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Monetary Policy

Monetary Policy

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Published by Yogesh Kende
what is Monetary Policy?
what is Monetary Policy?

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Published by: Yogesh Kende on Oct 24, 2009
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MONETARY POLICY

Contents
 Introduction  Objectives  Scope  Instruments

of Monetary Policy

 Quantitative Measures Qualitative Measures
 Controlling

Inflation  Monetary Policy of India

INTRODUCTION
•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 pre-determined macro-economics goals. •At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money supply or raising the rate of return.

Contents
 Introduction  Objectives  Scope  Instruments

of Monetary Policy

Quantitative Measures  Qualitative Measures
 Controlling

Inflation  Monetary Policy of India

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.

Contents
 Introduction  Objectives  Scope  Instruments

of Monetary Policy

Quantitative Measures Qualitative Measures
 Controlling

Inflation  Monetary Policy of India

SCOPE OF MONETARY POLICY
The scope of Monetary policy depends on two factors 1. Level of Monetization of the Economy In this all economic transactions are carried out with money as a medium of exchange . This is 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.

2. Level of Development of the Capital Market
Some instrument of Monetary Policy are work through capital market such as Cash Reserve Ratio (CRR) etc. When capital market is fairly developed then the Monetary Policy effects the

Contents
 Introduction  Objectives  Scope  Instruments

of Monetary Policy

Quantitative Measures Qualitative Measures
 Controlling

Inflation  Monetary Policy of India

• 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 decides to reduce money in circulation it sells the government bonds and securities. • The central bank carries out its open operations through the commercial banks. market

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

• A rise in the discount rate reduces the net worth of the government bonds against which commercial banks borrow funds from the central bank. This reduces commercial banks capacity to borrow from the central bank. • When the central bank raises its discount rate, commercial banks raise their discount rate too. Rise in the discount rate raises the cost of bank credit which discourages business firms to get their bill of exchange discounted.

• 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 for meeting the cash demand by the depositors. • By changing the CRR, the central bank can change the money supply overnight. • When economic conditions demand a contractionary monetary policy, the central bank raises the CRR. And when economic conditions demand monetary expansion ,the central bank cuts down the CRR.

• In India ,the RBI has imposed another reserve requirement in addition to CRR. It is called 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 cash reserve ratio.

Contents
 Introduction  Objectives  Scope  Instruments

of Monetary Policy

Quantitative Measures Qualitative Measures
 Controlling

Inflation  Monetary Policy of India

When there is a shortage of institutional credit available for the business sector, the large and financially strong sectors or industries tend to capture the lion’s share in the total institutional credit. As a result the priority sectors and essential industries are of necessary funds.

Below two measures are generally adopted:  Imposition of upper limits on the credit available to large industries and firms  Charging a higher or progressive interest rate on the bank loans beyond a certain limit.

The banks provide loans 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.

The moral suasion is a method of persuading and convincing the commercial banks to advance credit in accordance with the directives of the central bank in overall economic interest of the country. Under this method the central bank writes letter to hold meetings with the banks on money and credit matters.

Contents
 Introduction  Objectives  Scope  Instruments

of Monetary Policy

Quantitative Measures Qualitative Measures
 Controlling

Inflation  Monetary Policy in India

An Expansionary Policy increases the total supply of money in the economy while a Contractionary Policy decreases the total money Supply into the market. Expansionary policy is traditionally used to combat a recession by lowering interests rates. Lowered interest rates means lower cost of credit which induces people to borrow and spend thereby providing steam to various industries and kick start a slowing economy.

A Contractionary Policy results in increasing interest rates to combat inflation. An Economy growing in an uninhibited manner leads to inflation Hence increasing interest rates increase the cost of credit thereby making people borrow less. Due to lesser borrowing the amount of money in the system reduces which in turn brings down inflation. A Contractionary Policy is also known as TIGHT POLICY as it tightens the flow of money in order to contain Inflationary forces.

The RBI makes an adjustment in its lending rate(Repo Rates) in order to influence the cost of credit. Thereby discouraging borrowing and hence reduces brings reduction in the system.

Whenever the liquid in the system increases, the RBI intervenes to stabilize the system. The Central Bank does this by issuing fresh bonds and treasury bills in open market. This tool was extensively used at the time when dollar inflows into our economy were very high, resulting in rupee appreciatin. Inorder to stabilize the exchange rates, RBI first bought additional dollars thereby stabilizing the rate of exchange.

 

CRRBy increasing the CRR, the RBI decreases the lending capacity of the bank to the extent of the increase in the ratio. E.g of the CRR is increased from 7.5% to 8.5% the banks were deprived of lending to the extent of 75 basis points of their deposit value.

CENTRAL BANK

CASH

SECURITIES AND TRESURY BILLS

BANK RATE
LE E A S TE RE RA INC ING ND

CASH RESERVE RATIO
E IN CRR %

STATUTORY LIQUID RATIO

COMMERCIAL BANKS

CORPORATES
REDUCED BORROWING OF LOANS

INC REA S

SO LD

INDIVIDUALS
REDUCE LIQUIDITY IN MARKET

Contents
 Introduction  Objectives  Scope  Instruments

of Monetary Policy

Quantitative Measures  Qualitative Measures
 Controlling

Inflation  Monetary Policy of India

Historically, the Monetary Policy is announced twice a year April-September and (October-March). The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy. The Monetary policy determines the supply of money in the economy and the rate of interest charged by banks. The policy also contains an economic overview and provides future forecasts. The Reserve Bank of India is responsible for formulating and implementing Monetary Policy..

The Monetary Policy aims to maintain price stability, full employment and economic growth. Emphasis on these objectives have been changing time to time depending on prevailing circumstances. For explanation of monetary policy, the whole period has been divided into 4 sub periods: a) Monetary policy of controlled expansion (1951 to 1972) b) Monetary Policy during Pre Reform period (1972 to 1991) c) Monetary Policy in the Post-Reforms (1991 to 1996) d) Easing of Monetary policy since Nov 1996

Monetary policy of controlled expansion (1951 to 1972)

To regulate the expansion of money supply and bank credit to promote growth. To restrict the excessive supply of credit to the private sector so as to control inflationary pressures.

Following steps were taken:
Changes in Bank Rate from 3% in 1951 to 6% in 1965 and it remained the same till 1971. 2) Changes in SLR from 20% in 1956 to 28% in 1971 3) Select Credit Control: In order to reduce the credit or bank loans against essential commodities, margin was increased. As a result of the above changes, the supply of money increased from 3.4% (1951 to 1956) to 9.1 (1961 to 1965).
1)

Monetary Policy during Pre Reform period (1972 to 1991):
Also known as the Tight Monetary policy: Price situation worsened during 1972 to 1974. Following Monetary Policy was adopted in 70’s and 80’s which were mainly concerned with the task neutralizing the impact of fiscal deficit and inflationary pressure.
1)Changes

in CRR to the legally maximum limit of 25% 2)Changes in SLR also to the maximum limit to 38.5%

Monetary Policy in the Post-Reforms – 1991 to 1996:
The year 1991-1992 saw a fundamental change in the institutional framework in setting the objective of monetary policy. It had twin objectives which were Price stability and economic growth. Following instruments were used: 1) Continuing the same maximum CRR and SLR of 25% and 38.5%, mopped up bank deposits to the extent of 63.5%. 2) In order to ensure profitability of banks, Monetary Reforms Committee headed by late Prof. S Chakravarty, recommended raising of interest rate on Government Securities which activated Open Market Operations (OMO). 3) Bank rate was raised from 10% in Apr 1991 to 12% in Oct 1991 to control the inflationary pressures.

Easing of Monetary policy since Nov 1996:
In 1996-97, the rate of inflation sharply declined. In the later half 1996-97, industrial recession gripped the Indian economy. To encourage the economic growth and to tackle the recessionary trend, the RBI eased its monetary policy. 1.Introduction of Repo rate. Repo rate increased from 3% in 1998 to 6.5% in 2005. This instrument was consistently used in the monitory policy as a result of rapid industrial growth during 2005-06. In the current monetary policy, the Repo rate was cut from 5.00% to 4.75%. 2.Reverse Repo rate –Through RRR, the RBI mops up liquidity from the banking system. In the current monetary policy, the Repo rate was cut from 3.50% to 3.25%.

Easing of Monetary policy since Nov 1996: (Contd)
3.

Flow of credit to Agriculture – The flow of credit to agriculture has increased from 34,013 (9.2% of overall credit) in 2008 to 52,742 (13% in overall credit) in 2009 – (Rs. in crore). Reduction in Cash Reserve Ratio – The CRR which was at 15% until 1995 gradually reduced to 5% in 2005. The CRR remained unchanged in the current monetary policy. Lowering Bank rate – The Bank rate was gradually reduced from 12% in 1997 to 6% in 2003. Since then the Bank Rate has remained unchanged to 6%.

4.

5.

Review of 2009/10 Monetary policy

The Policy Review projects GDP growth at 6% this FY due to slackening private consumption and investment demand. The RBI set its inflation projection for March 10 at 4% (currently at -1.21%). The RBI also projects the CPI to come down into the single digit zone. Assurance of a non-disruptive borrowing in 2009-10. Recently, the Government increased the borrowing plan from Rs. 2.41 lakh crore to 2.99 Lakh crore because of ample liquidity in the market due to slow credit growth. The fiscal stimulus packages of the Government and monetary easing and regulatory action of the Reserve Bank have helped to arrest the moderation in growth and keep our financial markets functioning normally.

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