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Monetary Policy

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MONETARY POLICY MONETARY POLICY
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Page 1: Monetary Policy

MONETARY POLICYMONETARY POLICY

Page 2: Monetary Policy

ContentsContents IntroductionIntroduction ObjectivesObjectives ScopeScope Instruments of Monetary PolicyInstruments of Monetary Policy

Quantitative MeasuresQuantitative Measures Qualitative MeasuresQualitative Measures

Controlling InflationControlling Inflation Monetary Policy of IndiaMonetary Policy of India

Page 3: Monetary Policy

INTRODUCTIONINTRODUCTION

•Monetary Policy is essentially a programme of action Monetary Policy is essentially a programme of action undertaken by the Monetary Authorities, generally the undertaken by the Monetary Authorities, generally the Central Bank, to control and regulate the supply of Central Bank, to control and regulate the supply of money with the public and the flow of credit with a view money with the public and the flow of credit with a view to achieving pre-determined macro-economics goals.to achieving pre-determined macro-economics goals.

•At the time of inflation monetary policy seeks to At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money contract aggregate spending by tightening the money supply or raising the rate of return.supply or raising the rate of return.

Page 4: Monetary Policy

ContentsContents IntroductionIntroduction ObjectivesObjectives ScopeScope Instruments of Monetary PolicyInstruments of Monetary Policy

Quantitative MeasuresQuantitative Measures Qualitative MeasuresQualitative Measures

Controlling InflationControlling Inflation Monetary Policy of IndiaMonetary Policy of India

Page 5: Monetary Policy

OBJECTIVESOBJECTIVES

To achieve price stability by controlling inflation and To achieve price stability by controlling inflation and deflation.deflation.

To promote and encourage economic growth in the To promote and encourage economic growth in the economy.economy.

To ensure the economic stability at full employment or To ensure the economic stability at full employment or potential level of output.potential level of output.

Page 6: Monetary Policy

ContentsContents IntroductionIntroduction ObjectivesObjectives ScopeScope Instruments of Monetary PolicyInstruments of Monetary Policy

Quantitative MeasuresQuantitative Measures Qualitative MeasuresQualitative Measures

Controlling InflationControlling Inflation Monetary Policy of IndiaMonetary Policy of India

Page 7: Monetary Policy

SCOPE OF MONETARY POLICYSCOPE OF MONETARY POLICY

The scope of Monetary policy depends on two factorsThe scope of Monetary policy depends on two factors

1. 1. Level of Monetization of the Economy -Level of Monetization of the Economy -In this all economic transactions are carried out with money as a In this all economic transactions are carried out with money as a medium of exchange . This is done by changing the supply of and medium of exchange . This is done by changing the supply of and demand for money and the general price level. It is capable of demand for money and the general price level. It is capable of affecting all economics activities such as Production, Consumption, affecting all economics activities such as Production, Consumption, Savings, Investment etc. Savings, Investment etc.

2. 2. Level of Development of the Capital MarketLevel of Development of the Capital MarketSome instrument of Monetary Policy are work through capital Some instrument of Monetary Policy are work through capital market such as Cash Reserve Ratio (CRR) etc. When capital market market such as Cash Reserve Ratio (CRR) etc. When capital market is fairly developed then the Monetary Policy effects the level of is fairly developed then the Monetary Policy effects the level of economic activities by the change in capital market. It works faster economic activities by the change in capital market. It works faster and more effectively.and more effectively.

Page 8: Monetary Policy

ContentsContents IntroductionIntroduction ObjectivesObjectives ScopeScope Instruments of Monetary PolicyInstruments of Monetary Policy

Quantitative MeasuresQuantitative Measures Qualitative MeasuresQualitative Measures

Controlling InflationControlling Inflation Monetary Policy of IndiaMonetary Policy of India

Page 9: Monetary Policy

• The open market operations is sale and purchase of government securities The open market operations is sale and purchase of government securities and Treasury Bills by the central bank of the country. and Treasury Bills by the central bank of the country.

• When the central bank decides to pump money into circulation, it buys When the central bank decides to pump money into circulation, it buys back the government securities, bills and bonds.back the government securities, bills and bonds.

• When it decides to reduce money in circulation it sells the government When it decides to reduce money in circulation it sells the government bonds and securities. bonds and securities.

• The central bank carries out its open market operations through the The central bank carries out its open market operations through the commercial banks.commercial banks.

Page 10: Monetary Policy

Discount rate or bank rate is the rate at which central bank Discount rate or bank rate is the rate at which central bank rediscounts the bills of exchange presented by the commercial rediscounts the bills of exchange presented by the commercial bank. bank.

The central bank can change this rate increase or decrease The central bank can change this rate increase or decrease depending on whether it wants to expand or reduce the flow of depending on whether it wants to expand or reduce the flow of credit from the commercial bank.credit from the commercial bank.

Page 11: Monetary Policy

• A rise in the discount rate reduces the net worth of the A rise in the discount rate reduces the net worth of the government bonds against which commercial banks borrow funds government bonds against which commercial banks borrow funds from the central bank. This reduces commercial banks capacity to from the central bank. This reduces commercial banks capacity to borrow from the central bank.borrow from the central bank.

• When the central bank raises its discount rate, commercial banks When the central bank raises its discount rate, commercial banks raise their discount rate too. Rise in the discount rate raises the raise their discount rate too. Rise in the discount rate raises the cost of bank credit which discourages business firms to get their cost of bank credit which discourages business firms to get their bill of exchange discounted.bill of exchange discounted.

Page 12: Monetary Policy

• The cash reserve ratio is the percentage of total deposits which The cash reserve ratio is the percentage of total deposits which commercial banks are required to maintain in the form of cash commercial banks are required to maintain in the form of cash reserve with the central bank.reserve with the central bank.

• The objective of cash reserve is to prevent shortage of cash for The objective of cash reserve is to prevent shortage of cash for meeting the cash demand by the depositors.meeting the cash demand by the depositors.

• By changing the CRR, the central bank can change the money By changing the CRR, the central bank can change the money supply overnight.supply overnight.

• When economic conditions demand a contractionary monetary When economic conditions demand a contractionary monetary policy, the central bank raises the CRR. And when economic policy, the central bank raises the CRR. And when economic conditions demand monetary expansion ,the central bank cuts conditions demand monetary expansion ,the central bank cuts down the CRR.down the CRR.

Page 13: Monetary Policy

• In India ,the RBI has imposed another reserve requirement in In India ,the RBI has imposed another reserve requirement in addition to CRR. It is called statutory liquidity requirement.addition to CRR. It is called statutory liquidity requirement.

• The SLR is the proportion of the total deposits which commercial The SLR is the proportion of the total deposits which commercial banks are statutorily required to maintain in the form of liquid banks are statutorily required to maintain in the form of liquid assets in addition to cash reserve ratio.assets in addition to cash reserve ratio.

Page 14: Monetary Policy

ContentsContents IntroductionIntroduction ObjectivesObjectives ScopeScope Instruments of Monetary PolicyInstruments of Monetary Policy

Quantitative MeasuresQuantitative Measures Qualitative MeasuresQualitative Measures

Controlling InflationControlling Inflation Monetary Policy of IndiaMonetary Policy of India

Page 15: Monetary Policy

When there is a shortage of institutional credit available for the When there is a shortage of institutional credit available for the business sector, the large and financially strong sectors or business sector, the large and financially strong sectors or industries tend to capture the lion’s share in the total institutional industries tend to capture the lion’s share in the total institutional credit. credit.

As a result the priority sectors and essential industries are of As a result the priority sectors and essential industries are of necessary funds.necessary funds.

Below two measures are generally adopted:Below two measures are generally adopted: Imposition of upper limits on the credit available to large Imposition of upper limits on the credit available to large

industries and firmsindustries and firms Charging a higher or progressive interest rate on the bank loans Charging a higher or progressive interest rate on the bank loans

beyond a certain limit.beyond a certain limit.

Page 16: Monetary Policy

• The banks provide loans only up to a certain percentage of the The banks provide loans only up to a certain percentage of the value of the mortgaged property. value of the mortgaged property.

• The gap between the value of the mortgaged property and The gap between the value of the mortgaged property and amount advanced is called Lending Margin.amount advanced is called Lending Margin.

• The central bank is empowered to increase the lending margin The central bank is empowered to increase the lending margin with a view to decrease the bank credit.with a view to decrease the bank credit.

Page 17: Monetary Policy

The moral suasion is a method of persuading and convincing the The moral suasion is a method of persuading and convincing the commercial banks to advance credit in accordance with the commercial banks to advance credit in accordance with the directives of the central bank in overall economic interest of the directives of the central bank in overall economic interest of the country.country.

Under this method the central bank writes letter to hold meetings Under this method the central bank writes letter to hold meetings with the banks on money and credit matterswith the banks on money and credit matters.

Page 18: Monetary Policy

ContentsContents IntroductionIntroduction ObjectivesObjectives ScopeScope Instruments of Monetary PolicyInstruments of Monetary Policy

Quantitative MeasuresQuantitative Measures Qualitative MeasuresQualitative Measures

Controlling InflationControlling Inflation Monetary Policy in IndiaMonetary Policy in India

Page 19: Monetary Policy

An Expansionary Policy increases the total supply of money in the An Expansionary Policy increases the total supply of money in the economy while a Contractionary Policy decreases the total money economy while a Contractionary Policy decreases the total money Supply into the market.Supply into the market.

Expansionary policy is traditionally used to combat a recession by Expansionary policy is traditionally used to combat a recession by lowering interests rates.lowering interests rates.

Lowered interest rates means lower cost of credit which induces Lowered interest rates means lower cost of credit which induces people to borrow and spend thereby providing steam to various people to borrow and spend thereby providing steam to various industries and kick start a slowing economy.industries and kick start a slowing economy.

Page 20: Monetary Policy

A Contractionary Policy results in increasing interest rates to A Contractionary Policy results in increasing interest rates to combat inflation.combat inflation.

An Economy growing in an uninhibited manner leads to inflationAn Economy growing in an uninhibited manner leads to inflation Hence increasing interest rates increase the cost of credit thereby Hence increasing interest rates increase the cost of credit thereby

making people borrow less.making people borrow less. Due to lesser borrowing the amount of money in the system Due to lesser borrowing the amount of money in the system

reduces which in turn brings down inflation.reduces which in turn brings down inflation. A Contractionary Policy is also known as TIGHT POLICY as it A Contractionary Policy is also known as TIGHT POLICY as it

tightens the flow of money in order to contain Inflationary forces. tightens the flow of money in order to contain Inflationary forces.

Page 21: Monetary Policy

The RBI makes an adjustment in its lending rate(Repo Rates) in The RBI makes an adjustment in its lending rate(Repo Rates) in order to influence the cost of credit. Thereby discouraging order to influence the cost of credit. Thereby discouraging borrowing and hence reduces brings reduction in the system.borrowing and hence reduces brings reduction in the system.

Page 22: Monetary Policy

Whenever the liquid in the system increases, the RBI intervenes to Whenever the liquid in the system increases, the RBI intervenes to stabilize the system.stabilize the system.

The Central Bank does this by issuing fresh bonds and treasury The Central Bank does this by issuing fresh bonds and treasury bills in open market. This tool was extensively used at the time bills in open market. This tool was extensively used at the time when dollar inflows into our economy were very high, resulting in when dollar inflows into our economy were very high, resulting in rupee appreciatin. Inorder to stabilize the exchange rates, RBI first rupee appreciatin. Inorder to stabilize the exchange rates, RBI first bought additional dollars thereby stabilizing the rate of exchange.bought additional dollars thereby stabilizing the rate of exchange.

Page 23: Monetary Policy

CRR-CRR- By increasing the CRR, the RBI decreases the lending capacity of By increasing the CRR, the RBI decreases the lending capacity of

the bank to the extent of the increase in the ratiothe bank to the extent of the increase in the ratio. E.g of the CRR is increased from 7.5% to 8.5% the banks were E.g of the CRR is increased from 7.5% to 8.5% the banks were

deprived of lending to the extent of 75 basis points of their deposit deprived of lending to the extent of 75 basis points of their deposit valuevalue.

Page 24: Monetary Policy

CENTRAL BANK

SECURITIES AND TRESURY BILLS

BANK RATE

COMMERCIAL BANKS

CORPORATES INDIVIDUALS

SOLD

CA

SH

INC

RE

AS

E

LEN

DIN

G R

ATE

CASH RESERVE RATIO

REDUCED BORROWING OF LOANS

INC

RE

AS

E IN

CR

R

%

REDUCE LIQUIDITY IN MARKET

STATUTORY LIQUID RATIO

Page 25: Monetary Policy

ContentsContents IntroductionIntroduction ObjectivesObjectives ScopeScope Instruments of Monetary PolicyInstruments of Monetary Policy

Quantitative MeasuresQuantitative Measures Qualitative MeasuresQualitative Measures

Controlling InflationControlling Inflation Monetary Policy of IndiaMonetary Policy of India

Page 26: Monetary Policy

Historically, the Monetary Policy is announced twice a year April-Historically, the Monetary Policy is announced twice a year April-September and (October-March).September and (October-March).

The Monetary Policy has become dynamic in nature as RBI reserves The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the its right to alter it from time to time, depending on the state of the economy.economy.

The Monetary policy determines the supply of money in the economy The Monetary policy determines the supply of money in the economy and the rate of interest charged by banks. The policy also contains an and the rate of interest charged by banks. The policy also contains an economic overview and provides future forecasts.economic overview and provides future forecasts.

The Reserve Bank of India is responsible for formulating and The Reserve Bank of India is responsible for formulating and implementing Monetary Policy..implementing Monetary Policy..

Page 27: Monetary Policy

The Monetary Policy aims to maintain price stability, full employment The Monetary Policy aims to maintain price stability, full employment and economic growth.and economic growth.

Emphasis on these objectives have been changing time to time Emphasis on these objectives have been changing time to time depending on prevailing circumstances.depending on prevailing circumstances.

For explanation of monetary policy, the whole period has been For explanation of monetary policy, the whole period has been divided into 4 sub periods:divided into 4 sub periods:a) Monetary policy of controlled expansion (1951 to 1972)a) Monetary policy of controlled expansion (1951 to 1972)b) Monetary Policy during Pre Reform period (1972 to 1991)b) Monetary Policy during Pre Reform period (1972 to 1991)c) Monetary Policy in the Post-Reforms (1991 to 1996)c) Monetary Policy in the Post-Reforms (1991 to 1996)d) Easing of Monetary policy since Nov 1996d) Easing of Monetary policy since Nov 1996

Page 28: Monetary Policy

Monetary policy of controlled expansion (1951 to 1972)

To regulate the expansion of money supply and bank credit to To regulate the expansion of money supply and bank credit to promote growth.promote growth.

To restrict the excessive supply of credit to the private sector so as to To restrict the excessive supply of credit to the private sector so as to control inflationary pressures.control inflationary pressures.

Following steps were taken:1)1) Changes in Bank Rate from 3% in 1951 to 6% in 1965 and it remained Changes in Bank Rate from 3% in 1951 to 6% in 1965 and it remained

the same till 1971.the same till 1971.2)2) Changes in SLR from 20% in 1956 to 28% in 1971Changes in SLR from 20% in 1956 to 28% in 19713)3) Select Credit Control: In order to reduce the credit or bank loans Select Credit Control: In order to reduce the credit or bank loans

against essential commodities, margin was increased.against essential commodities, margin was increased.As a result of the above changes, the supply of money increased from As a result of the above changes, the supply of money increased from

3.4% (1951 to 1956) to 9.1 (1961 to 1965). 3.4% (1951 to 1956) to 9.1 (1961 to 1965).

Page 29: Monetary Policy

Monetary Policy during Pre Reform period (1972 to 1991):

Also known as the Tight Monetary policy: Price situation worsened Also known as the Tight Monetary policy: Price situation worsened during 1972 to 1974.during 1972 to 1974.

Following Monetary Policy was adopted in 70’s and 80’s which were Following Monetary Policy was adopted in 70’s and 80’s which were mainly concerned with the task neutralizing the impact of fiscal deficit mainly concerned with the task neutralizing the impact of fiscal deficit and inflationary pressure. and inflationary pressure.

1)1)Changes in CRR to the legally maximum limit of 25%Changes in CRR to the legally maximum limit of 25%2)2)Changes in SLR also to the maximum limit to 38.5%Changes in SLR also to the maximum limit to 38.5%

Page 30: Monetary Policy

Monetary Policy in the Post-Reforms – 1991 to 1996:

The year 1991-1992 saw a fundamental change in the institutional The year 1991-1992 saw a fundamental change in the institutional framework in setting the objective of monetary policy. It had twin framework in setting the objective of monetary policy. It had twin objectives which were Price stability and economic growth. Following objectives which were Price stability and economic growth. Following instruments were used:instruments were used:1) Continuing the same maximum CRR and SLR of 25% and 38.5%, Continuing the same maximum CRR and SLR of 25% and 38.5%, mopped up bank deposits to the extent of 63.5%.mopped up bank deposits to the extent of 63.5%.2) In order to ensure profitability of banks, Monetary Reforms In order to ensure profitability of banks, Monetary Reforms Committee headed by late Prof. S Chakravarty, recommended raising of Committee headed by late Prof. S Chakravarty, recommended raising of interest rate on Government Securities which activated Open Market interest rate on Government Securities which activated Open Market Operations (OMO).Operations (OMO).3) Bank rate was raised from 10% in Apr 1991 to 12% in Oct 1991 to ) Bank rate was raised from 10% in Apr 1991 to 12% in Oct 1991 to control the inflationary pressures.control the inflationary pressures.

Page 31: Monetary Policy

Easing of Monetary policy since Nov 1996: In 1996-97, the rate of inflation sharply declined. In the later half 1996-In 1996-97, the rate of inflation sharply declined. In the later half 1996-97, industrial recession gripped the Indian economy. To encourage the 97, industrial recession gripped the Indian economy. To encourage the economic growth and to tackle the recessionary trend, the RBI eased its economic growth and to tackle the recessionary trend, the RBI eased its monetary policy.monetary policy.1.1.Introduction of Repo rate. Repo rate increased from 3% in 1998 to 6.5% Introduction of Repo rate. Repo rate increased from 3% in 1998 to 6.5% in 2005. This instrument was consistently used in the monitory policy as in 2005. This instrument was consistently used in the monitory policy as a result of rapid industrial growth during 2005-06. In the current a result of rapid industrial growth during 2005-06. In the current monetary policy, the Repo rate was cut from 5.00% to 4.75%.monetary policy, the Repo rate was cut from 5.00% to 4.75%.2.2.Reverse Repo rate –Through RRR, the RBI mops up liquidity from the Reverse Repo rate –Through RRR, the RBI mops up liquidity from the banking system. In the current monetary policy, the Repo rate was cut banking system. In the current monetary policy, the Repo rate was cut from 3.50% to 3.25%.from 3.50% to 3.25%.

Page 32: Monetary Policy

Easing of Monetary policy since Nov 1996: (Contd)

3.3. Flow of credit to Agriculture – The flow of credit to agriculture has Flow of credit to Agriculture – The flow of credit to agriculture has increased from 34,013 (9.2% of overall credit) in 2008 to 52,742 (13% increased from 34,013 (9.2% of overall credit) in 2008 to 52,742 (13% in overall credit) in 2009 – (Rs. in crore).in overall credit) in 2009 – (Rs. in crore).

4.4. Reduction in Cash Reserve Ratio – The CRR which was at 15% until Reduction in Cash Reserve Ratio – The CRR which was at 15% until 1995 gradually reduced to 5% in 2005. The CRR remained unchanged 1995 gradually reduced to 5% in 2005. The CRR remained unchanged in the current monetary policy.in the current monetary policy.

5.5. Lowering Bank rate – The Bank rate was gradually reduced from 12% Lowering Bank rate – The Bank rate was gradually reduced from 12% in 1997 to 6% in 2003. Since then the Bank Rate has remained in 1997 to 6% in 2003. Since then the Bank Rate has remained unchanged to 6%.unchanged to 6%.

Page 33: Monetary Policy

Review of 2009/10 Monetary policy The Policy Review projects GDP growth at 6% this FY due to The Policy Review projects GDP growth at 6% this FY due to

slackening private consumption and investment demand.slackening private consumption and investment demand. The RBI set its inflation projection for March 10 at 4% (currently at -The RBI set its inflation projection for March 10 at 4% (currently at -

1.21%). The RBI also projects the CPI to come down into the single 1.21%). The RBI also projects the CPI to come down into the single digit zone.digit zone.

Assurance of a non-disruptive borrowing in 2009-10. Recently, the Assurance of a non-disruptive borrowing in 2009-10. Recently, the Government increased the borrowing plan from Rs. 2.41 lakh crore to Government increased the borrowing plan from Rs. 2.41 lakh crore to 2.99 Lakh crore because of ample liquidity in the market due to slow 2.99 Lakh crore because of ample liquidity in the market due to slow credit growth.credit growth.

The fiscal stimulus packages of the Government and monetary easing The fiscal stimulus packages of the Government and monetary easing and regulatory action of the Reserve Bank have helped to arrest the and regulatory action of the Reserve Bank have helped to arrest the moderation in growth and keep our financial markets functioning moderation in growth and keep our financial markets functioning normally.normally.

Page 34: Monetary Policy

THANK YOUTHANK YOU


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