Monetary Policy and money

market in India.
Group 3
Group Members
Hardik Shah 81
Virag Parekh 87
Karan Shrimankar 92
Heena Vaishnav 95
Danish Bansari 102
Shekhar Mehta
Veena Kapta 158
Definition Of Monetary Policy
A macroeconomic policy tool used to
influence interest rates, inflation, and
credit availability through changes in the
supply of money available in the
economy. In India it is also called the
Reserve Bank of India’s ‘Credit Policy’ as
the stress is primarily on directing credit.
Monetary Policy
Monetary policy is the process a
government, central bank, or monetary
authority of a country uses to control

(i) the supply of money,

(ii) availability of money,
(iii) cost of money or rate of interest to
attain a set of objectives oriented towards
the growth and stability of the economy.
Conti…
Monetary theory provides insight into how to craft
optimal monetary policy.

Monetary policy is referred to:-

 Expansionary policy - It increases the total supply of
money in the economy and is traditionally used to combat
unemployment in a recession by lowering interest rates.
Contractionary policy - It decreases the total money
supply, and also involves raising interest rates to combat
inflation.
Monetary policy is contrasted with fiscal policy, which
refers to government borrowing, spending and taxation.
Need for Monetary Policy
 In today's global trade it is very necessary to have a monetary
policy which directly affects the growth of a country's economy and
inflation.

International monetary policy coordination based on considerations

of structural asymmetries across countries.
 In a two-country world with a traded and a non-traded sector in
each country, optimal independent monetary policy cannot replicate
the natural-rate allocations.
 There are potential welfare gains from coordination since the
planner under a cooperating regime internalizes a terms-of-trade
externality that independent central banks tend to overlook. Yet,
with symmetric structures across countries, the gains are
quantitatively small.
If the size of the traded sector differs across
countries, the gains can be sizable and increase
with the degree of asymmetry.
 The planner's optimal policy not only
internalizes the terms-of-trade externality, it also
creates a terms-of-trade bias in favor the country
with a larger traded sector.
 The planner tries to balance the terms-of-trade
bias against the need to
stabilize fluctuations in the terms-of-trade gap.
 Theory of Monetary Policy
 Monetary policy rests on the relationship between the
rates of interest in an economy, that is the price at which
money can be borrowed, and the total supply of money.
 Monetary policy uses a variety of tools to control one or
both of these, to influence outcomes like economic
growth, inflation, exchange rates with other
currencies and unemployment.
 Where currency is under a monopoly of issuance, or
where there is a regulated system of issuing currency
through banks which are tied to a central bank, the
monetary authority has the ability to alter the money
supply and thus influence the interest rate
In practice, all types of monetary policy
involve modifying the amount of base
currency (M0) in circulation. This process
of changing the liquidity of base currency
through the open sales and purchases of
(government-issued) debt and credit
instruments is called open market
operations.
Types of monetary policy
The distinction between the various types
of monetary policy lies primarily with the
set of instruments and target variables that
are used by the monetary authority to
achieve their goals.
 Monetary Policy: Target Market Variable: Long Term Objective:

Interest rate on overnight A given rate of change in

Inflation Targeting debt the CPI
Interest rate on overnight
Price Level Targeting debt A specific CPI number
The growth in money A given rate of change in
Monetary Aggregates supply the CPI
The spot price of the The spot price of the
Fixed Exchange Rate currency currency
Low inflation as measured
Gold Standard The spot price of gold by the gold price
Usually unemployment +
Mixed Policy Usually interest rates CPI change
Achieving low level of inflation
Policymakers must have credible announcements;
1) Private agents must believe that these announcements
will reflect actual future policy. If an announcement
about low-level inflation targets is made but not
believed by private agents, wage-setting will anticipate
high-level inflation and so wages will be higher and
inflation will rise. A high wage will increase a
consumer's demand (demand pull inflation) and a
firm's costs (cost push inflation), so inflation rises.
Hence, if a policymaker's announcements regarding
monetary policy are not credible, policy will not have
the desired effect.
2) If policymakers believe that private agents anticipate low
inflation, they have an incentive to adopt an expansionist
monetary policy; however, assuming private agents have
rational expectations, they know that policymakers have
this incentive. Hence, private agents know that if they
anticipate low inflation, an expansionist policy will be
adopted that causes a rise in inflation. Consequently
private agents expect high inflation. This anticipation is
fulfilled through adaptive expectation (wage-setting
behavior);so, there is higher inflation (without the benefit
of increased output). Hence, unless credible
announcements can be made, expansionary monetary
policy will fail.
Various Ways of Announcements
To establish an independent central bank
with low inflation targets.

Reputation
Monetary decisions today take into account a wider range of
factors:

short term interest rates;

long term interest rates;
velocity of money through the economy;
exchange rates;
credit quality;
bonds and equities (corporate ownership and debt);
government versus private sector spending/savings;
international capital flows of money on large scales;
financial derivatives such as options, swaps, futures
contracts, etc.
Inflation targeting under Monetary
policy
 This policy approach the target is to keep
inflation, under a particular definition such as
Consumer Price Index, within a desired range.
 The inflation target is achieved through periodic
adjustments to the Central Bank interest rate
target.
 The interest rate used is generally the interbank
rate at which banks lend to each other overnight
for cash flow purposes. Depending on the country
this particular interest rate might be called the
cash rate.
Price level targeting
Price level targeting is similar to inflation
targeting except that CPI growth in one
year is offset in subsequent years such
that over time the price level on aggregate
does not move.
Monetary aggregates
This approach is also sometimes called
monetarism.

While most monetary policy focuses on a

price signal of one form or another, this
approach is focused on monetary
quantities.
Fixed exchange rate
This policy is based on maintaining a fixed
exchange rate with a foreign currency.
There are varying degrees of fixed
exchange rates, which can be ranked in
relation to how rigid the fixed exchange
rate is with the anchor nation.
The local government or monetary
authority declares a fixed exchange rate
Fixed-convertibility System
Gold standard
 The gold standard is a system in which the price of the
national currency as measured in units of gold bars and
is kept constant by the daily buying and selling of base
currency to other countries and nationals.
 The selling of gold is very important for economic
growth and stability.
 The gold standard might be regarded as a special case
of the "Fixed Exchange Rate" policy. And the gold
price might be regarded as a special type of
"Commodity Price Index".
 Today this type of monetary policy is not used
anywhere in the world
Monetary policy tools
Monetary base
Reserve requirements
Discount window lending
Interest rates
Currency board
 Monetary Policy of RBI
CONTROLLED EXPANSION

 Speed up economic development in the country to raise

national income and standard of living.

 To prevent heavy depreciation of the rupee.

 Maintaining the momentum of economic growth. To

consider measures in a calibrated manner to respond to
evolving circumstances with a view to stabilizing
inflationary expectations.
RBI’s ANTI-INFLATIONARY POLICY
• Economic aims given above were nearly the same but policy
of CONTROLLED EXPANSION was changed to CREDIT
RESTRAINT.
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 TOOLS OF MONETARY POLICY

There are two kinds of tools:

Quantitative tools –control the volume of

credit and inflation, indirectly.

Qualitative tools –they control the supply

of money in selective sectors of the economy.

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Quantitative Tools
Bank Rate
Bank Rate is the rate at which RBI allows finance to commercial banks.
Bank Rate is a tool, which RBI uses for short-term purposes. Any revision in
Bank Rate by RBI is a signal to banks to revise deposit rates as well as
Prime Lending Rate.
Role of bank rate is limited in India because
The structure of interest rates is administered by RBI
Commercial banks enjoy specific refinance facilities.

CRR
All scheduled commercial banks are required to maintain a fortnightly
minimum average daily cash reserve equivalent with RBI .The apex bank is
empowered to vary this ratio between 3 and 15 per cent. RBI uses CRR
either to impound the excess liquidity or to release funds needed for the
economy from time to time.
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 SLR

Every bank is required to maintain at the close of business every

day, a minimum proportion of their Net Demand and Time Liabilities
as liquid assets in the form of cash, gold etc, in addition to cash
reserve requirements. The ratio of liquid assets to demand and time
liabilities is known as Statutory Liquidity Ratio (SLR). Present SLR is
25%.
• Repos and Reverse Repo
RBI is empowered to enter a transaction in which two parties agree to sell
and repurchase the same security. Under such an agreement the seller sells
specified securities with an agreement to repurchase the same at a mutually
decided future date and a price. Similarly, the buyer purchases the securities
with an agreement to resell the same to the seller on an agreed date in future
at a predetermined price. Such a transaction is called a Repo when viewed
from the prospective of the seller of securities (the party acquiring fund) and
Reverse Repo when described from the point of view of the supplier of funds.
Thus, whether a given agreement is termed as Repo or a Reverse Repo
depends on which party initiated the transaction.
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OPEN MARKET OPERATIONS
An instrument of monetary policy
It involves buying and selling of govt. securities by the
RBI to influence the volume of cash reserves with
commercial banks and thus influence their loans and
advances
To contract the flow of credit ,RBI starts selling govt
securities
To increase the credit flow RBI starts purchasing the
govt securities.
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Selective and Direct Credit Control
Or Qualitative Measures
The main objective is to check speculation
and rising prices
The RBI issues directives to banks relating to
the purpose for which advances may or may
not be made
The margins to be maintained in respect of
secured advances
The maximum amount of advance to any
borrower
The maximum amt. of guarantee that can be
given on behalf of any firm
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Monetary Policy 2009-10
Key Figures
Reverse Repo Rate 3.25%
Repo Rate changed at 4.75%
Bank Rate Unchanged at 6%
CRR Unchanged at 5%
Inflation 9-9.5%
GDP 6.1%

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SUMMARY OF THE MONETARY
POLICY AS ON Feb 16, 2010
1. Consumer prices increased by 1.85 percent in January,
driving annual inflation up by 1.66 percentage points
to 8.19 percent and this was due to the administered
price and tax adjustments
2. In January, unprocessed food prices picked up at a
slower pace than the seasonal norm.
3. Energy prices were up 3.94 percent in January owing
to adjustments in Special Consumption Tax and
administered prices. Thus, the annual rate of increase
in energy prices rose to 8.13 percent. Annual energy
inflation is likely to increase further in coming months
due to base effects.
4. 22 percent increase in tobacco prices; but
excluding tobacco, it slowed down from a
month earlier.
5. Rate of increase in the prices of services,
excluding transport and catering, remained
modest.
6. Due to tax adjustments, unprocessed food price
increases and base effects, annual inflation
would continue to rise markedly in February
and hover above the target for some time.
Factors Affecting Inflation
7. Industrial production grew by a robust 25.2
percent year-on-year in December, which
seemingly points to a vigorous recovery.
8. Production and imports data indicate that
private consumption demand increased
quarter-on-quarter during the fourth quarter
but remained at low levels.
9. Production and imports data for capital goods
suggest that the recovery in private investment
demand continued into the final quarter.
10. Uncertainty regarding foreign demand
remains. The Committee noted that the pace of
recovery in real exports (excluding gold) is far
below the pre-crisis level.
11. Although there has been a mild improvement
in employment conditions, unemployment rates
remain at high levels.
12. Inflation would display a declining trend once
the temporary factors, such as unprocessed food
price volatility and tax hikes, taper off.
Monetary Policy and Risks
13. Credit markets have continued to improve
due to lagged effects of the monetary easing.
The tightness in credit conditions have been
moderating since the publication of the July
Inflation Report.
14. Inflation is expected to exceed the levels
envisaged for February; however, as vegetable
prices normalize during March, inflation
would revert back to the levels consistent with
the January Inflation Report forecast.
Effect on Interest Rate
 Another major factor in interest rate changes is the
"monetary policy" of governments. If a government "loosens
monetary policy", this means that it has "printed more
money". Simply put, the Central Bank creates more money
by printing it. This makes interest rates lower, because more
money is available to lenders and borrowers alike.
 If the supply of money is lowered, this "tightens" monetary
policy and causes interest rates to rise. Governments alter
the "money supply" to try and manage the economy. The
trouble is, no one is quite sure how much money is
necessary and how it is actually used once it is available.
This causes economists endless debate.
Effect on Inflation Rate
 Another very important factor is inflation. Investors want to
preserve the "purchasing power" of their money. If inflation is high
and risks going higher, investors will need a higher interest rate to
consider lending their money for more than the shortest term. After
the very high inflation years of the 1970s and early 1980s, lenders
had to receive a very high interest rate compared to inflation to
lend their money.
 As inflation dropped, investors then demanded lower rates as their
expectations become lower. Imagine the plight of the long-term
bond investor in the high inflation period. After lending money at
5-6%, inflation moved from the 2-3% range to above 12%! The
investor was receiving 7% less than inflation, effectively reducing
the investor's wealth in real terms by 7% each year!
Money Market In India
The India money market is a monetary system
that involves the lending and borrowing of short-
term funds
India money market has seen exponential growth
just after the globalization initiative in 1992
It has been observed that financial institutions do
employ money market instruments for financing
short-term monetary requirements of various
sectors such as agriculture, finance and
manufacturing.
The performance of the India money market
has been outstanding in the past 20 years.
Central bank of the country - the Reserve
Bank of India (RBI) has always been playing
the major role in regulating and controlling
the India money market.
The intervention of RBI is varied - curbing
crisis situations by reducing the cash reserve
ratio (CRR) or infusing more money in the
economy.
Types of Money Market instruments in
India -
Treasury Bills (T-Bills)
Repurchase Agreements
Commercial Papers
Certificate of Deposit
Banker's Acceptance

 In a recent initiative, for overcoming the liquidity crunch

in the Indian money market, the RBI infused more than
Rs 75,000 crore along with reductions in the CRR.