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MONETARY AND CREDIT POLICY

Dr. MONIKA CHOPRA

INTRODUCTION
It refers to the use of official instruments under the control of central bank to regulate the availability, cost & use of money and credit with the aim of achieving optimum levels of output & employment, price stability, balance of payments equilibrium or any other goals set by the state

Monetary Policy
Demand for Money Transaction Demand Precautionary Demand Speculative Demand

Monetary Policy
Supply vs. Demand For Money: Money Supply; Done by Central Bank Is inelastic Excess supply vs. excess Demand and restoration of Equillibrium Shift in Money supply; shift in equillibrium

Inflation
Current 6.46% Inflation Target 5% Anticipated inflation: transaction costs Unanticipated inflation: decrease in wealth of lenders( Rise) or decrease in wealth of borrowers (fall) Destabilization of businesses.

Tools of Monetary Policy


1.Bank Rate Policy:
U/s 49 of RBI Act: It is the rate at which RBI is prepared to buy/rediscount bills of exchange or other commercial paper eligible under the act.

Tools of Monetary Policy


However bill market is not developed so it is not truly operative It is the minimum rate at which central bank of a country provides loans to commercial banks. It is also called Discount rate as it is used for rediscounting of bills of exchange or other papers as well as against approved securities.

Tools of Monetary policy


Impact of increase or decrease in bank rate Disadvantages: Not a pace setter Earlier all rates of borrowing lending were linked to bank rate but PLR was introduced and bank rate lost its glitter. Deposit and lending rates are not linked to bank rate

Tools of Monetary Policy

Advantages: It is a signaling device and speaks about RBIs mind regarding money supply. Used to calculate penalties for non maintenance of CRR, SLR

Tools of Monetary Policy


II. Cash Reserve Ratio (CRR): Percentage of total Demand and Time Liabilities required to be kept as cash with RBI by banks. Earlier it could vary between 5-20% for Demand liabilities and 2-8% for time liabilities From 1962-2007 it could vary between 3-20% of Total DTL but now it can go from 0-100%

Tools of Monetary Policy


Currently CRR is 4% Impact of increase or decrease in CRR.

III Statutory Liquidity Ratio: (23%) Percentage of DTL to be kept in liquid securities like dated securities, T-bills, State Development Loans.

Tools of Monetary Policy

Impact of tight and liberal policy.

IV. Open Market operations: Purchase and sale by the central bank of a variety of assets such as foreign exchange, gold, government securities.

Tools of Monetary Policy


Earlier there were ceilings on RBIs holdings of govt. securities related to its capital, reserves and deposit liabilities as well as maturity period for holding. Currently no restrictions Used to finance govt. borrowings. Provide seasonal finance to banks: invest in slack season and sell in busy season

Tools of Monetary Policy


V. Repo and Reverse Repo: Repo: 7.75%, reverse repo:6.75%. VI. Liquidity Adjustment Facility: Banks can pledge their surplus govt. bonds and borrow funds for a day at a preannounced rate: repo rate. Used for daily mismatches in liquidity Size: 5 crores and multiples thereof.

Tools of Monetary Policy


LAF was being used by banks for arbitrage between call rate (current 78.80%) and LAF. Securities used in LAF are within SLR.

VII. MARGINAL STANDING FACILITY In order to provide greater liquidity cushion, it has been decided to:

Tools of Monetary Policy


Commercial banks can borrow under the marginal standing facility (MSF) upto 2 per cent of their net demand and time liabilities (NDTL). It is useful even when banks dont have excess collateral above SLR to participate in REPO for borrowing i.e. securities within SLR can also be used in MSF

Tools of Monetary Policy


Banks can continue to access the MSF even if they have excess statutory liquidity ratio (SLR). The MSF rate, determined with a spread of 100 basis points above the repo rate. Current:8.75

Requirements of Effective central banks


Operational independence(key rates) and target independence(Inflation) Credibility Transparency

Monetary Policy: Transmission mechanism


Increase in Money Supply Central bank buys securities: Banks reserves increase. Interbank Lending rate decreases Short term and Long term lending rates decrease Business investment, consumer purchase of auto, housing increase Depreciation of currency increases exports

Monetary Policy: Transmission mechanism

Domestic demand, consumption, GDP increase, exports rise while imports become costly and there is an increase in domestic inflation also.

Monetary Policy targets


Inflation Target Interest rate Target Exchange Rate Target: Difficult to maintain in case of sale of foreign currency as it may deplete forex reserves

Expansionary vs. Contractionary Policy


Determining whether a monetary policy is contractionary or expansionary Neutral Interest Rate = Real GDP growth + Inflation target If policy rate> neutral interest rate: contractionary If policy rate < neutral interest rate: expansionary

Limitations of Monetary Policy


Impact on Bond Markets Liquidity Trap in case of Deflation: Demand for money is elastic but individuals do not supply money and hold cash balances due to which short term rates do not decrease.

Limitations of Monetary Policy


Policy rate cant be zero; Alternative is quantitative easing Central bank purchases securities even Mortgage and credit risk securities to facilitate banks

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