Monetary Policy of India

Submitted by: Achal Jain(19) Bhawna Jain(20) Harsha Jain(21) Manisha Jain(22) Mishal Jain(23) Gaurav Jakhotia(24)

Topics to be covered
Introduction to Monetary Policy Money Measures Monetary Policy tools used Types and their effects Monetary policy and inflation, growth, currency and interest rates Limitations of monetary policy

Monetary Policy
Central Banks actions Expansionary (accommodative) Contractionary (restrictive)

Stable Prices & Positive Economic Growth

Fiscal Policy
Governments use of spending & taxation * Balanced * Budget Surplus * Budget Deficit

Money Measures
Medium of Exchange
Means of payment Unit of account Store of value

Narrow Money Broad Money

Broad Money = Narrow Money + Liquid Assets LiquidityBroad Money < LiquidityNarrow Money

Control Inflation (Price Stability) Equal Income Distribution Full Employment

Monetary Policy Objectives

BOP Equilibrium

Sustainable Positive Economic Growth

Exchange Rate Stability

Cash Reserve Ratio (CRR)

Cash reserve ratio is the cash parked by the banks in their specified current account maintained with RBI. RBI is empowered to vary CRR between 5 percent and 3 percent. Current CRR rate is 4.25%

Statutory Liquidity Ratio (SLR)

Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio. The maximum limit of SLR is 40% and minimum limit of SLR is 23%. Current rate is 23%

Difference between CRR & SLR?

SLR
It restricts the bank's leverage in pumping more money into the economy

CRR
It is the portion of deposits that the banks have to maintain with the RBI

To meet SLR, banks can use cash, gold or approved securities

Has to be cash only

Impact on Economy
Higher CRR + SLR Less loan Higher interest rate Expensive to start new business or buy house More Loan Lower interest rate More people can afford loan Boost in economy

Lower CRR + SLR

Curb inflation
Lead to slowdown

Inflation

Bank Rate Policy

Bank Rate is the rate at which RBI allows finance to commercial banks. Any upward revision in Bank Rate by central bank is an indication that banks should also increase deposit rates as well as Base Rate / Benchmark Prime Lending Rate. Current Bank rate is 9%.

A fluctuation in bank rates impacts every sphere of a countrys economy. For instance, the prices in stock markets tend to react to interest rate changes. A change in bank rates affects customers as it influences prime interest rates for personal loans.

Credit Authorization Scheme

The Credit Authorization Scheme (CAS) for bank advances was introduced by the Reserve Bank of India in 1965.

Under the Scheme, all scheduled commercial banks have to obtain prior authorization of the Reserve Bank before granting any fresh credit limit of Rs. 1 crores or more to any single borrower.
This limit was, however, raised to Rs. 2 crores in 1975.

Open Market Operations (OMO)

An activity by a central bank to buy or sell government bonds on the open market.

A central bank uses them as the primary means of implementing monetary policy.

The usual aim of open market operations is to control the short term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.

Repo & Reverse Repo Rates

Repo rate is the rate at which RBI lends to commercial banks generally against government securities.
Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and increase in Repo rate discourages the commercial banks to get money as the rate increases and becomes expensive.

Reverse Repo rate is the rate at which RBI borrows money from the commercial banks.
The increase in the Repo rate will increase the cost of borrowing and lending of the banks which will discourage the public to borrow money and will encourage them to deposit. As the rates are high the availability of credit and demand decreases resulting to decrease in inflation.

This increase in Repo Rate and Reverse Repo Rate is a symbol of tightening of the policy. As of December 2012, the repo rate is 8 % and reverse repo rate is 7%

Credit Ceiling
In this operation RBI issues prior information or direction that loans to the commercial banks will be given up to a certain limit. In this case commercial bank will be tight in advancing loans to the public. They will allocate loans to limited sectors.

Few example of ceiling are agriculture sector advances, priority sector lending.

Moral Suasion
A persuasion tactic used by an authority (i.e. RBI) to influence and pressure, but not force, banks into adhering to policy. Often termed simply 'suasion', it has been used to persuade banks and other financial institutions to keep to official guidelines. The 'moral' aspect comes from the pressure for 'moral responsibility' to operate in a way that is consistent with furthering the good of the economy. For example, RBI may request commercial banks not to give loans for unproductive purpose which does not add to economic growth but increases inflation.

Taylors Rule
Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions.

In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle.

First proposed by the U.S. economist John B. Taylor, the rule is intended to foster price stability and full employment by systematically reducing uncertainty and increasing the credibility of future actions by the central bank. It may also avoid the inefficiencies of time inconsistency from the exercise of discretionary policy.

As an equation
The nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:
In this equation, is the target short-term nominal interest rate, is the rate of inflation as measured by the GDP deflator, is the desired rate of inflation, is the assumed equilibrium real interest rate, is the logarithm of real GDP, and is the logarithm of potential output, as determined by a linear trend.

In this equation, both equal to 0.5

and

should be positive and

Monetary Policy and Economic Growth, Inflation, Interest and Exchange Rates
Central banks manipulation of short term rates affect inflation rate and economic growth It is known as TRANSMISSION MECHANISM The monetary transmission mechanism refers to the process through which changes in monetary policy instruments (such as monetary aggregates or short-term policy interest rates) affect the rest of the economy and, in particular, output and inflation.

Monetary Policy and Economic Growth, Inflation, Interest and Exchange Rates

Suppose the economy is in RECESSION

What are the steps in transmission mechanism?

Transmission Mechanism
Central Bank buys securities Bank Reserves Increase Interbank Lending Rate Decrease Other short term rate decrease

Consumers purchase houses, autos and durable goods

Business invest in Plant and Equipment due to low interest rates Currency depreciation increases foreign demand for domestic goods

Real Interest Decrease causes Domestic Currency Depreciation

Long Term Interest Rates Decrease

Consumption, Investment, Net Exports Increase, AD Increase

Inflation, employment and Real GDP increases

Monetary Policy and Economic Growth, Inflation, Interest and Exchange Rates
Transmission Mechanism affects 4 things simultaneously : 1. Market Rate Decrease 2. Asset Price increase due to lower discount rates 3. Firms and individual expectations for economic growth rise, may expect central bank to reduce interest rates further 4. Domestic currency depreciates as real interest rate declines 4 things together leads to: I. Domestic Demand increase (Savings reduce) II. Net external demand increase (X-M) III. Increase in overall demand and import prices tends to increase Aggregate Demand and Domestic Inflation.

Expansionary and Contractionary Monetary Policy

Expansionary Monetary Policy
Expansionary policy increases the total supply of money in the economy more rapidly than usual.

Contractionary Monetary policy

Contractionary policy expands the money supply more slowly than usual or even shrinks it.
Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.

Expansionary policy is traditionally used to weaken unemployment in a recession by lowering interest rates.

What Affects Money Holdings?

Nominal interest rate: is the opportunity cost of holding money versus holding interest bearing assets. When interest rises then the cost of holding money rises since the amount held could be earning a positive return in an interest bearing asset. So when interest rises economic agents hold less money in their portfolio and hold more bonds. General price level: when the price level rises more money is needed to make a given transaction, so people tend to increase their holdings of money when the price level rises.

Level of real income: when individuals have more income they tend to hold more money as a store of value and to carry out more transactions using money.

Liquidity Preference Curve

If I is the nominal rate of interest Money supply at M0. DM is known as the liquidity preference curve.

Effect of Expansionary Monetary policy on Liquidity preference curve

By increasing the supply of money the nominal interest rate will fall, investments will increase and consumption will rise. Because the supply of money rises, people buy more goods and services. The fall in the nominal interest rate will mean that net exports will rise since the value of money will fall. When the value of the money falls exports are cheaper and imports are dearer. Thus net exports (X - M) must rise.

Effect of Expansionary monetary policy on Unemployment and inflation

When consumers spend more money, businesses enjoy increased revenues and profits. This allows companies to update plant and equipment assets and to hire new employees.

Unemployment
decreases

Inflation may be there

Inflation can be a result of expansionary monetary policy if the economy is too robust and creates too much money.

Effect of Contractionary Monetary policy on Liquidity preference curve

As the money supply is contracted, interest rates rise, investment will fall, consumption will fall and net exports will fall.

Effect of Contractionary monetary policy on Unemployment and inflation

Increases Unemployment

Increased unemployment results from the slowing production and increasing interest rates

Inflation decreases

The main purpose of a contractionary monetary policy is to slow down the rampant inflation that accompanies a booming economy

Global Economic Analysis Effect of Expansionary Monetary Policy

Price Effect
Strengthen current account Lower exchange rate Less foreign investment Reduced Interest rates

Income Effect
Weaken current account Lower exchange rate More foreign investment

GDP rises

Limitations
Liquidity Trap
Elastic demand for money Hold more money even when there is a fall in short term rates

Credit Bubble
Increased Money supply Less lending by banks

Non-Monetized transactions
Developing countries Transactions in rural area