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Monetary Policy
RBI and Monetary Policy in India
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What is Monetary Policy?
The term monetary policy refers to actions takenby central banks to affect monetary magnitudesor other financial conditions.
Monetary Policy operates on monetarymagnitudes or variables such as money supply,interest rates and availability of credit.
Monetary Policy ultimately operates through itsinfluence on expenditure flows in the economy.
In other words affects liquidity and by affectingliquidity, and thus credit, it affects total demandin the economy.
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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 thancurrencies and coins.
So central banks today guide monetarydevelopments with instruments that control overdeposit creation and influence general financialconditions.
Credit policy is concerned with changes in thesupply of credit.
Central Bank administers both the Credit and
Monetary policy
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Aims of Monetary policy
MP is a part of general economic policy of thegovt.
Thus MP contributes to the achievement of thegoals 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
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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.
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Contd..
Price Stability contributes improvements in thestandard of living of people.
It promotes saving in the economy whilediscouraging unproductive investment.
Stable prices enable exports to compete ininternational markets and contribute to thestrengthening of BoP.
Price stability leads to interest rate stability, andexchange rate stability (via export import
stability). It contributes to the overall financial stability ofthe economy.
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Operation of Monetary
Policy
Instruments
1. 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.
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Instruments of Monetary Policy
Variations in Reserve Ratios
Discount Rate (Bank Rate)
(also called rediscount rate) Open Market Operations (OMOs)
Other Instruments
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Variations in Reserve Ratios
Banks are required to maintain a certainpercentage of their deposits in the form ofreserves or balances with the RBI
It is called Cash Reserve Ratio or CRR
Since reserves are high-powered moneyor base money, by varying CRR, RBI can
reduce or add to the banks requiredreserves and thus affect banks ability tolend.
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Discount Rate (Bank Rate) Discount rate is the rate of interest charged by the
central bank for providing funds or loans to thebanking system.
Funds are provided either through lending directly orrediscounting or buying commercial bills and
treasury bills. Raising Bank Rate raises cost of borrowing by
commercial banks, causing reduction in creditvolume to the banks, and decline in money supply.
Variation in Bank Ratehas an effect on t
hedomestic interest rate, especially the short term
rates.
Market regards the increase in Bank rate as theofficial signal for beginning of a tight money
situation.
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Open Market Operations (OMOs)
OMOs involve buying (outright ortemporary) and selling of govt securitiesby 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 th
e sellers bank, wh
ich
in turn credits the sellers deposit accountin that bank.
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Money Supply
Currency issued by government fiduciary
supply
Money supply is expressed in two broadmeasures Narrow money and Broad
Money
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Monetary Magnitudes
Reserve Money (M0): Currency in circulation + Bankers deposits with the
RBI + Other deposits with the RBI
M1: Currency with the public + Deposit money of the public (Demand
deposits with the banking system + Other deposits with the RBI).
M2: M1 + Savings deposits with Post office savings banks. M3: M1+ Time deposits with the banking system
M4: M3 + All deposits with post office savings banks (excluding National
Savings Certificates).
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Currency Growth
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Money supply
how the banking system creates money
three ways t
he RBI can control t
he moneysupply
why the RBI cant control it precisely
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Banks role in the money supply
The money supply equals currency plusdemand (checking account) deposits:
M = C + D
Where
C = Currency with Public
D = Demand deposits with Public
Since the money supply includes demanddeposits, the banking system plays animportant role.
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A few preliminaries
Reserves(R): the portion of deposits that bankshave not lent.
To a bank, liabilities include deposits,
assets include reserves and outstanding
loans
100-percent-reserve banking: a system in which
banks hold all deposits as reserves.
Fractional-reserve banking:a system in which banks hold a fraction of their
deposits as reserves.
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SCENARIO 1: No Banks
With no banks,
D = 0 and M = C = Rs.1000.
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SCENARIO 2: Fractional-Reserve Banking
The money supply
now equals Rs.1800:
The depositor still
has Rs.1000 in
demand deposits,
but now the
borrowerholds
Rs.800 in currency.
FIRSTBANKSbalance sheet
Assets Liabilities
deposits Rs.1000
Suppose banks hold 20% of deposits in reserve, making loans withthe rest.
Firstbank will make Rs.800 in loans.
reserves
Rs.1000
reserves Rs.200
loans Rs.800
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SCENARIO 2: Fractional-Reserve Banking
The money supply
now equals Rs.1800:
The depositor still
has Rs.1000 in
demand deposits,
but now the
borrowerholds
Rs.800 in currency.
FIRSTBANKSbalance sheet
Assets Liabilities
reserves Rs.200
loans Rs.800
deposits Rs.1000
Thus, in a fractional-reservebanking system, banks create money.
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SCENARIO 2: Fractional-Reserve Banking
But thenSecondbank will
loan 80% of this
deposit
and its balance
sheet will look like
this:
SECONDBANKSbalance sheet
Assets Liabilities
reserves Rs.800
loans Rs.0
deposits Rs.800
Suppose the borrower deposits the Rs.800 in Secondbank.
Initially, Secondbanks balance sheet is:
reserves Rs.160
loans Rs.640
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SCENARIO 2: Fractional-Reserve Banking
THIRDBANKSbalance sheet
Assets Liabilities
reserves Rs.640
loans Rs.0
deposits Rs.640
If this Rs.640 is eventually deposited in Thirdbank,
then Thirdbank will keep 20% of it in reserve, and loan the rest out:
reserves Rs.128
loans Rs.512
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Finding the total amount of money:
Original deposit = Rs.1000
+ Firstbank lending = Rs. 800
+ Secondbank lending = Rs. 640
+ Thirdbank lending = Rs. 512+ other lending
Total money supply = (1/rr )v Rs.1000
where rr = ratio of reserves to deposits
In our example, rr = 0.2, so M = Rs.5000
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Money creation in the banking system
A fractional reserve banking systemcreates money,
but it doesnt create wealth:
bank loans give borrowerssome new money
and an equal amount of new debt.
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A model of the money supply
the monetary base, B = C + R
controlled by the central bank
C = Currency with Publi
c
R= Currency deposits fo Comm. Banks with RBI
the reserve-deposit ratio, rr = R/D
depends on regulations & bank policies
the currency-deposit ratio, cr= C/D
depends on households preferences
exogenous variables
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The H Theory of Money Supply
Currency
with PublicC
Currency
with Public
C
Cash
ReservesR
Demand DepositsD
B= C+R
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The Money Multiplier
The supply of money is the multiples of cashreserves
One rupee kept as bank reserves gives rise tomuch more amount of demand deposits
The relation ship between Base money andmoney supply is determined by moneymultiplier(m)
m = M / BRearranging we have
M = B.m
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A model of the money supply
the monetary base, B = C + R
controlled by the central bank
C = Currency with Publi
c
R= Currency deposits fo Comm. Banks with RBI
the reserve-deposit ratio, rr = R/D
depends on regulations & bank policies
the currency-deposit ratio, cr= C/D
depends on households preferences
exogenous variables
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slide 30
Solving for the money supply:
M C D! C D
BB
! v m B! v
C D
C R
!
1cr
cr rr
!
C DmB
!
where
C D D D
C D R D
!
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The money multiplier
Ifrr
< 1, then
m
> 1 If monetary base changes by (B,
then (M = m v (B
m is called the money multiplier.
,M m B! v1
wherecr
mcr rr
!
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Money Supply
Y
X
Money Supply
0
MS1 MS2
Rate ofInterest
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Money Demand
Y
X0
Rate ofInterest
Quantity of Money
i3
i2
i1
M1 M2 M3
Md
Md
Two set economy
1.Currency in Hand + DD
2. Bonds
If the interest rates are
high high opportunity
cost for holding cash
bonds can earn higher
returns than holding cash
which does not pay any
returns
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Money Demand
Y
X0
Rate ofInterest
Quantity of Money
i3
i2
i1
M1 M2 M3
Md1
Md1
Md2
Md2
If the level of incomeincrease the money
demand curve will shift
right
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Money market Equilibrium
Money market is in equilibrium at a rate of
interest when demand for money is equal
to the fixed money supply
MS = MD
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0
InterestRate
Quantity Of Money (Crores of Rupees)
Money Market Equilibrium
Money supply
9
7E1
The amount of money
demanded (held) dependson interest rates
LO1
5E2
E3
M1 M2M3
Excess money supply at
a given interest rate
people buys bonds
raises bonds
decreases interest rates
Increases the quantity of
money demanded will
be equal to money
supply and vice versa
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If there is excess money supply at a given
interest rate people buys bonds raises
bonds decreases interest rates
It increases the quantity of money
demanded will be equal to money supply
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0
InterestRate
Quantity Of Money (Crores of Rupees)
Money Market Equilibrium
Money supply
9
7E1
The amount of money
demanded (held) dependson interest rates
LO1
M
E2
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Link between goods market and
money market Goods market Equilibrium Money market equilibrium
IS LM Model
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Goods market Equilibrium
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Goods market Equilibrium1. If interest rates decrease, Investments Increase and
aggregate demand will increase Higher will be the
equilibrium of national income
2. If the interest rates increases, investments will
decrease , aggregate demand will decrease lowerwill be the equilibrium of national income
3. By joining points A, B & D we will get IS Curve
4. IS curve slopes downwards decrease in interestrates increases national Income and vise versa
5. IS curve may shift due government expenditure
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Money Market Equilibrium
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LM Curve1. Is derived from Keynesian theory
2. Greater the level of income greater the money held for
transaction motive, the money Demand curve will be
higher
3. Money supply has to match the higher money demand
4. LM curve is derived by connecting intersections
different money demand curves and money supply
curves corresponding to different levels of income
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Simultaneous equilibrium of Goods Market
and money market
Point at which Goods
market is in equilibrium
and Money market is inequilibrium
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IS-LM Curve1. Investment demand function
2. Consumption function
3. Money demand function
4. Quantity of money
Saving and investment, productivity of capital andpropensity to consume and save, demand for money
and supply of money all these factors determine the
rate of interest and level of income.
Changes in the factors will shift the equilibrium of IS-LMCurves
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If supply of money is high, interest rates
will fall, LM curve will shift right
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Inflation In economics, inflation is a persistent rise in the
general level of prices of goods and services in
an economy over a period of time
Inflation also reflects an erosion in the purchasing
power of money a loss of real value
A chief measure of price inflation is the inflation rate,the annualized percentage change in a general price
index (normally the Consumer Price Index) over time.
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Inflation
Negative effects - decrease in the real value of money and
other monetary items over time, uncertainty over future
inflation may discourage investment and savings, and high
inflation may lead to shortages of goods if consumers
begin hoarding out of concern that prices will increase in
the future.
Positive effects - ensuring central banks can
adjust nominal interest rates (intended to
mitigate recessions),and encouraging investment in non-monetary capital projects.
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Inflation
Inflation Price Inflation and Money inflation
Excess money supply will lead to price inflation
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Inflation
Headline inflation is a measure of the total inflationwithin an economy and is affected by areas of the
market which may experience sudden inflationary spikes
such as food or energy
Inflationary Spikes- sudden price rise in some
commodities
Hyperinflation is inflation that is very high or out of
control. Hyperinflation often occurs when there is a largeincrease in the money supply not supported by gross
domestic product (GDP) growth
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Inflation
Stagflation combination of stagnation and inflation
Suppressed inflation govt. polices suppress inflation
Disinflation keeping the inflation rates lower
Deflation opposite to inflation prices fall persistently
revenues for producers fall- low investments fall in
demand fall in incomes
An inflationary gap, in economics, is the amount by
which the real Gross domestic product, or real GDP,
exceeds potential GDP
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Inflation rates around the world
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Inflation rates in India
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Causes of Inflation
The quantity theory of inflation rests on the quantity equation ofmoney, that relates the money supply, its velocity, and the nominal
value of exchanges.
Currently, the quantity theory of money is widely accepted as an
accurate model of inflation in the long run. Consequently, there isnow broad agreement among economists that in the long run, the
inflation rate is essentially dependent on the growth rate of money
supply.
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Keynesian view
Keynesian economic theory proposes that changes in
money supply do not directly affect prices, and thatvisible inflation is the result of pressures in the
economy expressing themselves in prices.
There are three major types of inflation, as part ofwhat Robert J. Gordon calls the "triangle model
Demand pull inflation
Cost push inflationBuilt-in-inflation
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Demand-pull inflation is caused by increases in aggregatedemand due to increased private and government
spending, etc. Demand inflation is constructive to a faster
rate of economic growth since the excess demand and
favourable market conditions will stimulate investment andexpansion.
increase in money supply
increase in disposable income
increase in aggregate spendingincrease in population of the country
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Cost-push inflation, also called "supply shock inflation," is
caused by a drop in aggregate supply (potential output).
This may be due to natural disasters, or increased prices of
inputs. For example, a sudden decrease in the supply of oil,leading to increased oil prices, can cause cost-push
inflation. Producers for whom oil is a part of their costs could
then pass this on to consumers in the form of increased
prices.
Built-in inflation is induced by adaptive expectations, and is
often linked to the "price/wage spiral". It involves workers
trying to keep their wages up with prices (above the rate of
inflation), and firms passing these higher labor costs on totheir customers as higher prices, leading to a 'vicious circle'.
Built-in inflation reflects events in the past, and so might be
seen as hangover inflation.
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Measuring InflationGenerally the inflation is measured using price index
Price index is a numerical measure that helps to compare prices of someclass of goods and services between time periods
Current years Price
Price index = ------------------------------ X 100
Base years Price
Producer price indices (PPIs) which measures average changes in prices
received by domestic producers for their output
consumer price index (CPI) measures changes in the price level
of consumer goods and services purchased by households.
Wholesale Price Index (WPI) is the price of a representative
basket of wholesale goods. Some countries (like India and The Philippines)
useWPI changes as a central measure of inflation.
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Inflation rate
Inflation rate =
The percentage increase in the price of goods and services,
usually annually.
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WPI & CPI
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Wage Price Spiral
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Impact of inflation
Negatives
Cost push Inflation wage spiral
Hoarding
Social unrests and revolts
Hyperinflation
Loss of allocative efficiency by producers
Shoe leather costs more trips to banksBusiness cycles
Positives
Labor-market adjustments
Room to maneuver to change interest rates
Mundell-Tobin effect savers will be induced to lend portion of money reduces interest rates
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Inflation and unemployment
An economic concept developed by A. W. Phillips stating that
inflation and unemployment have a stable and inverse relationship.
According to the Phillips curve, the lower an economy's rate of
unemployment, the more rapidly wages paid to labor increase in
that economy.
he theory states that with economic growth comes inflation, which
in turn should lead to more jobs and less unemployment. However,
the original concept has been somewhat disproven empirically due
to the occurrence of stagflation in the 1970s, when there were high
levels of both inflation and unemployment.
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Philips Curve short Run
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Philips Curve Long Run
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I fl ti V U l t
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Inflation Vs Unemployment
Trade off