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CHANGE IN OBJECTIVES OF
MONETARY POLICY AND USE OF
MONETARY INSTRUMENTS
Macroeconomics Project Report
Contents
MONETARY POLICY...............................................................................................................................3
OBJECTIVES OF MONETARY POLICY.................................................................................................4
MONETARY INSTRUMENTS..................................................................................................................4
QUANTITATIVE INSTRUMENTS...........................................................................................................5
QUALITATIVE INSTRUMENTS..............................................................................................................5
CASH RESERVE RATIO...........................................................................................................................5
STATUTORY LIQUDITY RATIO............................................................................................................9
OPEN MARKET OPERATIONS.............................................................................................................12
BANK RATE............................................................................................................................................13
REPO RATE.............................................................................................................................................15
REVERSE REPO RATE...........................................................................................................................15
QUALITATIVE INSTRUMENTS............................................................................................................18
MORAL SUSAION..................................................................................................................................18
CREDIT RATIONING..............................................................................................................................18
SELECTIVE CREDIT CONTROL...........................................................................................................19
DIRECT ACTION.....................................................................................................................................19
REFERENCES..........................................................................................................................................20
REFERENCES
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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 (to achieve
policy goals). The beginning of monetary policy as such comes from the
late 19th century, where it was used to maintain the gold standard.
A policy is referred to as contractionary if it reduces the size of the money
supply or raises the interest rate. An expansionary policy increases the
size of the money supply, or decreases the interest rate. Furthermore,
monetary policies are described as follows: accommodative, if the interest
rate set by the central monetary authority is intended to create economic
growth; neutral, if it is intended neither to create growth nor combat
inflation; or tight if intended to reduce inflation, generally RBI announces
monetary policy twice in a year during slack session (April-september)
and busy session (October-march).
3
OBJECTIVES OF MONETARY POLICY
It is generally believed that central banks ideally should have a single
overwhelming objective of price Stability. In practice, however, central
banks are responsible for a number of objectives besides price
Stability, such as currency stability, financial stability, growth in
employment and income, the primary Objectives of central banks in many
cases are legally and institutionally defined. However, all
Objectives may not have been spelt out explicitly in the central bank
legislation but may evolve through traditions and tacit understanding
between the government, the central bank and other major
Institutions in an economy, in general we considered with three main
objectives
To promote and encourage economic growth in the Economy
To achieve price stability by controlling inflation and Deflation
To ensure economic stability at full employment or Potential level
of output
MONETARY INSTRUMENTS
In order to control the above objectives there are some monetary
instruments by which RBI takes measure in order to have a control over
the objectives.
TYPES OF INSTRUMENTS
There are two types of instruments namely
4
QUANTITATIVE INSTRUMENTS
Cash reserve ratio (CRR)
Statutory liquidity ratio (SLR)
Bank rate
Open market operations (OMO)
Repo & reverse repo rate
QUALITATIVE INSTRUMENTS
Selective credit control
Rationing of credit
Moral persuasion
Direct action
5
PRE-REFORM (1970-1990)
16
14
12
10
6 6
5 5
4
6
2
From the above graph in the pre-reform period (i.e, 1970-1990)
The CRR rate is gradually increasing, the maximum rate that CRR
reached is 15% in mid 1990’s, the reason we can see in the below
graph which is related with the rate of inflation and also with the
rate of GDP.
POST-REFORM (1991-2009)
16
15 14.5 15
14 14
In the post-reform (i.e. 1991-2009) after liberalization the CRR rate has
12
gradually decreased. But in initial 1990’s-1991 there was a tremendous
increase in CRR rate, this was due to increase in the inflation rate.
10
8
7
6
CHANGE IN CRR WITH CHANGE IN INFLATION
16
14
From the above graph it can be observed that the inflation rate is high this
is due to the increase in oil prices in 1990-1992. Then RBI took a measure
by increasing12 the CRR rate to 15% to control the inflation rate if we also
take the recent condition where the food inflation reached around 20%,
then RBI has increased the CRR rate from 5% to 5.75% i.e. by increasing
75 basis by which RBI has collected 36,000 cores from all the commercial
banks by that10 the inflation has fallen to 18% so, by this we can say that
CRR plays a major role in order to control the inflation rate.
6
8
STATUTORY LIQUDITY RATIO
In India RBI has imposed another reserve
requirement in addition to CRR called statutory liquidity ratio (SLR)
Statutory liquidity ratio or SLR refers to the amount that all the banks
have to maintain inform of liquid assets like cash, gold and securities etc.
In India, RBI always determines the percentage of statutory liquidity
ratio. There are some statutory requirements for temporarily placing the
money in government bonds. Following this requirement, Reserve bank of
India fixes the SLR.
SLR rate = total demand/time liability *100%
9
PRE-REFORM (1970-1990)
10
POST-REFORM (1991-2009)
50
40 39 38
35
In the post reform (i.e. 1991-2009) after liberalization the statutory
30
liquidity ratio is gradually decreasing till 1998 and thereafter it remained
constant at 25% and in 2009 first time it decreased below 25%(i.e. 24%)
and presently it remained at 25%.
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10 11
OPEN MARKET OPERATIONS
An important instrument of monetary policy, that Reserve bank of India
purchases and sells securities in open market operations.
Open market operations are the means of implementing monetary policy
by which a central bank controls its national money supply by buying and
selling government securities, or other financial instruments. It is
conducted simply by increasing or decreasing the amount of money that
bank has e.g., in its reserve account at the central bank, in exchange for a
bank selling or buying a financial instrument.
➢ How Open market operations are a tool for credit control?
Monetary Policy works through expansion or contraction of
investment and consumption expenditure. A central bank, reserve
bank, or monetary authority is a banking institution granted the
exclusive privilege to lend a government its currency. Like a normal
commercial bank, a central bank charges interest on the loans made
to borrowers, primarily the government of whichever country the
bank exists for, and to other commercial banks, typically as a 'lender
of last resort'. However, a central bank is distinguished from a
normal commercial bank because it has a monopoly on creating the
currency of that nation, which is loaned to the government in the
form of legal tender. It is a bank that can lend money to other banks
in times of need. Its primary function is to provide the nation's
money supply, but more active duties include controlling
subsidized-loan interest rates, and acting as a lender of last resort to
the banking sector during times of financial crisis private banks
often being integral to the national financial system.
Contractionary policy can be implemented by reducing the size of
12
the monetary base. This directly reduces the total amount of money
circulating in the economy. A central bank can use open market
operations to reduce the monetary base. The central bank would
typically sell bonds in exchange for hard currency. When the central
bank collects this hard currency payment, it removes that amount of
currency from the economy, thus contracting the monetary base.
BANK RATE
120000
It is the minimum rate at which central bank provides loan to
commercial banks. It is also called discounting rate because bank provides
finance to the commercial banks by rediscounting the bill of exchange.
13
When central banks raises bank rate commercial banks raises lending rate
and vice-versa
➢ How bank rate is used as tool for credit control?
Bank rate is used by the central bank to ensure safety and directly
regulate the lending capacity and control the money supply in the
economy. When the RBI feels that there is an increase in inflation
rate, RBI increases the bank rate, which leads to an increase in the
commercial lending’s and thus reduces the investments, henceforth
reducing the money supply and inflation.
16
15
From the above graph it is noted that as the bank rate decreases the
14also decreases, we can see that
interest rate 14 in post-reform the bank rate is
decreased from 12% to 6% in 2001-2002 there after it remained constant
at a 6%. 13
12.5
12 12 12 12
14
10
REPO RATE
When ever there is deficient of the fund with the banks
then the banks barrow money from RBI, Repo rate is the rate at which all
banks barrow rupees from RBI. A reduction in repo rate will help banks
to get money at cheaper rate. When repo rate increases then the
borrowings from RBI becomes more expensive.
15
RELATIONSHIP BETWEEN REPO AND REVERSE RATE
From the above graph it is observed that both repo and reverse repo rate
7
are gradually increasing after a point i.e. in mid 2008 both the rates as
decreased and the present repo rate (4.75%) and reverse repo rate 6
(3.25%).
6 6 6
5
5 5
4.5
4
2 16
CHANGE IN ALL THE MONETARY INSTRUMENTS WITH THE
CHANE IN INFLATION RATE AND INTREST RATE
Feb-10 6 0 4.75 0.00 3.25 0.0 5.75 15.00 25 4.17 7.31 -22.45
17
The above table shows that the change in monetary instruments with
change in the inflation rate etc
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QUALITATIVE INSTRUMENTS
These are the instruments that does not deal
with the numbers, these instruments deal with only change in political,
economical change or by controlling some of the selective credit controls
MORAL SUSAION
A persuasion tactic used by an authority (i.e. Federal Reserve
Board) to influence and pressure, but not force, banks into adhering to
policy. Tactics used are closed-door meetings with bank directors,
increased severity of inspections, appeals to community spirit, or vague
threats.
Example of moral suasion is when the Fed Chairman speaks on the
markets - his opinion on the overall economy can send financial markets
falling or flying.
CREDIT RATIONING
Allocation of loans to creditworthy borrowers by other than pure market
means. Credit rationing occurs when interest rates are kept below the
level at which an unregulated market would set, leading to an excess of
demand for loans.
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SELECTIVE CREDIT CONTROL
DIRECT ACTION
Direct action is politically motivated activity undertaken by individuals,
groups, or governments to achieve political goals outside of normal
social/political channels. Direct action can include nonviolent and violent
activities which target persons, groups, or property deemed offensive to
the direct action participant.
E.g.: Direct tax levy
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REFERENCES
www.rbi.org
www.indiabudget .nic.in
www.wikepedia .com
RBI hand book
Other text books
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