Monetary Policy

CONSTITUENTS OF MONETARY ENVIRONMENT

Money supply and its composition Quantum and direction of credit Structure of interest rates (cost of credit) Liquidity in the business sector The state of banks and non-bank financial institutions Competition in the financial sector Financial risk Government borrowing operations Yield on financial assets Foreign exchange market and exchange rate Financial product development.

 Monetary Policy Monetary policy is all about supply of currency in the country. If we are talking about supply of currency then the term has a wide meaning, since the supply of currency is affected by many means and in turn , affects many other variables many. It is a country's central bank that controls the supply of money. Monetary policy has direct bearing on inflation and commercial bank interest rate. So even the slightest change in the monetary policy affects inflation and bank interest rate. The central bank designs the monetary policy in keeping with the government's economic policy. Monetary policy is about expansion and contraction of money and the central bank is the implementing body of the monetary policy.

 Measures of Money Supply in India (Monetary Aggregates) There are two basic measures of money globally: narrow and broad. The former usually consists of the currency with the public and demand deposits with banks. The latter includes the time deposits with banks. Till 1998, the RBI calculated four components of money supply in India, now termed as old money measures. These are known as money stock measures of monetary aggregates. Old Money Aggregates/Measures are as follows: M1 = Currency with the public, i.e., coins and currency notes + demand deposits with banks + other deposits with RBI. M2 = M1 + Post Office savings. M3 = M1 + time deposits of the public with banks; this is also known as broad money. M4 = M3 + saving and time deposits with the post office.

New Monetary Aggregates M0 = Currency in Circulation + Bankers Deposits with the RBI + 'Other' Deposits with the RBI. M1 (NM1) = Currency with the Public + Demand Deposits with the Banking System + 'Other' Deposits with the RBI. M2 (NM2) = M1 + Time Liabilities Portion of Savings Deposits with the Banking System + Certificates of Deposit issued by Banks + Term Deposits of residents with a contractual maturity of up to and including one year with the Banking System M3(NM3) = M2 + Term Deposits of residents with a contractual maturity of over one year with the Banking System + Call/Term borrowings from 'Nondepository' Financial Corporations by the Banking System. The new broad money aggregate (referred to as NM3 for purpose of clarity) in the Monetary Survey would comprise of NM2, long-term deposits of residents, and call/term borrowings from non-bank sources which have emerged as an important source of resource mobilisation for banks

 Liquidity Measures Three liquidity measures have been designed recently which are referred to as L1, L2, and L3. These are defined as follows: L1 = NM3 + Postal Deposits. L2 = L1 + Liabilities of the financial institutions. L3 = L2 + Public deposits with non-bank finance companies.

Factors Affecting Money Supply in India There are five sources which contribute to the aggregate monetary resources in the country (M3): Net bank credit to the bank Bank credit to the commercial sector Net foreign exchange assets of the banking sector Government currency liabilities to the public Non monetary liabilities of the banking sector.

 Need to Regulate the Supply of Money The supply of money has a direct impact on inflation, level of investment, employment generation, interest rate, etc. It is clear that supply of money has an effect on every aspect of the economy and has a close relationship with development. Supply of money is a sensitive issue as even a slight imbalance can create havoc in the form of deflation or hyperinflation in the country. In the initial stages of perestroika in the erstwhile USSR, because of imbalances in supply of money, the value of the Russian trouble decreased to such an extent much that people used to carry bags full of roubles to purchase bread. Every country manages supply of money in the national interest through its central bank.

 Money Supply and Inflation There is a direct relationship between the supply of money and inflation. It is based on the simple fundamental of demand and supply. The value of a currency is defined by its purchasing power. As the supply of money increases its value decreases. Decrease in purchasing power means an increase in inflation. When the supply of money increases with the people it gives them more purchasing power, which results in an increase in demand. Prices rise if demand increases without a correspondent increment in supply. This doesn't mean that money supply is directly proportional to inflation. Because increment in supply of money not only increases the demand, it also increases investment, i.e., supply. Part of the increased money also goes into savings. This is the reason that with an increase in money supply, the government promotes investment and savings so that it does not have an inflationary impact. There is thus a close relationship between inflation and supply of money, but not a proportional relation.

 Supply of Money, Interest Rate and Investment The supply of money also has an impact on interest rates and level of investment. In fact, economists have propounded the theory that to boost development and to create employment, the government should expand money. So it is clear that there is cyclical relation between money supply, inflation, interest and investment. We can put the four things in the following manner:

Relation between supply of money and inflation

Supply of Money

Low Interest Rate

Higher Investment

Inflation

Increase Demand

Employment

 Monetary Management It is the central bank of a country that is responsible for the regulation of supply of money. In India it is the RBI which manages the supply of money.

 Reserve Bank of India In 1921, the govt. of India established the Imperial Bank as the central bank of India. But it was not very successful. Upon the recommendation of the Central Banking Enquiry Committee, on April 1, 1935, the Reserve Bank of India began working. The entire share capital of RBI was initially owned by private shareholders. It was nationalised in 1949. Its head office is in Mumbai and it has branches in New Delhi, Kolkata, Chennai, Bangalore, Kanpur, Ahmedabad, Hyderabad, Patna and Nagpur. The State Bank of India works as its Agent in the cities where the RBI does not have an office. The Preamble of the RBI Act, 1934 states that, "Whereas it is expedient to constitute a Reserve Bank of India to regulate the issue of bank notes and the 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."

Functions of the Reserve Bank of India Issue of Currency Banker to Government Banker's Bank Controller of Credit Exchange Management and Control Collection and Publication of Data Supervisory Function Promoter of the Financial System Money Market Agriculture Sector Industrial Finance

 Monetary Policy From its inception, the RBI has followed the policy of controlled expansion, i.e., adequate financing of economic growth while ensuring reasonable price stability. Expansion of money is required in developing country for the purpose of development and investment. But this expansion results in inflation. So the RBI has to be cautious in order to achieve a trade-off between expansion and inflation. Not only this, the RBI also manages the forex exchange rate through open market operations, as after liberalisation it is the market forces that decide the exchange rate. The keynote of monetary policy can be said to be controlled expansion of bank credit and money supply, with special attention to seasonal requirement for credit. The RBI regards money supply and the volume of bank credits as the two major intermediate variables, but it seeks to control the former through the latter. It is said that money supply doesn't change on its own; it changes because of certain underlying development with regard to bank credit.

 RBI and Credit Control For the sake of credit control, the RBI resorts to bank rate manipulations, open market operations, reserve requirement changes, direct action, and rationing of credit and moral suasion. Apart from employing these traditional methods of credit control, it directly influences commercial banks' lending policy, rate of interest, and form of securities against loans and portfolio distribution.

The instrument of monetary policy (methods of credit control) may be broadly divided into the following parts: Open Market Operations Bank Rate Direct Regulation of Interest Rates on Commercial Banks' Deposits and Loans Cash Reserve Ratio (CRR) Statutory Liquidity Ratio (SLR) Direct Credit Allocation and Credit Rationing Selective Credit Controls (SCC) Credit Authorisation Scheme (CAS) Fixation of Inventory and Credit Norms Credit Planning Moral Suasion Liquidity Adjustment Facility (LAF)

Conclusion
Monetary policy in India has been formulated in the context of economic planning, whose main objective has been to accelerate the growth process in the country. In a country like India that has followed an expansionary fiscal policy which leads to inflationary conditions, to manage a monetary policy under these circumstances is like tightrope walk. During the planning period prior to liberalisation, the RBI used higher CRR and SLR rates to control inflation. After 1992, the demand of the day was development and investment and the development sector was expanding and was and in need of money. Indian corporations had to compete with companies which were getting money at 4% to 5% interest rates. Then the RBI had to reduce CRR and SLR to reduce interest rates and to make available money for investment purposes.