Monetary Policy

Monetary Policy
Vidhisha Vyas
Contents
Introduction
Objectives
Contents
Instruments of Monetary Policy
Quantitative Measures
Qualitative Measures
Controlling Inflation
Monetary Policy of India
Reserve Bank of India Central Bank

Established under the Reserve Bank of India
Act, 1934 on April 1, 1935
Initially, a private shareholders' bank with
capital of Rs. 5 crore
Nationalised in 1949
Central Board of Directors 20 members
Four Local Boards 5 members each
Major Functions of RBI
Monetary Policy Function

Supervision and Regulation Function
Payment System Policy and Oversight Function
Management of forex reserves, including gold
Issue of Currency Function
Banker to banks and Lender of Last Resort
Management of Government Debt Function
Banker to Government
Preamble of the RBI Act, 1934

Preamble of the Act: 'to regulate the issue of
Bank notes and keeping of reserves with a view
to securing monetary stability in India and
generally, to operate the currency and credit
system of the country to its advantage'.
No explicit mandate for price-stability or
formal inflation targeting
Evolved to include macro-economic and
financial stability
Introduction
What is Monetary Policy?
What is the role of Monetary Policy?
How does Monetary Policy Works?
Introduction
Monetary policy is a program of action

undertaken by
the monetary authorities,
generally the Central Bank, to control and
regulate the supply of money with the public
and flow of credit with a view to achieving
pre-determining macro economic goals.
At the time of inflation , monetary policy seeks
to contract aggregate spending by tightening
the money supply or raising the rate of return.
Objectives
To achieve price stability by controlling
inflation and deflation.
To promote and encourage economic growth in
the economy.
To ensure the economic stability at full
employment or potential level of output.
Scope of Monetary policy

The scope of monetary policy depends on two
factors:
Level of Monetization of the economy:
In this all economic transactions are carried out with
money as a medium of exchange done by changing
the supply of and demand for money and the general
price level. It is capable of affecting all economics
activities such as Production, Consumption, Savings,
Investment etc.
Level of development of capital market Some
instrument of Monetary Policy work through
How does Monetary Policy achieve its

goal
Monetary policy impacts demand in the
economy through affecting interest rates.
Traditionally this was done through changing
money supply.
Now it is done by directly changing interest
rates.
Money demand and supply

Money is something that is used as a medium of
exchange, a store of value and a unit of account.
In its narrow most definition (M0) money
comprises of all currency in circulation.
M1 is all currency plus demand deposits.
M3 consists of currency plus demand deposits
plus time deposits.
Adding post office deposits to M1 we get M2 and
to M3 we get M4.
Monetary base
The monetary base (M0), also known base
money or high powered money is the money
that is directly created by the central bank.
M0 = net central bank lending to the
government plus net foreign exchange assets
of the central bank.
Money is created when the central bank either
lends to the money, or adds to its kitty of
foreign exchange reserves.
Money multiplier
Suppose an exporter brings 2 dollars into India and RBI buys the
dollars at Rs 50 per dollar. This leads to an increase in M0 by Rs
100.
He deposits Rs 100 in a bank.
The bank holds, for example, Rs 10 as reserves and lends out Rs
90.
Borrowers of the Rs 90 hold it in bank deposits.
Banks that receive these deposits hold 9 and lend out the rest.
The banking system as a whole lends out a multiple of the amount
that was initially created by the central bank.
m= 1/RR
Where m is money multiplier and RR is reserve ratio.
The size of the multiplier effect depends on the percentage of deposits that
banks are required to hold as reserves. In other words, it is money used to
create more money and is calculated by dividing total bank deposits by the
reserve requirement.
Credit expansion
Bank
1
2
3
4
.
.
n
Total
Round deposits
100
90
81
72.90
.
.
0
1000
Money demand
Transactions
demand
for
money
is
proportionate to income
Speculative demand for money depends on
interest rates
Precautionary demand for money is a small
part
Open Market Operations

The open market operations is sale and purchase
of government securities and Treasury Bills by
the central bank of the country.
When the central bank decides to pump money
into circulation, it buys back the government
securities, bills and bonds.
When it decide to reduce money in circulation it
sells the government bonds and securities.
The central bank carries its open market
operations through the commercial banks.
Discount Rate and Bank Rate Policy

Discount rate or bank rate is the rate at which
central bank rediscounts the bills of exchange
presented by commercial banks.
The Central bank can change this rate, increase
and decrease depending on whether it wants to
expand or reduce the flow of credit from the
commercial bank.
Working of the discount rate policy

A rise in the discount rate reduces the net worth of
the govt. Bonds against which commercial bank
borrows funds from the central bank. This reduces
commercial bank capacity to borrow from central
bank.
When the central bank raises its discount rate,
commercial bank raises the lending rate too. Rise
in the discount rate raises the cost of bank credit
which discourages the business firms to get their
bills discounted.
Cash reserve Ratio

The cash reserve ratio is the percentage of total
deposits which commercial banks are required to
maintain in the form of cash reserve with the
central bank.
The objective of cash reserve is to prevent
shortage of cash demand by the depositors.
By changing CRR RBI can change money supply
overnight.
Contractionary policy= increase in CRR
Expansionary Policy=Decrease in CRR
Statutory Liquidity Requirement

The SLR is the proportion of the total deposits
which commercial banks are statutorily
required to maintain in the form of liquid
assets in addition to CRR.
Credit Rationing
When there is a shortage of institutional credit
available for the business sectors, the large and
financially strong industries tend to capture major
share in institutional credits.
As a result priority and necessity sector have
shortage of funds.
So RBI impose upper limit to the credit being
issued to industries.
Charging higher and progressive interest rate on
the bank loans beyond certain limit
Changes in Lending Margin

The bank provide loan only up to a certain
percentage of the value of the mortgaged
property.
The gap between the value of the mortgaged
property and amount advanced is called
lending margin.
The central bank is empowered to increase the
lending margin with a view to decrease the
bank credit.
Moral Suasion
Persuading commercial banks to advance
credit in accordance with the directives of the
central bank in overall economic interest of the
country.
Central bank write letters to bank , hold
meetings on money and credit matters.
Increase or Decrease in the Lending

Rate
RBI make changes in its repo rates in order to
affect the cost of the credit, thereby
encouraging or discouraging the credit as per
the requirement of the economy.
Contractionary monetary policy

A rise in interest rates
Assets lose value. The wealth effect reduces
spending.
Firms can hold less inventories
Borrowing for investment is more expensive
Reduction in aggregate expenditure.
Similarly, with a reduction in interest rates,
monetary policy is expansionary.
Monetary Policy of India Overview
A Technical Advisory Committee constituted in

July 2005 to advise Reserve Bank on Monetary
Policy.
Till 2004-05: Announced Twice by RBI
- April May: Annual Policy
- October November: Mid-term Review
From 2005-06: Additional Quarterly Reviews in

July and January.
Annual Policy & Mid-term Review presented in
the meeting with bankers and Quarterly reviews
released to the Press till 2008.
From January 2009: Quarterly Reviews presented
in the meeting with bankers.
Dates are being pre-announced since 2005-06.
Monetary policy sub periods
A)MP of controlled expansion (1951-1972)

B)MP during pre-reform period (1972-1991)
C)MP in post reform period(1991-1996)
D) Easing of MP(1996-)
MP of controlled period
Reserve banks responsibility in the circumstances is
mainly to moderate the expansion of credit and money
supply in such away as to ensure the legitimate
requirements of industry and trade and curb the use of
credit for unproductive and speculative purposes.
To ensure controlled expansion, RBI used the
instruments:
Changes in bank rate
Changes in cash reserve ratio
Selective credit control
Chang in bank rate from 3%in 1951 to 6% in

1961 and it remained same till 1971.
Changes in SLR from 20% in 1956 to 28% in
1971.
Supply of money increase between 1951 -1971
is from 3% to 9%
Monetary Policy during Pre- reformed

period
Price situation worsened during the years
of 1972- 1974. to contain inflationary
pressures RBI further tightened its monetary
policy.
It is similar to tight monetary policy.
CRR at 25%
SLR to max. limit of 38.5%.
MP in post reform period(1991-1996)

Fundamental change
Continuing same CRR and SLR increase bank
deposits hugely.
S. Chakravarthy committee recommended to
increase interest rate on government securities
activating open market operations.
Bank rates raised from 10% to 12% in order to
curb inflation.
In 1996-97 rate of inflation declined sharply.

Followed by Industrial recession.
Introduction of Repo rate. Increase to 6.5% in
2005 from 3% in 1998.
Reverse repo rate came into existence.
Easing of MP(1996-)
Flow of credit to agriculture.
Reduction of CRR. From 15% in 1996 to 5%
in 2005.
Lowering Bank rate from 12% in 1997 to 6%
in 2003.
Latest Trends
Bank Rate: 6.00% (w.e.f. 29/04/2003)
Cash Reserve Ratio (CRR): 6.00% (w.e.f.
24/04/2010)
Statutory Liquidity Ratio (SLR): 24%(w.e.f.
18/12/2010)
Repo Rate: 8.50% (w.e.f.25/10/2011)
Reverse Repo Rate : 7.50% (w.e.f. 25/10/2011)

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Monetary Policy

Reserve Bank of India Central Bank

Major Functions of RBI

Monetary Policy Function

Preamble of the RBI Act, 1934

Monetary policy is a program of action

Scope of Monetary policy

How does Monetary Policy achieve its

Money demand and supply

Open Market Operations

Discount Rate and Bank Rate Policy

Working of the discount rate policy

Cash reserve Ratio

Statutory Liquidity Requirement

Changes in Lending Margin

Increase or Decrease in the Lending

Contractionary monetary policy

Monetary Policy of India Overview

A Technical Advisory Committee constituted in

From 2005-06: Additional Quarterly Reviews in

Monetary policy sub periods

A)MP of controlled expansion (1951-1972)

Chang in bank rate from 3%in 1951 to 6% in

Monetary Policy during Pre- reformed

MP in post reform period(1991-1996)

In 1996-97 rate of inflation declined sharply.

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