Monetary Policy

Key points to remember under monetary policy:

a. Role and definition of money supply. Two key definitions of money supply used in India
are Narrow money and Broad money (first one is more liquid). Key distinguishing
feature of money is its `liquidity` or the ease with which it can be exchanges for other
goods and services or other assets in the economy. As opposed to this, `hard` assets such
as stocks, corporate bonds, gold or property are `illiquid`. It is not easy to use them for
transaction purposes.
b. Broadly speaking, money includes currency in circulation + deposits with banks. In
modern economies money supply is controlled by the central banks via their control over
the monetary base which is defined as currency in circulation + reserves of the banks.
Reserves are banks deposits with the central bank + vault cash (literally the cash
(currency + coinage) that is kept in the vaults of the commercial banks for meeting their
daily transaction needs.
c. Currency in circulation + commercial banks deposits with the central bank is the
liabilities of the central bank. It is easy to see how banks deposits are central banks
liabilities. As for currency in circulation here is a short explanation.
d. In olden times, when currencies used to be backed by gold (say in UK during 19th and
early 20th century), people could take the Currency note say a ten Pound note - to the
Bank of England (largest bank of England that acted as the Central Bank) and get
equivalent worth of `gold` in return (of course subject to certain restrictions). In that
sense, the ten pound note in the hands of a worker or a merchant was a liability of the
Central Bank. An IOU under which central bank promises to pay the bearer, equivalent
amount of gold.

In modern times of course we do not have such `convertibility` of rupee in to gold but the
currency in circulation is still the responsibility and the liability of the central bank. If
you have a 1000 rupee note that has been soiled by usage, you can go to the RBI or its
authorized branches and get it replaced. The central bank will not pay you in gold but it
will give you equivalent amount of Indian currency (notes and coins).

e. Under the Reserve Bank of India Act (section 22), the Bank has the 'sole right' to issue
currency notes in India. Bank notes in circulation and those held by the Banking
Department constitute the liabilities of the Issue Department of the Reserve Bank, and are
backed by assets specified in section 33 of the Bank Act. These include gold coin and
bullion, foreign securities, rupee coins which constitute the liability of the Government of
India, the latter's rupee securities, and other eligible bills of exchange and promissory
notes payable in India. Once again, whether you can buy foreign securities or currency in
return for Indian rupee is subject to the existing laws on `Currency Convertibility`.
f. Under fractional reserve banking system, banks add to the money supply by lending out
money and generating deposits in the process.
g. Full deposit multiplier is given by 1/rr , where rr is reserves to deposit ratio. Here it is
being assumed that people do not hold any cash; all money is kept in the form of
deposits. In reality that is not true. Firms and households do keep some money a cash
balance implying a leakage from the banking system. The actual money multiplier is,
therefore, given by :
mm = Money supply/Monetary base = (C+D)/(C+R) = (cu+1)/(cu+r)
h. If cu increases or r increases, money multiplier goes down (more leakage from the
banking system in the first case, greater fraction of deposits kept as reserves in the latter).
i. Central bank controls money supply by influencing the Monetary Base and the reserve to
deposit ratio.
j. Open market operations in government securities and Forex intervention (through swaps
or directly) are two ways of influencing monetary base.
1. OMO using government securities: RBI buys government securities in the secondary
market from banks, institutional investors etc. worth 100 cr. It pays them for these
securities by writing a check drawn on its name. Sellers of the government security
deposit these checks with their banks who in turn present them to the RBI. RBI credits
100 cr. to the accounts of these banks. Reserves (deposits with RBI+ vault cash) goes
up by 100 cr. Monetary base C+R - also goes up by 100 cr.
2. Forex Swap: Suppose RBI engages in a USD-Rupee swap deal with a commercial bank
whereby it buys USD in return for Rupee from the bank right now with the promise of
repaying the USD at a later date to the bank. The immediate result of this would be an
increase in the Net Foreign Assets of the RBI on asset side. At the same time, since RBI
has credited rupees to the commercial banks account with RBI, deposits of the
commercial bank with RBI go up (they enter the liability side of RBI balance sheet).
These deposits are part of Reserves so R goes up, Monetary Base goes up and hence
money supply in India goes up. Opposite will happen if RBI enters a Forex swap
whereby it sells USD right now to the bank in return for Rupee.
3. The last point clearly shows that there is a trade-off between keeping exchange rate
constant and keeping domestic money supply unchanged since intervention in foreign
exchange market to protect exchange rate changes domestic money supply. One way out
is `Monetary Sterilization` - coupling foreign exchange intervention with an open market
operation in the opposite direction. But that has its limit.
k. Mandatory Reserve Requirements affect money supply by changing `excess` reserves
with the banks.
1. CRR or Cash Reserve Ratio is the proportion of total deposits that the banks need to keep
with the RBI (for details refer to the circular posted on Moodle). Suppose CRR is 3% and
banks have total deposit liabilities of 100 cr. Then they must keep 3% of this amount or 3
cr. with the RBI as deposits or reserves. Of course banks will keep some extra reserves
with RBI to meet their transaction need, inter-bank clearances, payments of fees etc.
Hypothetical example: Suppose banks have total demand and time liabilities of 100 cr.
CRR is 2 percent and bank wants to keep another two percent as excess reserves and
lends out the rest. Total reserves of the bank with the RBI will be 4 cr. (2+2 =4 %). If the
 CRR is raised to 3 percent then the bank will be forced to reduce its demand and time
liabilities to 80 cr. (4 cr. = 3+2= 5% of 80 cr.) assuming that it still wants 2 percent as
excess reserves. It will have to call back existing loans and reduce fresh lending.
Otherwise it will have to borrow from the RBI to increase its reserves with the
RBI. Higher CRR reduces the money supply by raising r reserve to deposit ratio.
Of course it is possible that bank continues to lend as before (100 cr.) but with smaller
excess reserves (1 percent). In that case immediate impact on money supply will be nil.
CRR is however supposed to change r reserve deposit ratio of the banks.
2. SLR or Statutory Liquidity Ratio is the fraction of banks deposit liabilities that it need to
keep in the form of cash, gold or unencumbered government securities. This is over and
above the CRR requirements. SLR is not changed frequently to adjust short term liquidity
conditions. It is mainly a tool to encourage banks to invest in government securities and
ensure that their balance sheets are `healthy (has enough safe assets). When SLR is
changed, however, it reduces the money banks have available for lending to the other
sectors (households and firms). SLR will affect the supply of bank credit when banks do
not have enough government securities already with them and are forced to draw down
on their reserves or borrow to buy additional government securities. Also, a high SLR
implies that banks have fewer free securities left in case they need to borrow from the
RBI through its Repo window under Liquidity Adjustment Facility (L.A.F). ( Banks
cannot use SLR securities to borrow under L.A.F).
l. Bank Rate: Rate at which RBI lends to the banks through its discount window. Higher
bank rate implies more costly credit for banks. If banks want to borrow from RBI and
lend they will have to charge a higher interest rate from their own borrowers.

m. Repo and Reverse Repo rates: There are rates for short term lending to/ borrowing from
the banks to help them manage their liquidity under the Liquidity Adjustment Facility. As
the name suggests, these involve Repurchase or Reverse Repurchase transactions using
government securities and some other approved securities. If banks are running short of
liquid cash, they can borrow overnight from RBI by entering in to a Repurchase
agreement sell securities with the agreement to buy it back at a later date at an approved
price that includes the interest on the loan. Similarly if they have excess cash, they can
park it with RBI using a Reverse Repo. Inter-bank `Call Money Market rates fluctuate in
between these two rates (Repo being the ceiling and Reverse Repo setting the floor).
When system has excess liquidity, Call money rate will be closer to the floor or the
Reverse Reo and when there is liquidity shortage; call money rate will be closer to the
ceiling or the Repo rate.

n. There is also an additional Marginal Lending Facility under which banks can borrow
from RBI once they have exhausted other avenues of support. They can use the securities
pledged under SLR to borrow through the MLF. But they have to pay a higher interest
rate.

o. Demand for money Transactions, Precautionary and Speculative is positively related

to income and inversely related to nominal interest rates.
 p. Money market equilibrium Demand for money = Supply of money

Increase in money supply reduces interest rate in the short-run

i M1S/p
M2s /p

Interest rate comes down

M/p

q. Lower interest rates prompt a rise in asset prices (lower interest rates implies higher
demand for houses, stocks and other assets since it is easier to borrow and invest in them.
This implies an increase in the price of assets) as well as depreciation in domestic
currency (in case of free capital flow lower interest rate will cause capital to flow out.
This means an increase in demand for dollars to buy foreign assets and hence a
depreciation in Rupee). Result is an increase in consumption and investment demand and
hence an increase in output and prices.

Long Run Fisher Effect: In the long run, as expectations of inflation adjust fully to the actual
level of inflation, real interest rate is given by the equality of savings and investment in the
economy (S(r) =I(r)). Nominal interest rate is then simply - i r e . A lose money policy or
soft interest rate regime in the short run will prompt higher inflationary expectations in the long
run and hence increase the nominal interest rates in the long run. Since Real Money demand

is:
= (, ) = ( + , ), high inflation will reduce Real Money Demand by raising
nominal interest rates. SO if people expect high inflation due to a loose monetary policy(fast
growth of money supply), they will try to protect themselves against inflation by moving in to
hard assets like gold or a foreign currency which is stable in value and away from domestic
currency and fixed income deposits. As people shift their wealth in to hard assets to protect
themselves against inflation real money balances in the economy come down ((C+DD)/P = M/P
comes down as people reduce C and DD to buy houses, gold etc.). Lose money policy therefore
actually proves contractionary in the long run as inflation outpaces money supply growth and
real money balances begin to decline.

r. During Hyperinflation, this abandoning of domestic money reaches its extreme as people
hoard goods, foreign currency and other hard assets. Thus, current and future expected
money growth drives inflation by stoking fear of future inflation and demand for goods
 for hoarding. Government, that needs revenues to finance deficit, finds that its real
revenue from taxes is coming down as a result of high inflation. Also, with more people
trying to replace domestic currency with other assets, government needs to generate
higher inflation just to keep inflation tax constant (in other words, paper money that is
was using to buy goods and services and pay salaries to its employees is becoming
increasingly worthless so it needs to print more of it). This has obvious harmful effects on
the economy. Ultimately hyperinflation is brought under control by signaling a credible
change in policy regime towards fiscal prudence and low and stable money growth. This
is often done by abandoning the domestic currency and issuing a new currency with its
value fixed in gold or some other hard currency.
s. Think of what happens to real` interest rates due to very high inflation. As people hoard
goods for consumption and put money in foreign currency assets to save themselves from
inflation, overall savings available for domestic investment comes down. This will
actually push up real interest rates too. That and the greater uncertainty associated with
higher inflation brings down investment and adversely affects growth.
t. Hyperinflation is one situation where conventional monetary policy breaks down. The
other is `liquidity trap` - a situation where nominal interest rates are close to zero but real
interest rates are still high and positive due to deflation.
u. `Quantitative Easing` is one way in which monetary authorities try to overcome the
situation of Liquidity Trap. Essentially, quantitative easing involves monetary authority
purchasing assets from banks and financial institutions in order to put cash in their hands
so that they can restart lending in the economy.
v. In conventional Open Market Operations central bank usually buys short term
government bonds to bring down short-term interest rates. However, in a situation where
short term interest rates are already at or close to zero, central bank can no longer target
short-term interest rates. Instead, it starts purchasing longer term assets including
corporate debt or Residential Mortgage Based securities and targets the growth in money
supply. Purchase of these assets increases their prices and therefore lowers their yield,
thereby bringing down the long-term interest rates and prompting investment.
w. QE is supposed to boost spending by creating inflationary expectations (r = i-expected
inflation comes down when inflationary expectations go up). It is also expected to bring
down the yields on government securities and hence discourage those who prefer to
invest in them due to their safety; forcing them to look for other more lucrative and
riskier alternatives. Finally, such large scale printing of money is supposed to bring down
exchange rate and hence encourage net exports which in turn increase total demand for
domestic goods.
x. Problem with quantitative easing is that it may not restore credit flow to businesses.
Liquidity might go towards speculating on commodities like oil instead of productive
investment opportunities in the economy. This would mean inflation but not growth
which is bad. Downward pressure on the value of domestic currency can actually worsen
 the situation if it prompts currency wars (all the countries trying to simultaneously
devalue their currency to gain export advantage at the expense of other countries -
Beggar Thy Neighbor) and liquidation of external debt. Finally, there is a real danger
that the central bank can go overboard with QE causing inflationary expectations and
inflation to go out of hand especially when higher money supply and higher demand is
not bringing forth greater supply of goods and services in the economy.
y. Quantitative easing could flood emerging economies with the dollars, thus making the
dollars cheaper and, hence, the US exports more competitive while forcing other related
currencies to appreciate on account of increase in capital inflows (efforts to expand
money supply in order to depreciate domestic currency in an environment where interest
rates are near zero would imply that the investors would like to take capital out to other
regions where interest rates are higher and growth prospects are better. As long as
investors have an appetite for risk, they will try to move to such alternative locations).
Resulting increase in monetary base and commodity prices will fuel inflation in emerging
economies forcing their Central Banks to tighten interest rates which will hurt growth in
those economies. The gush of capital flows is likely to fuel stock and housing price
bubble and might eventually call for capital control from regulatory authorities.
z. A couple of Monetary Policy transmission issues:
aa. Just like fiscal policy, monetary policy has `inside` and `outside` lags. Policy makers
therefore need to foresee future developments and act accordingly.
bb. In India a significant segment of financial system has administered interest rates (Small
Savings Schemes such as Postal Savings scheme in particular have higher rates compared
to the rest and these rates are only change through administrative actions). This creates
problems for monetary policy transmission which is supposed to work through bringing
down interest rates.
cc. Financial repression in the form of priority sector lending implies huge NPAs (Non-
Performing Assets). This implies a huge gap between the lending and the borrowing rates
of the banks. One of the ways in which banks can be made to reduce their lending rates to
the borrowers without having to inject extra liquidity is by removing financial repression
and helping them bring down NPAs.