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Monetary policy

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  • 1. Monetary Policy RBI and Monetary Policy in India

2. Monetary Magnitudes

  • M 1= Currency with public+
  • Demand deposits with banks+Other Deposits with RBI
  • M 2= M 1 + Post Office Deposits
  • M 3= M 1 + Time Deposits with Banks
  • M 4= M 3 + Total Post Office Deposits

3. Growth of M 3and Differential Contribution of Components

  • Source: RBI-Macroeconomic and Monetary Developments: Third Quarter Review 2005-06

4. What is Monetary Policy?

  • The term monetary policy refers to actions taken by central banks to affect monetary magnitudes or other financial conditions.
  • Monetary Policy operates on monetary magnitudes or variables such asmoney supply, interest rates and availability of credit.
  • Monetary Policy ultimately operates through its influence on expenditure flows in the economy.
  • In other words affects liquidity and by affecting liquidity, and thus credit, it affects total demand in the economy.

5. Credit Policy

  • Central Bank may directly affect the money supply to control its growth.
  • Or it might act indirectly to affect cost and availability of credit in the economy.
  • In modern times the bulk of money in developed economies consists of bank deposits rather than currencies and coins.
  • So central banks today guide monetary developments with instruments that control over deposit creation and influence general financial conditions.
  • Credit policy is concerned with changes in the supply of credit.
  • Central Bank administers both the Credit and Monetary policy

6. Aims of Monetary policy

  • MP is a part of general economic policy of the govt.
  • Thus MP contributes to the achievement of the goals of economic policy.
  • Objective of MP may be:
  • Full employment
  • Stable exchange rate
  • Healthy BoP
  • Economic growth
  • Reasonable Price Stability
  • Greater equality in distribution ofincome & wealth
  • Financial stability

7. Price Stability: The Dominant Objective

  • There is convergence of views in developed and developing economies, that price stability is the dominant objective of monetary policy.
  • Price stability does not mean complete year-to-year price stability which is difficult to attain.
  • Price stability refers to the long run average stability of prices.
  • Price stability involves avoidance of both inflationary and deflationary pressures.


  • Price Stability contributes improvements in the standard of living of people.
  • It promotes saving in the economy while discouraging unproductive investment.
  • Stable prices enable exports to compete in international markets and contribute to the strengthening of BoP.
  • Price stability leads to interest rate stability, and exchange rate stability (via export import stability).
  • It contributes to the overall financial stability of the economy.

9. Operation of Monetary Policy

  • Instruments
  • Discount Rate
  • (Bank Rate)
  • 2.Reserve Ratios
  • 3. Open Market
  • Operations
  • Operating
  • Target
  • Monetary Base
  • Bank Credit
  • Interest Rates
  • Intermediate
  • Target
  • Monetary
  • Aggregates(M3)
  • Long term
  • interest rates
  • Ultimate
  • Goals
  • Total Spending
  • Price Stability
  • Etc.

10. Instruments of Monetary Policy

  • Variations in Reserve Ratios
  • Discount Rate (Bank Rate)
  • (also called rediscount rate)
  • Open Market Operations (OMOs)
  • Other Instruments

11. Variations in Reserve Ratios

  • Banks are required to maintain a certain percentage of their deposits in the form of reserves or balances with the RBI
  • It is calledCash Reserve Ratio or CRR
  • Since reserves are high-powered money or base money, by varying CRR, RBI can reduce or add to the banks required reserves and thus affect banks ability to lend.

12. Discount Rate (Bank Rate)

  • Discount rate is the rate of interest charged by the central bank for providing funds or loans to the banking system.
  • Funds are provided either through lending directly or rediscounting or buying commercial bills and treasury bills.
  • Raising Bank Rate raises cost of borrowing by commercial banks, causing reduction in credit volume to the banks, and decline in money supply.
  • Variation in Bank Rate has an effect on the domestic interest rate, especially the short term rates.
  • Market regards the increase in Bank rate as the official signal for beginning of a tight money situation.

13. Open Market Operations (OMOs)

  • OMOs involve buying (outright or temporary) and selling of govt securities by the central bank, from or to the public and banks.
  • RBI when purchases securities, pays the amount of money by crediting the reserve deposit account of the sellers bank, which in turn credits the sellers deposit account in that bank.


  • Monetary policy also known as Money and Credit Policy:
  • It concerns itself with the supply of money as also credit to economy
  • Till 1998-99:It was announced twicein a year:Oct.for Oct..March.to coincide with busy season
  • Aprilfor April to Septto coincide with lean season of agri.With decline in agri. And rise in industrial credit since 1999-2000 in April RBI makes an annual policystatement and a review in Oct.


  • Since 1951 and till 1990s.
  • Two sets of objectives pursued
  • a)controlled expansion of money
  • b)sectoral deployment of funds
  • Done keeping in mind plan priorities
  • Special attention
  • Core industries (coal, iron, steel and engg.)
  • foodgrains (rice, wheat etc.)
  • priority sectors ( agri., SSI)
  • weaker sections of population

16. In general, the interaction between monetary and fiscal policy occurs To control inflationary or deflationary impact of fiscal policy For instance, a substantial multi-year rise in the deficit need not cause an increase in inflation was demonstrated in USA: Between 1979-85budget deficit rose from 2.7% of GDP to 5.1% of GDPnational debt rose from 26% of GDP to 36% of GDP

  • However, GDP price inflation fell from 8.2 % to 3.2%
  • This due to a tough anti-inflationary monetary policy pursued by the Federal Reserve.


  • In India, for instance, In 90s
  • growth of economy remain primary aim
  • control of inflation urgent concern
  • (91.double digit.17%)
  • 8th (92-97)aimed at achieving trend rate of inflation 5%
  • MP of 90s favoredprocess of stabilization and structuraladjustment initiated in 91


  • Various measures used by RBI include:
  • Rate of interest (or price of money)
  • Quantity or supply of money
  • Access to or demand for money
  • One imp. Instrument is bank rate or discount rate..
  • Rate at which RBI lends to the banking system
  • Through it: short term interest
  • long term rates
  • level of economic activity
  • international capital inflows
  • Second imp. Instrument is sale or purchase of govt. securities
  • (by sale of securities banks resources reduce and vice versa


  • Third imp. Instrument
  • Cash Reserve Ratio: Banks Cash Holding/Total Deposit Liabilities
  • Fourth Imp. Instrumentis Statutory Liquidity Ratio(SLR)
  • RBI imposes an obligation on banks to buy govt. Securties (of
  • Low interest rates)(25% at present)
  • To achieve the objective of sectoral deployment of credit..
  • Direct (Quantity)
  • Reserve ratios
  • Quantitative controls on RBI lending to banks and commercial sector
  • Quantitative credit controls
  • Indirect Instruments administrative setting of various interest rates:
  • e.g. RBI lending
  • commercial bank lending
  • deposits


  • In 1960s .. Emphasis was on indirect measures with little variation
  • in reserve ratios
  • In1970s Emphasis shifted to direct approaches and persisted sincethen
  • Shift from indirect to direct measures was prevalent more
  • due to rising deficit or inflation
  • Monetary instrument in India, both direct and indirect, operate
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