Monetary policy

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Monetary Policy:

Monetary Policy T.J. Joseph

Macroeconomic Policies (Economic Stabilization Policies):

Macroeconomic Policies ( Economic Stabilization Policies) Stabilization policies are policies by the government to maintain full employment and reasonably stable price level The objectives of the macroeconomic policies are mainly two: Sustain economic growth (maintain full employment) Control inflation (stabilize general price level) Types of Macroeconomic Policies Fiscal Policies Monetary Policies

Monetary Policy:

Monetary Policy How does a monetary authority decide on when to expand or contract credit and by how much? Decision based on the overall objectives of the monetary policy

Meaning of Monetary Policy:

Meaning of Monetary Policy “Monetary policy is essentially a programme of action undertaken by the monetary authorities, generally the central bank, to control and regulate the supply of money with the public and the flow of credit with a view to achieving predetermined macroeconomic goals ” The objectives of monetary policy are the same as of macroeconomic policy – price stability, currency stability, financial stability, growth in employment and income

Monetary Policy and Money Supply:

Monetary Policy and Money Supply The money supply is controlled by the RBI through: Changing the reserve requirements Changing the policy rates (bank rate, repo rate and reverse repo rate) Open-market operations Thus the quantity of money supplied does not depend on the interest rate and is vertical

Instruments of Monetary Policy:

Instruments of Monetary Policy Credit Control by the Central Bank Instruments of credit control Broadly categorized into two: General instruments are intended to regulate the total volume of credit (quantitative) Include (1) policy rates, (2) open market operations, ( 3) power to vary the reserve requirements Selective instruments to regulate the purpose for which commercial banks generated credit (qualitative )

Variable Reserve Ratios:

Variable Reserve Ratios Banks are required to maintain a percentage of their deposits in the form of balances with the RBI, known as legal reserve requirement (statutory reserve requirement) RBI has the power to vary this ratio and used as an instrument of credit control An increase in reserve requirement ratio will reduce the reserves for lending by the banks A lowering of the reserve ratio will enable the banks to expand credit The most easiest way to control credit

Bank Rate:

Bank Rate The minimum rate at which the central bank of a country provided financial assistance to commercial banks By raising or lowering bank rate, the central bank can reduce or expand credit granted by banks Currently bank rate in India is 6.0%

Bank Rate:

Bank Rate How bank rate works? ↑ bank rate → ↑ cost of borrowing by commercial banks from the central bank → ↑ in lending rate of commercial banks → less borrowing Adverse effect on the level of production and prices Usually used during inflationary situation Similarly, a fall in bank rate lower the lending rates of CBs and lead to expansion of bank credit and may raise income and output

Conditions for successful working of bank rate:

Conditions for successful working of bank rate A well organized money market in order to have impact on other rates in the market Reactions of borrowers to change in the lending rates A fall in output may coexist with a rise in price Customers’ assessment of the economic situation. If the business conditions are not favorable lowering of lending rate may not attract much borrowers

Bank Rate in India:

Bank Rate in India

Policy Rates (www.rbi.org.in, 27/01/2012):

Policy Rates ( www.rbi.org.in , 27/01/2012) Bank rate 6 % Repo rate 8.5 % Reverse repo rate 7.5 % Repo (from the perspective of the seller of a security) or Reverse repo (from the perspective of the buyer of a security) is a Repurchase agreement in which two parties agree to sell and repurchase a security on an agreed date at a predetermined price. When banks sell securities, repo rate is applicable; when banks buy securities to park surplus funds, reverse repo rate is applicable.

Reserve Ratios (www.rbi.org.in, 27/01/2012):

Reserve Ratios (www.rbi.org.in, 27/01/2012) Cash Reserve ratio 5.5 % Statutory Liquidity ratio 24 %

Open Market Operations:

Open Market Operations Primary instrument of credit control in developed markets Involve the purchase and sale of securities by the central bank The purchase of securities by a central bank leads to an increase in the bank reserves This leads to a multiple expansion of credit and deposits On the other hand sale of securities by the central bank will reduce bank reserves and lead to multiple contraction of credit This is not used as an instrument of credit control in India, because this market is very narrow in India

Selective Credit Controls:

Selective Credit Controls Purpose is to regulate the flow of credit for financing specific activities RBI encourages the flow of credit to agriculture and to other sectors like export For borrowings of CBs to refinance such operations RBI charges a lower interest rate than the bank rate The ultimate objective is to prevent a rise in the price of these commodities with the help of bank credit Selective credit controls have been operation in India against commodities like foodgrains , oilseeds, cotton, etc.

The Effects of Money on Output and Prices:

The Effects of Money on Output and Prices Transmission Mechanism of Monetary Policy Suppose RBI is concerned about inflation and has decided to slow down the economy Step 1: Suppose RBI reduces reserves with the banks through any of its credit control activity Step 2: Reduction in bank reserves result in a multiple contraction in deposit or credit creation, thereby reducing the money supply

The Effects of Money on Output and Prices:

The Effects of Money on Output and Prices Step 3: Reduction in money supply increases interest rates and tightens credit conditions, and lowers the value of people’s assets Step 4: With higher interest rates and lower wealth , investment falls. It may raise the exchange rate of the currency, depressing net exports Step 5: Tight money leads to reduced aggregate demand, reduces income, output, jobs and inflation

In short……:

In short…… In a fully employed economy, the higher money supply would be chasing the same amount of output and would therefore mainly end up raising prices That is, in the long run, prices and wages are more flexible, and money supply changes tend to have a larger impact on prices and a smaller impact on output

Exercise 1:

Exercise 1 Suppose the RBI buys bonds from the public worth Rs.30mn and issues cheques worth the same amount. The public deposits these cheques with the banks and withdraws Rs.10mn as currency holding keeping Rs.20mn as demand deposit. Suppose the banks are required to maintain a total cash reserves of 25%, what will be the change in money supply?

Exercise 2:

Exercise 2 Suppose money supply is Rs.2500 crores , all bank deposits are Rs.2000 crores , and the statutory reserve ratio is 25%. Compute the money multiplier. Suppose the RBI purchases 50 crores of government securities from the market. What will be the increase in money supply?

References:

References 1. Chapters 12 & 13, ‘ Principles of Economics’ , 8 th edn ., by Michael Melvin and William Boyes . 2. Chapters 2 & 5, ‘Macroeconomic Policy Environment’ by Shymal Roy.

Videos:

Videos http://www.moneycontrol.com/video/economy/monetary-tightening-may-not-help-tame-inflationeco-advisor_434618.html http://economictimes.indiatimes.com/Chetan-Ahya-reviews-RBI-monetary-policy/videoshow/5162691.cms http://economictimes.indiatimes.com/Need-to-coordinate-monetary-and-fiscal-policy-D-Subbarao/videoshow/4893491.cms

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