Macro Economics

Government in the Business Money, banking and monetary policy C.S. Adhikari

Money- The Basics

What is money: A medium of exchange, a store of value and unit of account. Distinction between income and money: What we earn in income, money is used to pay income. Money supply: currency, chequeable deposits with banks, fixed or time deposits with banks.

Why do we demand for money

Real demand for money: Md/ Price level, higher the Price level higher the Md. Nominal demand for money Transactional demand for money = f( Income, rate of interest and frequency of payment, financial sophistication), positive relationship with GDP Precautionaly demand for money = f(Income,rate of interest)

Contd...
- Speculative demand for money = f(interest rate capital gains). - Inverse relationship between bond prices and rate of interest. Rs. 100 bond with a fixed coupon rate of Rs. 10 every year, traded at Rs. 105 he gets Rs. 10 on Rs.105 rather than Rs. 100 which works out 9.52% return. If it is traded at Rs. 95 then the yield is 10.52%.

How does Money supply affect GDP

GDP is the total production of Gs and Ss MS refers to a stock of liquid assests which can be exchanged for Gs and Ss. GDP depends on the stock of money multiplied by the speed with which the money changes hands. Demand for money and Supply of money decide interest rate. Real interest rate and nominal interest rate. With inflation lender looses and borrower gains.

Banking
A bank is a financial institution and a financial intermediary that accepts deposits and channels those deposits into lending activities, either directly or through capital markets. A bank connects customers that have capital deficits to customers with capital surplus.

Creation of credit
Every advance made by a bank creates a corrosponding deposit. Both happen simultanenously. Bank receive primary deposits from public from household savings, payments received from RBI for sale of govt. Bond, payments received from abroad and deposited in the banks and money deposited for convenience in transaction. With these deposits banks keep Statutory Credit Ratio as prescribed by RBI and excess reserves and loan out the balalance to borrowers.

A Rs. 100 crs primary deposit by setting aside Rs. 20 crs (20% SCR) can create total credit of Rs. 500 crs by repeateldly lending and depositing by banks and keeping aside 20% SCR every time. - Deposit multiplier = Total deposit creation/ primary deposit (500/100=5) - Credit multiplier= additional credit creation/ total cash reserves (400/100=4)

Contd..
It is appropriate to say that economic development in India is primarily policy led. What are the various policies which significantly influence the management and growth of the economy? Monetary policy, fiscal policy, exim policy and industrial policy.

Contd...
In this session we are going to discuss the monetary policy. Before we discuss monetary policy per se, let us understand why policy are formulated and what are the general objectives of a policy and how do we judge the efficacy of a policy.

Define Policy

Economic Theory helps us understand how the world works (positive economics) Economic Policy goes a step ahead and examines issues such as : - What do we want to change? Why? - What is good and what is bad about the way system is operating - Can we make it better? - Normative considerations at the centre stage.

Criteria for Judging Economic Outcomes

1. Efficiency In economics it refers to allocative efficiency. An efficient economy is one that produces what people want at the least possible cost. 2. Equity Fairness Subjective Social Welfare always at centre stage Programs are driven by equity concerns

Contd..
.

3.Growth An increase in the total output (GNP/GDP) of an economy. Build economic and social overhead capital. Enhance resource potential of both men and material. 4. Stability It refers to the following conditions: Steady growth of national output Low Inflation Full employment

What is Monetary Policy

Monetary Policy is: Essentially a program of actions undertaken by the monetary authorities generally the central bank. It aims at to control and regulate the supply of and demand for money with the public and the flow of credit with a view to achieving predetermined macro economic goals.

Scope of Monetary Policy

It refers to all those economic activities involving money which can be influenced by monetary policy. Interest rates, asset prices, exchange rate, consumption, investment, GDP and prices. The effectiveness of monetary policy depends on the monetisation of economy and development of financial markets. Financial market comprises capital market, commercial banks, credit organisations, financial institutions, commodity market, currency market, foreign exchange market etc.

Objectives of MP
Taditional:
Price stability (5-6% Inflation) Adequate availability of credit to productive sectors

Recent Objectives
Foreign exchange stability Stimulating growth by maintaining price stability through money supply targeting thorough changing monetary base (currency with public and banks' reserves with RBI Money supply targets (14%) based on expected increase in output (8%)and tolerable level of inflation (6%)

Contd...
- Achieving Money supply targets depends upon the
velocity of circulation of money is stalble and the credit multiplier and the deposit multiplier are predictable and the GDP growth is materialised. - If anything goes wrong in these three aspectes, RBI resorts to changes in interest rate (bank rate or OMO). - M3 targeting and interest rate targeting cannot place together.

Components of Money Supply

M1 = Currency with public + Demand Deposits with banks + Other deposits with RBI M2 = M1 + Post Office saving Deposits M3 = M1 + Time Deposits with Banks M4= M3+ all post office deposits M1 Narrow money and M3 is known as broad money and from the monetary policy point of view M3 is considered.

Instruments of Monetary Policy:general credit controls

CRR or SRR
A requirement that banks must hold a proportion of their total deposits in the form of cash reserves with RBI. It was 15% in 1991 and 4% as of now. CRR is quick and direct instrument to effect money supply. But it does not fetch any interest for banks and impacts the growth directly and hence less in use. It is an instrument to prevent banks to lend excessively and land into financial crisis. It directly effects the money supply and creation of money through money multiplier.

Statutory Liquidity Ratio(SLR)

-Banks are required to maintain 23% of their daily demand and time deposits in the form of liquid assets such as excess reserves, govt securities, current account balance. - Bank tend to invest more in G-Sec, govt. bonds as these are risk free.(lazy banking-Rakesh mohan). -As against the stipulated SLR of 23% it was 29.47% in April 5 '13 and 29.88% Nov 15, '13. - Safe banking rather than productive banking.

Open market operations

-Open Market operations refer to sale and purchases of Govt.
Securities and T-Bills, Foreign Exchange, Gold, Short-term commercial bills and other approved securities by RBI. -G-sec are predominantly held by Banks and Insurance agencies. -Conduct repo (repurchase) transactions whereby RBI purchases G-Sec from the banks with an agreement that the G-Sec will be bought back by the banks at a later date at a specified rate and conduct reverse repo purchase. - Purchases of foreign exchange from the banks with an agreement that the banks will buy back the foreign exchange at a later date at a specified exchange rate and selling to banks.

OMO
-RBI sets the quantity targets and invites bid/auction through commercial banks at market rate of interest. For example on 19thNov in the morning auction RBI received accepted 64 bids for Rs. 407.70 billion for 1 day repo at 7.75% interest. - The buyers of govt. bonds are commercial banks, financial corporations, corporates, HNIs etc. - Effectiveness of OMO depends upon the liquidity position of banks, rate of interest on bonds, state of economy etc.

RBI operations as on 18.11.13

-C. Liquidity Adjustment Facility
(i) Repo(1 day) amt.41,076crs @7.7%int. (ii) Term Repo $ (11 days) amt.39,005.00 @8.51%* (iii) Reverse Repo (1 day) amt.4.00 @ 6.75% -D. Marginal Standing Facility(1 day) Rs.28,975.00 crs. @8.75% interest. Overnight segment: I: call money Rs. 17071 crs @ 7 to 8.85% interest

II:CBLO Rs. 70001 crs @ 8.5-8.85int(collateral borrowing and lending operations)

III:Mkt repo Rs.23593crs @7.95 to 8.85int

Bank rate
-The rate at which RBI lends or discouns their bills of
exchange, comercial papers(GSec) to commercial banks through its discount window to meet their depositors' demands and reserve reqirements. - By lowering the bank rate, RBI can increase money supply and vice-versa The rate at which RBI lends or discouns their bills of exchange, comercial papers(GSec) to commercial banks through its discount window to meet their depositors' demands and reserve reqirements.

Bank rate
- By lowering the bank rate, RBI can increase money supply and creation of money and vice-versa. - Discount window is not always open, in such case bank borrow from banks having extra reserves at call money market rate.

- Bank Rate down from 12% in 1997 to 8.75 as of now.

- Effectiveness of bank rate depends upon the development of financial mkts. The dependence of banks on RBI has gone down considerably as many avenues of mobilisation of capital are available.

Direct controls: Selective credit control

-General credit controls, expansionary or contrationary impact on
all the sectors of the economy. - Some time priorities of development require different kind of treatment of credit to different sectors. - Credit rationing, change in leding margins, moral suation, direct controls.

-Directed interest rates on small savings, PF.

-Mandatory requirements of banks to keep 23% their deposits in the form of G-sec commonly know as SLR ( interest bearing). - Lending to priority sector (40%) - Social function Vs efficienty and monetary transmission mechanism.

How does MP works

We know that money supply is one of the determinants of agg. Demand. It influences the income and price level as there is organic link bet the product mkt and money mkt through invt and rate of intt. According to Keynes during recession and unemployment it works in the following way.

Transmission mechanism Expansionary MP

Central bank buys securities through OMO. It reduces CRR It lowers Bank rate Money supply increases,it works through interest rate channel, asset prices channel and exchange rate channel. These three channels have special bearing on the aggregate consumption and aggregate investment which ultimate impact on GDP and general prices.

Transmission Mechanism Tight MP

This is used to arrest Inflation RBI sells securities through OMOs It raises CRR and SLR and Bank rate It raises maxm margin against holding of stocks of goods MS decreases, intt rate rises, invt exp declines, AD declines and price level falls.

 Inter relationship among money, interest rate, output and prices. Demand for money is dependent upon level of output, price level and interest rate. Supply of money is based on expected increase in income, expected level of price increase and income elasticity of demand for money. All these issues involve the use of proper transmission mechanism.

 Transmission Mechanism Refers to : - Origin and Transmission of different types of shocks in the financial system. - The nature and extent of feedback in policy. - Effectiveness of different policy instruments. Transmission channels are used in monetary policy.

Contd..
Main are : Quantum channel, Interest rate channel, Exchange rate channel. - Quantum channel through reserve money, credit aggregates affect the real output and price level directly of course with a time lag. - Remaining channels are indirect channels and effect real activities through changes in interest rate or exchange rate.

Evolution of Monetary Policy

Imperatives Onset of Reforms has brought about :

Changed institutional framework brought about by financial sector reforms. Domain of operations of Financial institutions and Banks. Intensification of the competition for resources for both FIs and Banks.

Contd...

Competition due to entry of new banks in private sector. Prudential Regulations in terms of capital adequacy, exposure norms in respect of investment in equity etc.

Board for financial supervision constituted with a focus on : - Restructuring system of inspection - Setting up of off-site surveillance - External auditors - Internal controls and audit procedures. Development of Financial Markets. Opening up of economy. Increase in foreign exchange reserves and capital inflows vis--vis exchange rate stability.

Gains From Reforms New Transmission channels have opened up. Indirect monetary control have assumed importance. CRR, a primary instrument of monetary policy, has been brought down from 15% in 1991 4% now, Bank Rate 8.75 %, Statutory Liquidity Ratio :- 23 % MSF: 8.75,Repo Rate :- 7.75 %,Reverse Repo :- 6.75 %

contd..
SLR down from 38.5% to 23% Deregulation and rationalisation of interest rate Operational flexibility to banks PLR down from 16.5% in 1991 to 10% Dormant Bank Rate activated from 1997. Bank Rate down from 12% in 1997 to 8.75

 Multiple indicator approach comprising interest rates in money, capital and Gilt market along with data on Currency, Credit, Fiscal Position, Trade, Capital Flows , Inflation rate, Exchange rate and Juxtaposed with output data need for drawing policy perspective. Repo and reverse repo (1997), Liquidity adjustment facility introduced in June 2000 to modulate short term liquidity and signal short term interest rates.

contd..
It operates through repo and reverse repo auctions of govt. securities since 1997 for NBFIs, primary dealers, FIIs, banks from 114 days and through call money market (for banks) for overnight to 14 days. Strengthening of regulatory framework to improve the functioning of MM, Credit Market, Capital Market, Govt. Security Market and Foreign Exchange Market.

 Abolition of system of automatic monetisation. Borrowing by Govt. at market interest rate through auction system. Call and Term money market purely inter bank market for banks. Accommodation of Large Capital Inflows and Control of its impact through OMO including repos and reverse repos.