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Page 1: Monetary policy

Monetary PolicyMonetary PolicyRBI and Monetary Policy in India

Page 2: Monetary policy

Monetary MagnitudesMonetary MagnitudesM1 = Currency with public+

Demand deposits with banks+ Other Deposits with RBI

M2 = M1+ Post Office DepositsM3 = M1+ Time Deposits with

BanksM4 = M3+ Total Post Office

Deposits

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Growth of MGrowth of M3 3 and Differential and Differential Contribution of ComponentsContribution of Components

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

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What is Monetary Policy?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 as money 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.

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Credit PolicyCredit PolicyCentral 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

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Aims of Monetary policyAims 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 employmentStable exchange rateHealthy BoPEconomic growthReasonable Price StabilityGreater equality in

distribution of income & wealthFinancial stability

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Price Stability: The Dominant Price Stability: The Dominant ObjectiveObjectiveThere 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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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.

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Operation of Monetary Operation of Monetary PolicyPolicy

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

UltimateGoals

•Total Spending• Price Stability Etc.

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Instruments of Monetary Instruments of Monetary PolicyPolicyVariations in Reserve RatiosDiscount Rate (Bank Rate)

(also called rediscount rate)Open Market Operations (OMOs)Other Instruments

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Variations in Reserve Variations in Reserve RatiosRatiosBanks are required to maintain a

certain percentage of their deposits in the form of reserves or balances with the RBI

It is called Cash Reserve Ratio or CRR

Since reserves are high-powered money or base money, by varying CRR, RBI can reduce or add to the bank’s required reserves and thus affect bank’s ability to lend.

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Discount Rate (Bank Rate)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.

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Open Market Operations Open Market Operations (OMOs)(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 seller’s bank, which in turn credits the seller’s deposit account in that bank.

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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 twice in a year:Oct….for Oct..March….to coincide with busy season

April…for April to Sept…to coincide with lean season of agri.With decline in agri. And rise in industrial credit since 1999-2000 in April RBI makes an annual policy statement and a review in Oct.

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Since 1951 and till 1990s….Two sets of objectives pursued…a)controlled expansion of moneyb)sectoral deployment of fundsDone keeping in mind plan

prioritiesSpecial attention…Core industries (coal, iron, steel

and engg.)foodgrains (rice, wheat etc.)priority sectors ( agri., SSI)weaker sections of population

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In general, the interaction between monetary and In general, the interaction between monetary and fiscal policy occurs To control inflationary or fiscal policy occurs To control inflationary or deflationary impact of fiscal policydeflationary impact of fiscal policy

For instance, a substantial multi-year rise in the deficit For instance, a substantial multi-year rise in the deficit need not cause an increase in inflation was need not cause an increase in inflation was demonstrated in USA:demonstrated in USA:

Between 1979-85……budget deficit rose from 2.7% of Between 1979-85……budget deficit rose from 2.7% of GDP to 5.1% of GDP……national debt rose from 26% GDP to 5.1% of GDP……national debt rose from 26% of GDP to 36% of GDP 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.

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In India, for instance, In 90s…

growth of economy remain primary aimcontrol of inflation urgent concern(91….double digit….17%)

8th (92-97)…aimed at achieving trend rate of inflation 5%

MP of 90s favored…process of stabilization and structural adjustment initiated in 91

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Various measures used by RBI include:a) Rate of interest (or price of money)b) Quantity or supply of moneyc) 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

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Third imp. Instrument… Cash Reserve Ratio: Banks’ Cash Holding/Total Deposit

Liabilities

Fourth Imp. Instrument is 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

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In 1960s.. Emphasis was on indirect measures with little variation

in reserve ratios In1970s…Emphasis shifted to direct approaches

and persisted since thenShift from indirect to direct measures was

prevalent more due to rising deficit or inflationMonetary instrument in India, both direct and

indirect, operate Through administrative controls or fiatThe crisis like droughts, oil crisis in 1966,1969,

1973 were dealt with effectively by cutting down domestic credit

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One of the main problem area in the monetary policy

lie with the Exogenous element in reserve money.

Reserve money comprise of:a) Increased RBI lending to govt. (relates to

fiscal deficit) b) Increased RBI lending to commercial banksc) Growth of net foreign exchange of RBI RBI can control only b) by prescribing high

SLRMonetary control has been reasonably

successful in spite of rising Fiscal deficit because of

aggressive use of the reserve ratiosIn a sense reserve ratios have not been

genuinely monetary policy Instrument but rather acted

as fiscal policy instrument


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