the monetary policy of india

8/6/2019 The Monetary Policy of India

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THE MONETARY POLICY OF

INDIA

�FY BFM 1



INTRODUCTION

Monetary policy is the process by which the monetaryauthority controls

the money supply

availability of money

cost of money or rate of interest

to ensure growth and stability of the economy.

2FY BFM



Monetary policy is referred to as either being an

� expansionary , or a� contractionary policy,

where an expansionary policy increases the total

supply of money in the economy, and acontractionary decreases the money supply.

Expansionary policy is used to combat

unemployment in recession by lowering the interest

rates, while contractionary policy involves raisinginterest rates in order to combat inflation.

3FY BFM



Objectives of Monetary Policy

� Price stability

� Ensure adequate flow of credit to the productive sectors of

the economy

� Stability for the national currency

� Growth in employment and income

4FY BFM



Instruments to Regulate Monetary Policy

QUANTITATIVE METHODS

� Discount Rate (Bank Rate): The discount rate is the interest

charged by Central Banks to member banks, other depository

institutions, and the government for loans.

5FY BFM

Higher interest

rates

Less

borrowing

Lower

aggregate

demand

Higher

aggregate

demand

More

borrowing

Lower interest

rates



� Open Market Operations: Open market operations is the buying

and selling of government securities by the government (Central

Bank).

�

Reserve Requirement: The reserve requirement is the amount of money that banks must hold as vault cash or keep on deposit

with their Central Banks.

FY BFM 6

Sells govt.

securities

Pumps

money into

the economy

Buys govt.

securities

Withdraws

money from

the economy

Increase reserve

requirement

Less loanable

funds to offer Less borrowing

Decrease

reserve

requirement

More loanable

funds to offerMore borrowing



Reserve Requirements are of 2 types:

1. Cash Reserve Ratio (CRR) refers to that portion of total deposits of

commercial banks that it has to keep with the reserve bank of india as cash

reserves.2. Statutory Liquidity Requirements (SLR) refers to that portion of the total

deposits of a commercial bank which it has to keep with itself in the form of

liquid assets.

� Reverse Repo Rate: The rate at which the Central

Bank borrows money from the banks (or banks lend

money to the CB) is termed the reverse repo rate. The

CB uses this tool when it feels there is too much

money floating in the banking system.

FY BFM 7

RRR increasedMember Banks

lend money to CB

Less money with

member banks

to lend to

consumers



� P rime Lending Rate ( P LR): The rate at which the commercial

banks lend money to their regular clients with high credit

worthiness. This particular class borrows huge amounts of money and hence, there is lot of fluctuation in the monetary

supply even with small changes in the PLR. It is one of the only

rates controlled by the commercial banks. The below shows

the lending rates given by the commercial banks in the last 10

years.

FY BFM 8



QUALITATIVE METHODS

� Regulation of Consumer Credit: It is an important instrument of

selective credit control which aims at regulating the consumerinstalment credit on higher purchase. Finance is the method of

using bank credit by consumers to buy expensive durable goods

like motor cars, houses, computer, etc. A certain percentage of

the price of the durable goods paid by the consumers as the cash

down payment in the remaining portion is financed by the bank.

FY BFM 9

Higher bank creditReduce

downpayment

Maximise period

of payment

Increase

downpaymentLower bank credit

Minimize period

of payment



� Marginal Requirement: Its one of the most important

instruments. The commercial banks give loans to their customers

against some securities, however, they do not give loans

equivalent to the full amount of the security, but of an amount

which is less than its value. This difference between the value of

the security and the amount of loan granted is known as marginal

requirements.

FY BFM 10

If marginal

requirements is 10%

Bank would give a

loan of Rs.9000

against a security of

Rs.10000

Higher the rate less is the money

supply and vice versa. Thus,

money supply can be regulated by

increasing or decreasing the

marginal requirement.



� Moral Suasion: It is the method of persuasion, request, informal

suggestions and advice towards member banks by the central

bank. The central bank relies upon this instrument to influence

its member banks as the head and leader of the financial

institutions.

� P ublicity: It is the method selective credit control. The central

bank expresses its views about various monetary and banking

policies. The central bank uses this method for influencing credit

policies as well as the public opinion in the country.

FY BFM 12



Contractionary Monetary PolicyIntroduction

Contractionary monetary policy seeks to reduce the size of the money supply.

They are fiscal policies, like lower spending and higher taxes, that reduce

economic growth. In India, monetary policy is controlled by the RBI.

Tools for Implementation

Monetary Base: The contractionary policy can be implemented by reducing

the size of the monetary base. A central bank uses open market

operations by typically selling bonds in exchange for hard currency. When

the central bank collects this hard currency payment, it removes that

amount of currency from the economy, thus reducing the total amount of

money circulating in the economy.

13FY BFM

CB sells

bonds

Collects

payment in

hard

currency

Reduces

the money

circulation

Contracts

the

monetary

base



Reserve Requirements: It can be implemented by requiring banks to

hold a higher portion of their total assets in reserve. By doing so,

the central bank reduces the availability of loanable funds. This

acts as a reduction in the money supply.

Interest Rates: In this method, the nominal interest rates are

increased. By raising the interest rate, a monetary authority can

contract the money supply, because higher interest rates

encourage savings and discourage lending.

How can monetary policy be used to control inflation?

Inflation is defined as continuing increase in price levels. Since price

level is a monetary variable, contractionary policy reduces

inflation by reducing upward pressure on price levels.

14FY BFM



Effects of Contractionary Policy

Contractionary monetary policy causes a decrease in bond prices and anincrease in interest rates.

Higher interest rates lead to lower levels of capital investment.

The higher interest rates make domestic bonds more attractive, so thedemand for domestic bonds rises and the demand for foreign bondsfalls.

The demand for domestic currency rises and the demand for foreign

currency falls, causing an increase in the exchange rate. (T

he value of the domestic currency is now higher relative to foreign currencies)

A higher exchange rate causes exports to decrease, imports to increaseand the balance of trade to decrease.

15FY BFM



Expansionary Monetary Policy

Introduction

Expansionary monetary policy seeks to increase the size of the money supply.

Tools for Implementation

Monetary Base: Expansionary policy can be implemented by increasing the size of the monetary base. This directly increases the total amount of money

circulating in the economy. The RBI would buy bonds in exchange for hard

currency. When the RBI disburses this hard currency payment, it adds that

amount of currency to the money supply, thus increasing the monetary base.

FY BFM 16

RBI buys

bonds

Disburses

payment in

hard

currency

Increases

money

circulation

Expands the

monetary

base



Reserve Requirements: It can be implemented by requiringbanks to hold a lower portion of their total assets in reserve.By doing so, the central bank increases the availability of

loanable funds. This acts as a increase in the money supply.

Interest Rates: In this method, the nominal interest rates aredecreased. By lowering the interest rate, a monetary authoritycan expand the money supply, because lower interest rates

discourage savings and encourage lending.

How does monetary policy affect the real economy?

Expansionary monetary policy should not be confused with an

increase in economic output in the real economy. Any changeto the real economy resulting from an expansionary monetarypolicy is subject to time lags and effects from other economicvariables; in addition, there are possible side effects of expansion, including inflation.

FY BFM 17



Effects of Expansionary Policy

Expansionary monetary policy causes an increase in bond prices and areduction in interest rates.

Lower interest rates lead to higher levels of capital investment.

The lower interest rates make domestic bonds less attractive, so thedemand for domestic bonds falls and the demand for foreign bondsrises.

The demand for domestic currency falls and the demand for foreigncurrency rises, causing a decrease in the exchange rate. (The value of

the domestic currency is now lower relative to foreign currencies)

A lower exchange rate causes exports to increase, imports to decreaseand the balance of trade to increase.

FY BFM 18



Monetary Policys Impact on

the Economy

The monetary policy not only impacts financing conditions in the

economy but also influences the expectations about economic

activity and inflation. Monetary policy can affect the prices of

goods, asset prices, exchange rates as well as consumption and

investment in the following ways:

Interest rate cuts lead to lower cost of borrowing, which results in higher

investment activity and the purchase of consumer durables.

The expectation that economic activity will strengthen may also prompt banks to

ease lending policy, which in turn enables businesses and households to boost

spending.

FY BFM 19



In a low interest-rate environment, shares become a more attractive buy, raising

households· financial assets.

This may also contribute to higher consumer spending, and makes companies·

investment projects more attractive.

Lower interest rates also tend to cause currencies to depreciate: Demand fordomestic goods rises when imported goods become more expensive.

All of these factors raise output and employment as well as investment and

consumer spending.

However, this stepped-up demand may cause prices and wages to

rise if goods and labor markets are fully utilized.

FY BFM 20



The Monetary Policy Transmission

Mechanism

The process throughwhich monetarypolicy decisionsimpact on aneconomy in

general and theprice level inparticular isknown as themonetary policytransmissionmechanism. Themain channels of

monetary policytransmission areset out in asimplified,schematic form inthe chart on thenext page.

FY BFM 21



� Interest rate channel: An expansion of the money supply by the central bank feedsthrough to a reduction of short-term market rates through this channel. As aresult, the real interest rate and capital costs decline, raisinginvestment. Additionally, consumers save less and opt for current consumptionover future consumption. This, in turn, causes demand to strengthen. However,this stepped-up demand may cause prices and wages to rise if goods and labormarkets are fully utilized.

FY BFM 22



� Credit channel: Central banks monetary policy decisions influencecommercial banks refinancing costs; banks are inclined to pass thechanges on to their customers. If financing costs diminish,investment and consumer spending rise, contributing to an

acceleration of growth and inflation.

FY BFM 23



� Exchange rate channel: Expansionary monetary policyaffects exchange rates because deposits denominated indomestic currency become less attractive than deposits

denominated in foreign currencies when interest rates arecut. As a consequence, the value of deposits denominatedin domestic currency declines relative to that of foreigncurrency-denominated deposits and the currencydepreciates. This depreciation makes domestic goodscheaper than imported goods, causing demand for domestic

goods to expand and aggregate output to augment.

� Wealth channel: Monetary policy impulses are alsotransmitted through the price of assets such as stocks andreal estate. The expansionary monetary policy effects of

lower interest rates make bonds less attractive than stocksand result in increased demand for stocks, which bids upstock prices. Conversely, interest rate reductions make itcheaper to finance housing, causing real estate prices to goup.

FY BFM 24

the monetary policy of india

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