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Monetary PolicyRBI and Monetary Policy in India


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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


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Growth of M3 and Differential Contribution ofComponents

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


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What is Monetary Policy? The term monetary policy refers to actions

taken by central banks to affect monetarymagnitudes or other financial conditions.

Monetary Policy operates on monetary

magnitudes or variables such as moneysupply, interest rates and availability ofcredit.

Monetary Policy ultimately operates throughits influence on expenditure flows in the

economy. In other words affects liquidity and by

affecting liquidity, and thus credit, it affectstotal demand in the economy.


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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 thancurrencies and coins. So central banks today guide monetary

developments with instruments that control overdeposit 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 policy

MP is a part of general economic policy of thegovt.

Thus MP contributes to the achievement of thegoals of economic policy.

Objective of MP may be:

Full employmentStable exchange rateHealthy BoPEconomic growthReasonable Price StabilityGreater equality in distribution ofincome & wealthFinancial stability


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Price Stability: The DominantObjective

There is convergence of views in developedand developing economies, that pricestability is the dominant objective ofmonetary policy.

Price stability does not mean completeyear-to-year price stability which is difficultto attain.

Price stability refers to the long run averagestability of prices.

Price stability involves avoidance of bothinflationary 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 ininternational markets and contribute to the

strengthening of BoP.

Price stability leads to interest rate stability, andexchange rate stability (via export importstability).

It contributes to the overall financial stability of


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Operation of MonetaryPolicy

Instruments

1. Discount Rate(Bank Rate)

2.Reserve Ratios

3. Open MarketOperations

OperatingTarget

Monetary Base Bank Credit Interest Rates

IntermediateTarget

MonetaryAggregates(M3)Long terminterest rates

Ultimate

Goals

Total Spending Price Stability

Etc.


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Instruments of MonetaryPolicy Variations in Reserve Ratios

Discount Rate (Bank Rate)

(also called rediscount rate)

Open Market Operations (OMOs)

Other Instruments


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Variations in Reserve Ratios

Banks are required to maintain acertain percentage of their deposits inthe form of reserves or balances with

the RBIIt is called Cash Reserve Ratio orCRR

Since reserves are high-powered

money or base money, by varyingCRR, RBI can reduce or add to thebanks required reserves and thus

affect banks ability to lend.


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Discount Rate (Bank Rate) Discount rate is the rate of interest charged by the

central bank for providing funds or loans to thebanking system.

Funds are provided either through lending directly orrediscounting 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 domesticinterest rate, especially the short term rates.

Market regards the increase in Bank rate as the


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Open Market Operations (OMOs)

OMOs involve buying (outright ortemporary) and selling of govtsecurities by the central bank, from or

to the public and banks. RBI when purchases securities, pays

the amount of money by crediting thereserve deposit account of the sellers

bank, which in turn credits the sellersdeposit account in that bank.


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Monetary policy also known as Money and

Credit Policy:

It concerns itself with the supply of moneyas also credit to economy

Till 1998-99:It was announced twice in ayear:Oct.for Oct..March.to coincide with

busy season

Aprilfor April to Septto coincide with

lean season of agri.With decline in agri. Andrise in industrial credit since 1999-2000 inApril 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 money

b)sectoral deployment of funds

Done 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 fiscal policy


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In general, the interaction between monetary and fiscal policyoccurs To control inflationary or deflationary impact of fiscalpolicy

For instance, a substantial multi-year rise in the deficit neednot cause an increase in inflation was demonstrated in USA:

Between 1979-85budget deficit rose from 2.7% of GDPto 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-inflationarymonetary policy pursued by the FederalReserve.


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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 ofstabilization 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 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


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

Fourth Imp. Instrumentis 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 littlevariation

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, 1973were dealt with effectively by cutting down domesticcredit

O f th i bl i th t


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One of the main problem area in the monetarypolicy

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 SLR

Monetary control has been reasonably successful

in spite of rising Fiscal deficit because of aggressiveuse of the reserve ratios

In a sense reserve ratios have not been genuinely

monetary policy Instrument but rather acted as

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