Monetary Policy

RBI and Monetary Policy in India

Monetary Magnitudes
M1 = Currency with public+ Demand deposits with banks+ Other Deposits with RBI M2 = M1+ Post Office Deposits M3 = M1+ Time Deposits with Banks M4 = M3+ Total Post Office Deposits

Growth of M3 and Differential Contribution of Components

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

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 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 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 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 employment Stable exchange rate Healthy BoP Economic growth Reasonable Price Stability Greater equality in distribution of income & wealth Financial stability

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.

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

Instruments
1. Discount Rate (Bank Rate) 2.Reserve Ratios 3. Open Market Operations

Operation of Monetary Policy

Operating Target
Monetary Base Bank Credit Interest Rates

Intermediate Target
Monetary Aggregates(M3) Long term interest rates

Ultimate Goals
Total Spending Price Stability Etc.

Instruments of Monetary Policy

Variations in Reserve Ratios Discount Rate (Bank Rate) (also called rediscount rate) Open Market Operations (OMOs) Other Instruments

Variations in Reserve Ratios

Banks 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 banks required reserves and thus affect banks ability to lend.

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

Open Market Operations (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 sellers bank, which in turn credits the sellers 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 Aprilfor April to Septto 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 money b)sectoral deployment of funds Done keeping in mind plan priorities Special 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 fiscal policy occurs To control inflationary or deflationary impact of fiscal policy For instance, a substantial multi-year rise in the deficit need not cause an increase in inflation was demonstrated in USA: Between 1979-85budget deficit rose from 2.7% of GDP to 5.1% of GDPnational debt rose from 26% 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 aim control of inflation urgent concern (91.double digit.17%) 8th (92-97)aimed at achieving trend rate of inflation 5% MP of 90s favoredprocess 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 money c) 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 In1970sEmphasis shifted to direct approaches and persisted since then Shift from indirect to direct measures was prevalent more due to rising deficit or inflation Monetary instrument in India, both direct and indirect, operate Through administrative controls or fiat The 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 banks c) Growth of net foreign exchange of RBI RBI can control only b) by prescribing high SLR Monetary control has been reasonably successful in spite of rising Fiscal deficit because of aggressive use of the reserve ratios In a sense reserve ratios have not been genuinely monetary policy Instrument but rather acted as