& Financial markets

Investment Expenditure

Working Capital Requirements

Monetary Policy

Changes in Bank Rate

Changes in Repo Rate

Regulating Cost & Availability of

Credit

27

India Releases New Monetary

Policy Framework

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The Indian govt. & RBI agreed on a monetary policy framework: managing inflation the

key determinant in the central bank’s policy decisions.

As part of the framework, the RBI will aim to lower inflation to 4%, with a band of 2% on

either side, by the financial year ending March 2017 and keep it around that level

The objective of monetary policy would now primarily be to maintain price stability, and

growth

India’s central bank has been using a mix of indicators for guiding monetary policy action

such as

Economic growth

Exchange rate

Inflation

Even banking system liquidity

The new framework will bring the Indian central bank’s decision-making closer to the

practices in some big western economies

The European Central Bank: Focuses solely on inflation

The U.S. Federal Reserve: Monitor inflation and unemployment.

Retail inflation in India rose to double-digit levels in late 2013, prompting authorities to

give greater policy attention to bringing about a sustainable decline.

A series of rate increases and a sharp decline in energy and food prices have helped

lower inflation to 5.1% in January.

Limitations of Monetary Policy

Existence of liquidity trap

Difficult to decrease the velocity of circulation by

monetary measures

Difficult to appreciate to recognition lag

It takes effect with too long a delay

The growth of nonbank financial intermediaries

seriously weakened the efficacy of monetary

policy.

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WARREN BUFFETT

If I were in charge of monetary policy,

'I probably wouldn't do much'30

References

Economic Environment of Business By Veena

Keshav Paillwar, PHI Learning Publishers