Monetary Policy in India

Ila Patnaik

NIPFP, January 2007

Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

1 / 38

Outline

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Introduction Objectives Money supply Instruments Impossible trinity Currency regime

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Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

2 / 38

Introduction

Monetary Policy

What is monetary policy? What is the role of monetary policy? How does monetary policy work?

Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

3 / 38

Introduction

Monetary Policy

What is monetary policy? What is the role of monetary policy? How does monetary policy work?

Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

3 / 38

Introduction

Monetary Policy

What is monetary policy? What is the role of monetary policy? How does monetary policy work?

Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

3 / 38

Introduction

When interest rates are reduced

Example Rahul takes a consumer loan Raj takes a loan to add capacity to his factory Rani takes a housing loan Increase in expenditure.

Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

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January 2007 4 / 38 . Ila Patnaik () Monetary Policy in India NIPFP.Introduction When interest rates are reduced Example Rahul takes a consumer loan Raj takes a loan to add capacity to his factory Rani takes a housing loan Increase in expenditure.

Introduction When interest rates are reduced Example Rahul takes a consumer loan Raj takes a loan to add capacity to his factory Rani takes a housing loan Increase in expenditure. January 2007 4 / 38 . Ila Patnaik () Monetary Policy in India NIPFP.

Introduction When interest rates are reduced Example Rahul takes a consumer loan Raj takes a loan to add capacity to his factory Rani takes a housing loan Increase in expenditure. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 4 / 38 .

January 2007 5 / 38 .9 percent Real estate prices Bank credit growth high GDP growth above 9 percent Ila Patnaik () Monetary Policy in India NIPFP.Introduction Recent hikes in interest rate CPI inflation rate up from 3 to 7 percent WPI inflation rate at 5.

9 percent Real estate prices Bank credit growth high GDP growth above 9 percent Ila Patnaik () Monetary Policy in India NIPFP. January 2007 5 / 38 .Introduction Recent hikes in interest rate CPI inflation rate up from 3 to 7 percent WPI inflation rate at 5.

Introduction Recent hikes in interest rate CPI inflation rate up from 3 to 7 percent WPI inflation rate at 5.9 percent Real estate prices Bank credit growth high GDP growth above 9 percent Ila Patnaik () Monetary Policy in India NIPFP. January 2007 5 / 38 .

9 percent Real estate prices Bank credit growth high GDP growth above 9 percent Ila Patnaik () Monetary Policy in India NIPFP. January 2007 5 / 38 .Introduction Recent hikes in interest rate CPI inflation rate up from 3 to 7 percent WPI inflation rate at 5.

January 2007 5 / 38 .9 percent Real estate prices Bank credit growth high GDP growth above 9 percent Ila Patnaik () Monetary Policy in India NIPFP.Introduction Recent hikes in interest rate CPI inflation rate up from 3 to 7 percent WPI inflation rate at 5.

Ila Patnaik () Monetary Policy in India NIPFP.Objectives What is monetary policy? Monetary policy is the management of money supply and interest rates by central banks to control prices and employment. January 2007 6 / 38 .

Objectives How does monetary policy achieve its goals? Monetary policy impacts demand in the economy through affecting interest rates Traditionally this was done through changing money supply Now it is done by directly changing interest rates. January 2007 7 / 38 . Ila Patnaik () Monetary Policy in India NIPFP.

January 2007 7 / 38 . Ila Patnaik () Monetary Policy in India NIPFP.Objectives How does monetary policy achieve its goals? Monetary policy impacts demand in the economy through affecting interest rates Traditionally this was done through changing money supply Now it is done by directly changing interest rates.

Objectives How does monetary policy achieve its goals? Monetary policy impacts demand in the economy through affecting interest rates Traditionally this was done through changing money supply Now it is done by directly changing interest rates. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 7 / 38 .

January 2007 8 / 38 .Objectives Contractionary monetary policy A rise in interest rates Individual loans more expensive Assets lose value. Firms can hold less inventories Borrowing for investment is more expensive Reduction in aggregate expenditure. Ila Patnaik () Monetary Policy in India NIPFP. The wealth effect reduces spending.

Firms can hold less inventories Borrowing for investment is more expensive Reduction in aggregate expenditure. The wealth effect reduces spending.Objectives Contractionary monetary policy A rise in interest rates Individual loans more expensive Assets lose value. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 8 / 38 .

January 2007 8 / 38 . Ila Patnaik () Monetary Policy in India NIPFP. The wealth effect reduces spending.Objectives Contractionary monetary policy A rise in interest rates Individual loans more expensive Assets lose value. Firms can hold less inventories Borrowing for investment is more expensive Reduction in aggregate expenditure.

Objectives Contractionary monetary policy A rise in interest rates Individual loans more expensive Assets lose value. The wealth effect reduces spending. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 8 / 38 . Firms can hold less inventories Borrowing for investment is more expensive Reduction in aggregate expenditure.

Objectives Expansionary monetary policy Similarly. January 2007 9 / 38 . monetary policy is expansionary. with a cut in interest rates. Ila Patnaik () Monetary Policy in India NIPFP.

The reverse repo rate is the rate at which banks lend to RBI. The repo rate is the rate at which RBI lends to banks in the short run. January 2007 10 / 38 . The next one will be announced on 31st January. Why people are expecting interest rates to go up? Ila Patnaik () Monetary Policy in India NIPFP.Objectives Credit policy RBI announces a credit policy every quarter. the cash reserve ratio was hiked. Interest rates were raised in the last credit policy. In recent weeks.

In recent weeks. Interest rates were raised in the last credit policy. Why people are expecting interest rates to go up? Ila Patnaik () Monetary Policy in India NIPFP. The reverse repo rate is the rate at which banks lend to RBI. The next one will be announced on 31st January. the cash reserve ratio was hiked. January 2007 10 / 38 . The repo rate is the rate at which RBI lends to banks in the short run.Objectives Credit policy RBI announces a credit policy every quarter.

January 2007 10 / 38 . The next one will be announced on 31st January. Why people are expecting interest rates to go up? Ila Patnaik () Monetary Policy in India NIPFP. the cash reserve ratio was hiked. The repo rate is the rate at which RBI lends to banks in the short run.Objectives Credit policy RBI announces a credit policy every quarter. In recent weeks. The reverse repo rate is the rate at which banks lend to RBI. Interest rates were raised in the last credit policy.

The repo rate is the rate at which RBI lends to banks in the short run. The reverse repo rate is the rate at which banks lend to RBI. Interest rates were raised in the last credit policy. Why people are expecting interest rates to go up? Ila Patnaik () Monetary Policy in India NIPFP.Objectives Credit policy RBI announces a credit policy every quarter. the cash reserve ratio was hiked. January 2007 10 / 38 . In recent weeks. The next one will be announced on 31st January.

In recent weeks. Why people are expecting interest rates to go up? Ila Patnaik () Monetary Policy in India NIPFP. The reverse repo rate is the rate at which banks lend to RBI.Objectives Credit policy RBI announces a credit policy every quarter. Interest rates were raised in the last credit policy. The next one will be announced on 31st January. The repo rate is the rate at which RBI lends to banks in the short run. January 2007 10 / 38 . the cash reserve ratio was hiked.

Money supply Money demand and supply What is money supply? How is the demand for money determined? How does the central bank change the interest rate? Ila Patnaik () Monetary Policy in India NIPFP. January 2007 11 / 38 .

January 2007 11 / 38 .Money supply Money demand and supply What is money supply? How is the demand for money determined? How does the central bank change the interest rate? Ila Patnaik () Monetary Policy in India NIPFP.

Money supply Money demand and supply What is money supply? How is the demand for money determined? How does the central bank change the interest rate? Ila Patnaik () Monetary Policy in India NIPFP. January 2007 11 / 38 .

Money supply Money supply Money is something that is used as a medium of exchange. M3 consists of currency plus demand deposits plus time deposits. In its narrow most definition (M0) money comprises of all currency in circulation. a store of value and a unit of account. Ila Patnaik () Monetary Policy in India NIPFP. Adding post office deposits to M1 we get M2 and to M3 we get M4. January 2007 12 / 38 . M1 is all currency plus demand deposits.

Ila Patnaik () Monetary Policy in India NIPFP. January 2007 12 / 38 . Adding post office deposits to M1 we get M2 and to M3 we get M4. M1 is all currency plus demand deposits. a store of value and a unit of account. M3 consists of currency plus demand deposits plus time deposits. In its narrow most definition (M0) money comprises of all currency in circulation.Money supply Money supply Money is something that is used as a medium of exchange.

Money supply Money supply Money is something that is used as a medium of exchange. In its narrow most definition (M0) money comprises of all currency in circulation. M1 is all currency plus demand deposits. M3 consists of currency plus demand deposits plus time deposits. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 12 / 38 . Adding post office deposits to M1 we get M2 and to M3 we get M4. a store of value and a unit of account.

Ila Patnaik () Monetary Policy in India NIPFP. a store of value and a unit of account. M3 consists of currency plus demand deposits plus time deposits. M1 is all currency plus demand deposits.Money supply Money supply Money is something that is used as a medium of exchange. Adding post office deposits to M1 we get M2 and to M3 we get M4. In its narrow most definition (M0) money comprises of all currency in circulation. January 2007 12 / 38 .

Ila Patnaik () Monetary Policy in India NIPFP. Adding post office deposits to M1 we get M2 and to M3 we get M4. January 2007 12 / 38 . M3 consists of currency plus demand deposits plus time deposits.Money supply Money supply Money is something that is used as a medium of exchange. a store of value and a unit of account. In its narrow most definition (M0) money comprises of all currency in circulation. M1 is all currency plus demand deposits.

January 2007 13 / 38 . also known base money or high powered money is the money that is directly created by the central bank.Money supply Monetary base The monetary base (M0). M0 = net central bank lending to the government plus net foreign exchange assets of the central bank Ila Patnaik () Monetary Policy in India NIPFP.

also known base money or high powered money is the money that is directly created by the central bank. January 2007 13 / 38 . M0 = net central bank lending to the government plus net foreign exchange assets of the central bank Ila Patnaik () Monetary Policy in India NIPFP.Money supply Monetary base The monetary base (M0).

or adds to its kitty of foreign exchange reserves. Ila Patnaik () Monetary Policy in India NIPFP.Money supply Money creation Money is created when the central bank either lends to the money. January 2007 14 / 38 .

January 2007 15 / 38 . Banks that receive these deposits hold 9 and lend out the rest. Borrowers of the Rs 90 hold it in bank deposits.Money supply Money multiplier Example 1 Suppose an exporter brings 2 dollars into India and RBI buys the dollars at Rs 50 per dollar. He deposits Rs 100 in a bank. The banking system as a whole lends out a multiple of the amount that was initially created by the central bank. for example. Rs 10 as reserves and lends out Rs 90. 2 3 4 5 6 Ila Patnaik () Monetary Policy in India NIPFP. This leads to an increase in M0 by Rs 100. The bank holds.

Money supply Money multiplier Example 1 Suppose an exporter brings 2 dollars into India and RBI buys the dollars at Rs 50 per dollar. The banking system as a whole lends out a multiple of the amount that was initially created by the central bank. January 2007 15 / 38 . The bank holds. 2 3 4 5 6 Ila Patnaik () Monetary Policy in India NIPFP. Borrowers of the Rs 90 hold it in bank deposits. Rs 10 as reserves and lends out Rs 90. He deposits Rs 100 in a bank. Banks that receive these deposits hold 9 and lend out the rest. for example. This leads to an increase in M0 by Rs 100.

for example.Money supply Money multiplier Example 1 Suppose an exporter brings 2 dollars into India and RBI buys the dollars at Rs 50 per dollar. Borrowers of the Rs 90 hold it in bank deposits. The bank holds. He deposits Rs 100 in a bank. This leads to an increase in M0 by Rs 100. January 2007 15 / 38 . Rs 10 as reserves and lends out Rs 90. 2 3 4 5 6 Ila Patnaik () Monetary Policy in India NIPFP. The banking system as a whole lends out a multiple of the amount that was initially created by the central bank. Banks that receive these deposits hold 9 and lend out the rest.

The banking system as a whole lends out a multiple of the amount that was initially created by the central bank. The bank holds. January 2007 15 / 38 . for example. Banks that receive these deposits hold 9 and lend out the rest. Borrowers of the Rs 90 hold it in bank deposits. He deposits Rs 100 in a bank. 2 3 4 5 6 Ila Patnaik () Monetary Policy in India NIPFP. This leads to an increase in M0 by Rs 100. Rs 10 as reserves and lends out Rs 90.Money supply Money multiplier Example 1 Suppose an exporter brings 2 dollars into India and RBI buys the dollars at Rs 50 per dollar.

He deposits Rs 100 in a bank. Banks that receive these deposits hold 9 and lend out the rest. January 2007 15 / 38 . The banking system as a whole lends out a multiple of the amount that was initially created by the central bank.Money supply Money multiplier Example 1 Suppose an exporter brings 2 dollars into India and RBI buys the dollars at Rs 50 per dollar. Rs 10 as reserves and lends out Rs 90. Borrowers of the Rs 90 hold it in bank deposits. This leads to an increase in M0 by Rs 100. 2 3 4 5 6 Ila Patnaik () Monetary Policy in India NIPFP. The bank holds. for example.

for example. 2 3 4 5 6 Ila Patnaik () Monetary Policy in India NIPFP. Rs 10 as reserves and lends out Rs 90. Borrowers of the Rs 90 hold it in bank deposits. This leads to an increase in M0 by Rs 100. The banking system as a whole lends out a multiple of the amount that was initially created by the central bank. He deposits Rs 100 in a bank.Money supply Money multiplier Example 1 Suppose an exporter brings 2 dollars into India and RBI buys the dollars at Rs 50 per dollar. Banks that receive these deposits hold 9 and lend out the rest. January 2007 15 / 38 . The bank holds.

He deposits Rs 100 in a bank. January 2007 15 / 38 . The banking system as a whole lends out a multiple of the amount that was initially created by the central bank. Borrowers of the Rs 90 hold it in bank deposits.Money supply Money multiplier Example 1 Suppose an exporter brings 2 dollars into India and RBI buys the dollars at Rs 50 per dollar. This leads to an increase in M0 by Rs 100. 2 3 4 5 6 Ila Patnaik () Monetary Policy in India NIPFP. Rs 10 as reserves and lends out Rs 90. for example. Banks that receive these deposits hold 9 and lend out the rest. The bank holds.

. .90 . n Total Bank deposits 100 90 81 72. 0 1000 Ila Patnaik () Monetary Policy in India NIPFP. January 2007 16 / 38 .Money supply Credit expansion Round 1 2 3 4 .

90 . 0 1000 Ila Patnaik () Monetary Policy in India NIPFP. . n Total Bank deposits 100 90 81 72.Money supply Credit expansion Round 1 2 3 4 . . January 2007 16 / 38 .

n Total Bank deposits 100 90 81 72. 0 1000 Ila Patnaik () Monetary Policy in India NIPFP. . .Money supply Credit expansion Round 1 2 3 4 . January 2007 16 / 38 .90 .

n Total Bank deposits 100 90 81 72. . .90 . January 2007 16 / 38 . 0 1000 Ila Patnaik () Monetary Policy in India NIPFP.Money supply Credit expansion Round 1 2 3 4 .

Money supply

Credit expansion

Round 1 2 3 4 . . n Total

Bank deposits 100 90 81 72.90 . . 0 1000

Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

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Money supply

Credit expansion

Round 1 2 3 4 . . n Total

Bank deposits 100 90 81 72.90 . . 0 1000

Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

16 / 38

Money supply

Credit expansion

Round 1 2 3 4 . . n Total

Bank deposits 100 90 81 72.90 . . 0 1000

Ila Patnaik ()

Monetary Policy in India

NIPFP, January 2007

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Money supply Credit expansion Round 1 2 3 4 . 0 1000 Ila Patnaik () Monetary Policy in India NIPFP.90 . n Total Bank deposits 100 90 81 72. . January 2007 16 / 38 . .

= 100(1/r)). Ila Patnaik () Monetary Policy in India NIPFP.2 Example The total change in money supply adds up to = 100+100(1-r)+100(1-r)(1-r)+. January 2007 17 / 38 . The multiple 10 is known as the money multiplier..Money supply Money multiplier . where r is the amount that banks hold as reserves = 1000 Money supply increases by Rs 1000 when the central bank increases the monetary base by Rs 100..

where r is the amount that banks hold as reserves = 1000 Money supply increases by Rs 1000 when the central bank increases the monetary base by Rs 100. = 100(1/r)). The multiple 10 is known as the money multiplier. Ila Patnaik () Monetary Policy in India NIPFP..2 Example The total change in money supply adds up to = 100+100(1-r)+100(1-r)(1-r)+..Money supply Money multiplier . January 2007 17 / 38 .

. The multiple 10 is known as the money multiplier. where r is the amount that banks hold as reserves = 1000 Money supply increases by Rs 1000 when the central bank increases the monetary base by Rs 100. = 100(1/r)). Ila Patnaik () Monetary Policy in India NIPFP. January 2007 17 / 38 ..2 Example The total change in money supply adds up to = 100+100(1-r)+100(1-r)(1-r)+.Money supply Money multiplier .

. January 2007 17 / 38 . Ila Patnaik () Monetary Policy in India NIPFP. The multiple 10 is known as the money multiplier.Money supply Money multiplier . = 100(1/r))..2 Example The total change in money supply adds up to = 100+100(1-r)+100(1-r)(1-r)+. where r is the amount that banks hold as reserves = 1000 Money supply increases by Rs 1000 when the central bank increases the monetary base by Rs 100.

Money supply Money demand 1 2 3 Transactions demand for money is proportionate to income Speculative demand for money depends on interest rates Precautionary demand for money is a small part Ila Patnaik () Monetary Policy in India NIPFP. January 2007 18 / 38 .

Money supply Money demand 1 2 3 Transactions demand for money is proportionate to income Speculative demand for money depends on interest rates Precautionary demand for money is a small part Ila Patnaik () Monetary Policy in India NIPFP. January 2007 18 / 38 .

Money supply Money demand 1 2 3 Transactions demand for money is proportionate to income Speculative demand for money depends on interest rates Precautionary demand for money is a small part Ila Patnaik () Monetary Policy in India NIPFP. January 2007 18 / 38 .

Instruments Instruments of monetary policy in India To change money supply Net loans to central government through open market operations Net purchase of foreign currency assets Change in cash reserve ratio Ila Patnaik () Monetary Policy in India NIPFP. January 2007 19 / 38 .

Instruments Instruments of monetary policy in India To change money supply Net loans to central government through open market operations Net purchase of foreign currency assets Change in cash reserve ratio Ila Patnaik () Monetary Policy in India NIPFP. January 2007 19 / 38 .

January 2007 19 / 38 .Instruments Instruments of monetary policy in India To change money supply Net loans to central government through open market operations Net purchase of foreign currency assets Change in cash reserve ratio Ila Patnaik () Monetary Policy in India NIPFP.

January 2007 20 / 38 .Instruments Difficulties with demand-supply approach Instability of money demand function Money supply is not exogenous Result: Interest rates do not move as hoped Lower chances of achieving a reduction or increase in aggregate demand Ila Patnaik () Monetary Policy in India NIPFP.

Instruments Difficulties with demand-supply approach Instability of money demand function Money supply is not exogenous Result: Interest rates do not move as hoped Lower chances of achieving a reduction or increase in aggregate demand Ila Patnaik () Monetary Policy in India NIPFP. January 2007 20 / 38 .

Instruments Difficulties with demand-supply approach Instability of money demand function Money supply is not exogenous Result: Interest rates do not move as hoped Lower chances of achieving a reduction or increase in aggregate demand Ila Patnaik () Monetary Policy in India NIPFP. January 2007 20 / 38 .

January 2007 20 / 38 .Instruments Difficulties with demand-supply approach Instability of money demand function Money supply is not exogenous Result: Interest rates do not move as hoped Lower chances of achieving a reduction or increase in aggregate demand Ila Patnaik () Monetary Policy in India NIPFP.

January 2007 21 / 38 .Impossible trinity Monetary policy in an open economy Impossible trinity Open capital account Pegged currency regime Independent monetary policy Ila Patnaik () Monetary Policy in India NIPFP.

January 2007 21 / 38 .Impossible trinity Monetary policy in an open economy Impossible trinity Open capital account Pegged currency regime Independent monetary policy Ila Patnaik () Monetary Policy in India NIPFP.

Impossible trinity Monetary policy in an open economy Impossible trinity Open capital account Pegged currency regime Independent monetary policy Ila Patnaik () Monetary Policy in India NIPFP. January 2007 21 / 38 .

Ila Patnaik () Monetary Policy in India NIPFP.Impossible trinity Monetary policy in an open economy Example Let us say you have inflation and so want a contractionary monetary policy. capital flows in from abroad in response to the higher interest rates. Since the capital account is open. This puts a pressure on the rupee to appreciate. You raise interest rates. January 2007 22 / 38 .

You raise interest rates. Since the capital account is open. capital flows in from abroad in response to the higher interest rates. January 2007 22 / 38 . This puts a pressure on the rupee to appreciate. Ila Patnaik () Monetary Policy in India NIPFP.Impossible trinity Monetary policy in an open economy Example Let us say you have inflation and so want a contractionary monetary policy.

capital flows in from abroad in response to the higher interest rates. Ila Patnaik () Monetary Policy in India NIPFP. Since the capital account is open. January 2007 22 / 38 .Impossible trinity Monetary policy in an open economy Example Let us say you have inflation and so want a contractionary monetary policy. This puts a pressure on the rupee to appreciate. You raise interest rates.

Ila Patnaik () Monetary Policy in India NIPFP. capital flows in from abroad in response to the higher interest rates. You raise interest rates. Since the capital account is open. January 2007 22 / 38 . This puts a pressure on the rupee to appreciate.Impossible trinity Monetary policy in an open economy Example Let us say you have inflation and so want a contractionary monetary policy.

This puts a pressure on the rupee to appreciate. Since the capital account is open.Impossible trinity Monetary policy in an open economy Example Let us say you have inflation and so want a contractionary monetary policy. You raise interest rates. January 2007 22 / 38 . Ila Patnaik () Monetary Policy in India NIPFP. capital flows in from abroad in response to the higher interest rates.

Ila Patnaik () Monetary Policy in India NIPFP. RBI cannot raise rates. January 2007 23 / 38 . An expansion in M3 will lower interest rates. and keep the exchange rate pegged at the same time. This leads to an expansion in net foreign exchange assets of the RBI and thus of M3.Impossible trinity But the exchange rate is pegged Example The RBI buys up the dollars coming in to prevent rupee appreciation.

and keep the exchange rate pegged at the same time.Impossible trinity But the exchange rate is pegged Example The RBI buys up the dollars coming in to prevent rupee appreciation. January 2007 23 / 38 . Ila Patnaik () Monetary Policy in India NIPFP. RBI cannot raise rates. An expansion in M3 will lower interest rates. This leads to an expansion in net foreign exchange assets of the RBI and thus of M3.

Impossible trinity But the exchange rate is pegged Example The RBI buys up the dollars coming in to prevent rupee appreciation. and keep the exchange rate pegged at the same time. An expansion in M3 will lower interest rates. Ila Patnaik () Monetary Policy in India NIPFP. RBI cannot raise rates. January 2007 23 / 38 . This leads to an expansion in net foreign exchange assets of the RBI and thus of M3.

Impossible trinity But the exchange rate is pegged Example The RBI buys up the dollars coming in to prevent rupee appreciation. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 23 / 38 . This leads to an expansion in net foreign exchange assets of the RBI and thus of M3. RBI cannot raise rates. and keep the exchange rate pegged at the same time. An expansion in M3 will lower interest rates.

RBI cannot raise rates.Impossible trinity But the exchange rate is pegged Example The RBI buys up the dollars coming in to prevent rupee appreciation. and keep the exchange rate pegged at the same time. January 2007 23 / 38 . This leads to an expansion in net foreign exchange assets of the RBI and thus of M3. Ila Patnaik () Monetary Policy in India NIPFP. An expansion in M3 will lower interest rates.

Impossible trinity Monetary policy in an open economy Example If the US hikes the Fed rate. If the RBI wants to prevent depreciation of the currency. Thus having a peg means following US monetary policy. capital will flow out and the currency will depreciate. January 2007 24 / 38 . it will have to sell dollars or raise rates. Both these are contractionary. Ila Patnaik () Monetary Policy in India NIPFP.

it will have to sell dollars or raise rates. January 2007 24 / 38 . Both these are contractionary. If the RBI wants to prevent depreciation of the currency. Thus having a peg means following US monetary policy. Ila Patnaik () Monetary Policy in India NIPFP.Impossible trinity Monetary policy in an open economy Example If the US hikes the Fed rate. capital will flow out and the currency will depreciate.

Thus having a peg means following US monetary policy. Both these are contractionary. If the RBI wants to prevent depreciation of the currency. January 2007 24 / 38 .Impossible trinity Monetary policy in an open economy Example If the US hikes the Fed rate. capital will flow out and the currency will depreciate. it will have to sell dollars or raise rates. Ila Patnaik () Monetary Policy in India NIPFP.

Impossible trinity Monetary policy in an open economy Example If the US hikes the Fed rate. capital will flow out and the currency will depreciate. January 2007 24 / 38 . Thus having a peg means following US monetary policy. it will have to sell dollars or raise rates. Ila Patnaik () Monetary Policy in India NIPFP. If the RBI wants to prevent depreciation of the currency. Both these are contractionary.

January 2007 25 / 38 .Impossible trinity Monetary policy in an open economy A country with an open capital account cannot hope to have an independent monetary policy if it runs a pegged exchange rate. Ila Patnaik () Monetary Policy in India NIPFP.

This is known as sterilizing the impact of the forex intervention. Ila Patnaik () Monetary Policy in India NIPFP.Impossible trinity Sterilised intervention The central bank could then try to impact money supply through open market operations. January 2007 26 / 38 .

Reinhart & Rogoff. Fear of floating (Calvo & Reinhart.Currency regime India’s currency regime RBI says that the rupee is a “market determined exchange rate”. 2003: identification of de facto currency regime – They classify India as a “peg to the US dollar”. ‘Pegging’: A nominal rate. and reduction in volatility of this rate. Ila Patnaik () Monetary Policy in India NIPFP. 2002) : currency flexibility in India has not changed over 1979-1999. January 2007 27 / 38 . is the main focus of trading by the central bank.

2003: identification of de facto currency regime – They classify India as a “peg to the US dollar”. and reduction in volatility of this rate. 2002) : currency flexibility in India has not changed over 1979-1999. ‘Pegging’: A nominal rate. Ila Patnaik () Monetary Policy in India NIPFP.Currency regime India’s currency regime RBI says that the rupee is a “market determined exchange rate”. January 2007 27 / 38 . Reinhart & Rogoff. Fear of floating (Calvo & Reinhart. is the main focus of trading by the central bank.

2003: identification of de facto currency regime – They classify India as a “peg to the US dollar”. Reinhart & Rogoff. 2002) : currency flexibility in India has not changed over 1979-1999. and reduction in volatility of this rate. Fear of floating (Calvo & Reinhart. ‘Pegging’: A nominal rate.Currency regime India’s currency regime RBI says that the rupee is a “market determined exchange rate”. is the main focus of trading by the central bank. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 27 / 38 .

is the main focus of trading by the central bank. 2003: identification of de facto currency regime – They classify India as a “peg to the US dollar”. Reinhart & Rogoff. ‘Pegging’: A nominal rate. 2002) : currency flexibility in India has not changed over 1979-1999. Fear of floating (Calvo & Reinhart. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 27 / 38 .Currency regime India’s currency regime RBI says that the rupee is a “market determined exchange rate”. and reduction in volatility of this rate.

Ila Patnaik () Monetary Policy in India NIPFP. a focus on INR/USD volatility. and deviations from the random walk for INR/USD. Calvo & Reinhart measure of currency flexibility: Did not change after 1999. A variety of tests highlight the INR/USD peg. January 2007 28 / 38 .Currency regime Currency regime The reserves buildup after mid-2002 cannot be explained by a quest for reserves as insurance.

Ila Patnaik () Monetary Policy in India NIPFP. and deviations from the random walk for INR/USD. Calvo & Reinhart measure of currency flexibility: Did not change after 1999. A variety of tests highlight the INR/USD peg. a focus on INR/USD volatility.Currency regime Currency regime The reserves buildup after mid-2002 cannot be explained by a quest for reserves as insurance. January 2007 28 / 38 .

Currency regime Currency regime The reserves buildup after mid-2002 cannot be explained by a quest for reserves as insurance. Ila Patnaik () Monetary Policy in India NIPFP. A variety of tests highlight the INR/USD peg. Calvo & Reinhart measure of currency flexibility: Did not change after 1999. a focus on INR/USD volatility. January 2007 28 / 38 . and deviations from the random walk for INR/USD.

Currency regime Currency regime INR/USD rate 35 40 45 1995 2000 Index 2005 Ila Patnaik () Monetary Policy in India NIPFP. January 2007 29 / 38 .

RBI has followed a policy of liberalisation of the capital account. January 2007 30 / 38 . Through the impossible trinity. and trying to have autonomous monetary policy. stifling the currency market must come at a cost in terms of loss of autonomy of monetary policy. Ila Patnaik () Monetary Policy in India NIPFP.Currency regime Implications of the impossible trinity Controls on the current account and the capital account have eased. while operating a pegged exchange rate with very low volatility.

RBI has followed a policy of liberalisation of the capital account. and trying to have autonomous monetary policy.Currency regime Implications of the impossible trinity Controls on the current account and the capital account have eased. Ila Patnaik () Monetary Policy in India NIPFP. Through the impossible trinity. stifling the currency market must come at a cost in terms of loss of autonomy of monetary policy. while operating a pegged exchange rate with very low volatility. January 2007 30 / 38 .

and trying to have autonomous monetary policy. January 2007 30 / 38 .Currency regime Implications of the impossible trinity Controls on the current account and the capital account have eased. RBI has followed a policy of liberalisation of the capital account. Ila Patnaik () Monetary Policy in India NIPFP. stifling the currency market must come at a cost in terms of loss of autonomy of monetary policy. Through the impossible trinity. while operating a pegged exchange rate with very low volatility.

Currency regime Questions Where does India stand in terms of opening the capital account? What has RBI’s stance of sterilisation been? Can we isolate episodes where there was a large scale of currency intervention? What happened to monetary policy in these episodes? Ila Patnaik () Monetary Policy in India NIPFP. January 2007 31 / 38 .

January 2007 31 / 38 .Currency regime Questions Where does India stand in terms of opening the capital account? What has RBI’s stance of sterilisation been? Can we isolate episodes where there was a large scale of currency intervention? What happened to monetary policy in these episodes? Ila Patnaik () Monetary Policy in India NIPFP.

Currency regime Questions Where does India stand in terms of opening the capital account? What has RBI’s stance of sterilisation been? Can we isolate episodes where there was a large scale of currency intervention? What happened to monetary policy in these episodes? Ila Patnaik () Monetary Policy in India NIPFP. January 2007 31 / 38 .

“Other capital flows” These may play a role in evasion of capital controls. Banking flows RBI has detailed control on capital flows intermediated by banks . and least-controlled. Ila Patnaik () Monetary Policy in India NIPFP.Currency regime Elements of openness Current account The current account was sharply liberalised in the 1990s. and is a well known channel for evading capital controls. RBI sets the interest rate on “NRI deposits”. outward flows: These are new. Loans These are subject to significant restrictions. January 2007 32 / 38 .e.g. foreign portfolio investment. Investment flows FDI.

Loans These are subject to significant restrictions. Ila Patnaik () Monetary Policy in India NIPFP.e. RBI sets the interest rate on “NRI deposits”. and is a well known channel for evading capital controls. foreign portfolio investment. “Other capital flows” These may play a role in evasion of capital controls.Currency regime Elements of openness Current account The current account was sharply liberalised in the 1990s. Investment flows FDI. outward flows: These are new. and least-controlled. January 2007 32 / 38 .g. Banking flows RBI has detailed control on capital flows intermediated by banks .

Ila Patnaik () Monetary Policy in India NIPFP. and least-controlled. Loans These are subject to significant restrictions. “Other capital flows” These may play a role in evasion of capital controls.Currency regime Elements of openness Current account The current account was sharply liberalised in the 1990s. January 2007 32 / 38 . Investment flows FDI.g. Banking flows RBI has detailed control on capital flows intermediated by banks . and is a well known channel for evading capital controls.e. foreign portfolio investment. RBI sets the interest rate on “NRI deposits”. outward flows: These are new.

January 2007 32 / 38 . “Other capital flows” These may play a role in evasion of capital controls. RBI sets the interest rate on “NRI deposits”. Investment flows FDI. Ila Patnaik () Monetary Policy in India NIPFP.g.e. outward flows: These are new. Banking flows RBI has detailed control on capital flows intermediated by banks . and is a well known channel for evading capital controls. Loans These are subject to significant restrictions. and least-controlled.Currency regime Elements of openness Current account The current account was sharply liberalised in the 1990s. foreign portfolio investment.

Investment flows FDI. and least-controlled. RBI sets the interest rate on “NRI deposits”.Currency regime Elements of openness Current account The current account was sharply liberalised in the 1990s. outward flows: These are new. foreign portfolio investment.g. January 2007 32 / 38 . Banking flows RBI has detailed control on capital flows intermediated by banks . “Other capital flows” These may play a role in evasion of capital controls.e. and is a well known channel for evading capital controls. Loans These are subject to significant restrictions. Ila Patnaik () Monetary Policy in India NIPFP.

Currency regime Episodes of capital inflows Episode 1: June 1993 to November 1994 (18 months) Episode 2: August 2001 onwards Ila Patnaik () Monetary Policy in India NIPFP. January 2007 33 / 38 .

Currency regime Episodes of capital inflows Episode 1: June 1993 to November 1994 (18 months) Episode 2: August 2001 onwards Ila Patnaik () Monetary Policy in India NIPFP. January 2007 33 / 38 .

1993 Foreign portfolio investment: Period Q2 1993-94 Q3 1993-94 Q4 1993-94 Inflow (Mln.Currency regime Initiation – capital market reforms. January 2007 34 / 38 . USD) 307 935 2283 Ila Patnaik () Monetary Policy in India NIPFP.

6 -1.2 -1. January 2007 35 / 38 .9 9.5 Ila Patnaik () Monetary Policy in India NIPFP.7 2.2 -3.1 4.7 11.6 9.6 (Billion USD) Net capital Inflows 3.4 -5.9 -4.Currency regime Evolution of BOP in Episode I Year 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 Current account balance -9.

CRR was raised to 14.Currency regime Banking reserve requirements Date 11-Jun-1994 09-Jul-1994 06-Aug-1994 29-Oct-1994 21-Jan-1995 17-Jul-1995 Action Cash Reserve Ratio (CRR) was raised from 14% to 14.5%. CRR for Foreign Currency Non-Resident (FCNR) Accounts was raised from 0% to 7.5%. January 2007 36 / 38 . CRR for Non-Resident accounts raised from 0% to 7. and CRR for FCNR accounts was raised to 15%.5%. Ila Patnaik () Monetary Policy in India NIPFP. CRR was raised to 15%. Conditions for overdraft facility to stock brokers to draw money from banks were made more stringent.75%.

and impacted interest rates well beyond. Slow down in the economy. Yet M3 growth did accelerate. NDA growth slowed. Ila Patnaik () Monetary Policy in India NIPFP. January 2007 37 / 38 .Currency regime Episode I 1 2 3 4 5 Began as a surge in capital inflows. NFA as percent of M0 went up from 20% to 45%. and reserve requirements were used. Monetary tightening started in month 12.

and impacted interest rates well beyond.Currency regime Episode I 1 2 3 4 5 Began as a surge in capital inflows. and reserve requirements were used. Slow down in the economy. Ila Patnaik () Monetary Policy in India NIPFP. NDA growth slowed. NFA as percent of M0 went up from 20% to 45%. Monetary tightening started in month 12. January 2007 37 / 38 . Yet M3 growth did accelerate.

NDA growth slowed. and reserve requirements were used. January 2007 37 / 38 . Yet M3 growth did accelerate. Monetary tightening started in month 12.Currency regime Episode I 1 2 3 4 5 Began as a surge in capital inflows. and impacted interest rates well beyond. Ila Patnaik () Monetary Policy in India NIPFP. NFA as percent of M0 went up from 20% to 45%. Slow down in the economy.

Currency regime Episode I 1 2 3 4 5 Began as a surge in capital inflows. Yet M3 growth did accelerate. Slow down in the economy. and impacted interest rates well beyond. NDA growth slowed. and reserve requirements were used. Monetary tightening started in month 12. January 2007 37 / 38 . NFA as percent of M0 went up from 20% to 45%. Ila Patnaik () Monetary Policy in India NIPFP.

January 2007 37 / 38 . NFA as percent of M0 went up from 20% to 45%. Monetary tightening started in month 12. Ila Patnaik () Monetary Policy in India NIPFP. and impacted interest rates well beyond. and reserve requirements were used.Currency regime Episode I 1 2 3 4 5 Began as a surge in capital inflows. Slow down in the economy. NDA growth slowed. Yet M3 growth did accelerate.

January 2007 38 / 38 .Currency regime Thank you Thank you Next class: How open is India’s capital account? Ila Patnaik () Monetary Policy in India NIPFP.

Currency regime Thank you Thank you Next class: How open is India’s capital account? Ila Patnaik () Monetary Policy in India NIPFP. January 2007 38 / 38 .

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