Monetary PolicyMonetary PolicyRBI and Monetary Policy in India
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
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
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.
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
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
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.
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.
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.
Instruments of Monetary Instruments of Monetary PolicyPolicyVariations in Reserve RatiosDiscount Rate (Bank Rate)
(also called rediscount rate)Open Market Operations (OMOs)Other Instruments
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.
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.
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.
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.
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
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.
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
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
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
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
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