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Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest. Monetary policy is usually used to attain a set of objectives oriented towards the growth and stability of the economy. These goals usually include stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy rapidly, and a contractionary policy decreases the total money supply or increases it only slowly. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation. The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets.
thus altering the monetary base. it alters the amount of currency in the economy. the management of the exchange rate will influence domestic monetary conditions. to sterilize that increase. The central bank would buy/sell bonds in exchange for hard currency. the central bank will have to sterilize or offset its foreign exchange operations. For example. the central bank must also sell government debt to contract the monetary base by an equal amount. the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Therefore. if the central bank buys foreign exchange. To maintain its monetary policy target. When the central bank disburses/collects this hard currency payment. Monetary policy tools Monetary base Monetary policy can be implemented by changing the size of the monetary base. . base money will increase. Accordingly. But even in the case of a pure floating exchange rate. and vice versa.A central bank can only operate a truly independent monetary policy when the exchange rate is floating. the monetary base expands. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate. if a central bank buys foreign exchange (to counteract appreciation of the exchange rate). If the exchange rate is pegged or managed in any way.
Interest rates The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. as well as achieve the desired Federal funds rate by open market operations. the monetary authority can directly change the size of the money supply. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool open market operations. Discount window lending Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. savings accounts or other financial assets. This rate has significant effect on other market interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. By calling in existing loans or extending new loans. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier. By changing the proportion of total assets to be held as liquid cash. By raising the interest rate(s) under its control. In other nations. the rest is invested in illiquid assets like mortgages and loans. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. In the United States open market operations are a relatively small part of the total volume in the bond market. a monetary authority can contract the money supply. but there is no perfect relationship. because higher interest . Banks only maintain a small portion of their assets as cash available for immediate withdrawal. In the United States. the Federal Reserve can set the discount rate. one must choose which one to control. the Federal Reserve changes the availability of loanable funds. the monetary authority may be able to mandate specific interest rates on loans.Reserve requirements The monetary authority exerts regulatory control over banks.
Both of these effects reduce the size of the money supply. Thus. To maintain a fixed exchange rate with the anchor nation. the anchor nation. 3. Currency board A currency board is a monetary arrangement that pegs the monetary base of one country to another. . The principal rationales behind a currency board are three-fold: 1. This limits the possibility for the local monetary authority to inflate or pursue other objectives. To import monetary credibility of the anchor nation. To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization). to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. 2.rates encourage savings and discourage borrowing. it essentially operates as a hard fixed exchange rate. whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. As such.
the RBI 'tightens' monetary policy which means reducing the amount of liquidity (floating money) in the economy. How the RBI conducts monetary policy The RBI has several tools for conducting monetary policy: two of the most important are the cash reserve ratio (CRR) and the liquidity adjustment facility (LAF).How RBI policy impacts interest rates The Reserve Bank of India (RBI). The repo rate is the RBI's lending rate and reverse repo rate is the RBI's borrowing rate. is one of the most important players in the Indian economy and financial markets. The RBI has several goals of which controlling inflation is one of the most important. These two rates help the RBI influence short-term interest rates in the rest of the financial system. . typically just a day. Thus recently the RBI raised the CRR from 7. It is in charge of monetary policy which has a big impact on liquidity and interest rates in the financial system. Raising the CRR is one of the most effective ways for the RBI to suck liquidity out of the financial system which reduces demand in the economy and therefore helps curb inflation. The LAF can be thought of as a way for the RBI to lend and borrow to banks for very short periods. Let's look at some of the basics of monetary policy and how it impacts the average investor. Though the RBI's policies may take up to a year to show their full effect they are perhaps the most effective way of reducing inflation. When inflation is rising and threatening to spin out of control. which is India's central bank and the bank. as it is today. The CRR is the proportion of their deposits which banks have to keep with the RBI.000 crores out of the banking system.5 per cent to 8 per cent which sucked Rs 18.
A tighter policy will harm some sectors like banking and real estate more than others. therefore an increase in the CRR immediately hurts their bottom line. this will reduce demand for housing as home loans become more expensive. In general a tighter policy will hurt investor sentiment and stock prices. you will know that the financial markets pay obsessive attention to the actions of the RBI. and major banks like SBI and ICICI have stated the recent CRR hike wouldn't necessarily lead to higher interest rates. For example banks don't earn interest on the reserves they keep with the RBI.Currently the RBI has left the repo/reverse repo rates untouched but if inflationary pressures remain strong it may be forced to increase them. Similarly if tighter policy leads to higher interest rates. it's possible that banks will respond by raising interest rates on various loans including home loans. Impact on interest rates What impact does monetary policy have on the different interest rates in the economy like the home loan rate? The RBI doesn't directly control these interest rates but in general a tighter monetary policy leads to higher interest rates. Companies which have high levels of debt are especially vulnerable. . There will be less liquidity floating around and higher interest rates will raise the cost of capital for companies hurting their bottom lines and stock prices. However if the RBI continues to tighten policy further by raising the CRR again or raising the repo/reverse repo rates. This is with good reason since any changes in monetary policy has an immediate impact on financial markets. This relationship isn't iron-clad though. Impact on stock markets If you watch investment channels or read business papers.
This helps with inflation since imports will now be cheaper in rupee terms. the rupee price of a barrel of oil will fall from Rs 4. In particular if Indian interest rates rise because of tighter policy.200. the demand for Indian interest-paying assets will also rise. . for example major IT stocks which have done quite well recently may fall.Impact on exchange rates The RBI's monetary policy will also have an impact on exchange rates.500 to Rs 4. the rising rupee will have a negative impact on export-oriented companies. leading to an increase in the value of the rupee. For example if the price of oil is $100 per barrel and the rupee rises in value from Rs 45 to Rs 42 per dollar. On the flip side.
RBI increased its policy rates.RBI Annual Monetary Policy 2010-11 An Update In its annual monetary policy review for 2010-11. Some in the second group even advocated a 50 bps hike in CRR. y Repo rate and Reverse repo rate increased by 25 bps to 5.75% respectively. Higher liquidity leads to asset price inflation and also leads to build up of inflationary expectations. The higher interest rates will in turn lead to lower demand and thereby lower inflation. Governor s statement added that in 2010-11. with immediate effect. The move was in line with market expectations y Cash reserve ratio (CRR) increased by 25 bps to 6. This percent is called CRR. RBI has signaled that though it wants to tighten liquidity it also wants to keep ample liquidity to meet the outflows. RBI s Domestic Outlook for 2010-11 . Both these rates are used by financial system for overnight lending and borrowing purposes.00%. An increase in these policy rates imply borrowing and lending costs for banks would increase and this should lead to overall increase in interest rates like credit. 3-G auctions and credit growth. to apply from fortnight beginning from 24 April 2010.25% and 3. Some felt CRR should not be raised as liquidity would be needed to manage the government borrowing program. fresh issuance will be around Rs 342300 cr compared to Rs 251000 cr last year. they are required to keep a certain percent with RBI. Impact: When banks raise demand and time deposits. Others felt CRR should be increased to check excess liquidity into the system which was feeding into asset price inflation and general inflationary expectations. This will lead to lower liquidity in the system. market participants were divided over CRR. deposit etc. Impact: Repo is the rate at which banks borrow from RBI and Reverse Repo is the rate at which banks deploy their surplus funds with RBI. By increasing the rate by 25 bps. Before the policy. An increase in CRR implies banks would be required to keep higher percentage of fresh deposits with RBI. despite lower budgeted borrowings.
2 8 by CSO Inflation (based on 8.3 17 9.5 Expected at 7. YoY) 2009-10 targets 2009-10 (Jan 10 Policy) Actual Numbers GDP 7. RBI s business outlook survey shows corporate are optimistic over the business environment. Growth in industrial sector and services has picked up in second half of 2009-10 and is expected to continue. for March end) Money (March end) Credit (March end) 16 17 17. if monsoons were better.9 with an 2010-11 targets (Apr 10 Policy) upward bias 5.5 Deposit (March end) 17 Source: RBI y Growth: RBI revised its growth forecast upwards for 2010-11 at 8% with an upward bias compared to 2009-10 figures of 7.1 20 18 Supply 16. .5 WPI.Table 1: RBI s Indicative Projections (All Fig In %.5 17. The exports and import sector has also registered a strong growth. It is important to note that RBI has placed the growth under the assumption of a normal monsoon.5%. It said Indian economy is firmly on the recovery path. Table 2 looks at growth forecasts of Indian economy for 2010-11 by various agencies. India could have achieved a near 8% growth in 2009-10 itself.
1 8. So.0.2 upward bias PM s Economic Advisory 7. contribution of non-food items to overall WPI inflation.2 per cent) inflation.3% by March 2010. increased sharply from (-) 0.2 Forecasters y Inflation: RBI s inflation projection for March 11 is at 5.7% in March 2010.2 7. which was negative at (-) 0.5 with 2010-11 an 8 with an upward bias 8. overall demand . First WPI non-food manufactured products (weight: 52.2 6.Table 2:Projections of GDP Growth by various agencies for 2010-11 (in %. Further.4% in November 2009 rose sharply to 53. to 4.5% with an upward bias (the final figure was at 9.9%).7 7.2 6. Fuel price inflation also surged from (-) 0.5 (+/. RBI said inflation is no longer driven by supply side factors alone.3 8.5 RBI s Survey of Professional 7. YoY) 2009-10 RBI 7.4%in November 2009.7 per cent in November 2009 to 12.2 Council Ministry of Finance IMF Asian Development Bank OECD 7.25) 8 8.7% in March 2010.5% compared to FY March-10 estimate of 8.
However. These movements were visible in March 2010 itself. higher growth in money supply would also lead to build up of higher inflation and inflationary expectations. credit and deposit are raised to 17%. These projections have been made consistent with higher expected growth in 2010-11.pressures on inflation are also beginning to show signs. o o o M2: M1 + Savings deposits with Post office savings banks. the number of Ms usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually used depends on the system. There are four Ms in India: o M1: Currency with the public + Demand Deposits + Other deposits with the RBI. Higher growth will lead to more demand for credit. High growth coupled with the borrowing program will need higher financial resources. These different types of money are typically classified as Ms. Narrow money includes most acceptable and liquid forms of payment like currency and bank demand deposits. Each measure can be classified by placing it along a spectrum between narrow and broad monetary aggregates. . There are various measures to calculate money supply. Therefore. Broad money includes narrow money and other kinds of bank deposits like time deposits. post office savings account etc. pushing RBI to increase rates before the official policy in April 2010. Let us understand what M1 and M3 mean. y Monetary Aggregates: RBI has increased the projections of all three monetary aggregates for 2010-11. 20% and 18% respectively. M3: M1+ Time deposits with the banking system M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates). projections for money supply. Then management of government borrowing program will remain a challenge as well.
High liquidity in global markets coupled with higher growth in emerging . This could put upwards pressure on inflation y Third. The difference in M1 and M3 comes from the growth rate in time and demand deposits. It will be interesting to watch trends in M1 and M3 from now on as well. So.9% in December 2009. Second.Growth in M3 is higher than M1 from April. It declines 15% in August 2009 and then again increases to 17. the growth rate in M1 is higher than M3. may harden further.6% in March 2010. Growth in Time deposits is higher than demand deposits between April-November 2009. RBI also outlined downside risks with its projections: y First. there is still substantial uncertainty about the pace and shape of global recovery y Second. y Fourth. From December 2009. It then declines to 15. Hence. Higher inflation in future could also lead to higher returns on assets and property in future. From Dec-2009 onwards. monsoon will continue to play a vital role both from domestic demand and inflation perspective. which have been on the rise during the last one year. First. it could be people are spending now as they expect higher inflation in future. onwards growth in demand deposits picks up. She added this could be interpreted in two ways. therefore people prefer to spend now. the difference between M1 and M3 comes from surge in growth of demand deposits and decline in growth of time deposits. spending on consumption and production is increasing as economy has recovered from recession.November 2009. policies in advanced economies are likely to remain highly expansionary. this just confirmed what Kohli said. if the global recovery does gain momentum. The growth rate in currency is volatile. This in turn reflects in differences in growth rate of M1 and M3. commodity and energy prices.
expectations. RBI also commented on India s exchange rate policy. Our exchange rate policy is not guided by a fixed or pre-announced target or band. Actively manage . therefore. As the economic situation is exceptional. prepared to respond swiftly effectively y being prepared to respond appropriately.economies foreign capital flows are expected to remain higher. Our policy has been to retain the flexibility to intervene in the market to manage excessive volatility and disruptions to the macroeconomic situation. RBI usually does not comment on its exchange rate policy. This will put pressure on exchange rate policy. Table 3: Comparing RBI s Policy Stance October 2009 Policy y January 2010 Policy y April 2010 Policy inflation while y Watch trend inflation and be Anchor Anchor inflation while expectations. Recent experience has underscored the issue of large and often volatile capital flows influencing exchange rate movements against the grain of economic fundamentals and current account balances. Actively manage y further build-up of inflationary pressures. a need to be vigilant against the build-up of sharp and volatile exchange rate movements and its potentially harmful impact on the real economy. There is. swiftly and effectively to being prepared to respond appropriately. Policy Stance The policy stance remains unchanged from January 2010 policy. swiftly and effectively to and Monitor liquidity to meet credit demands of productive sectors while securing price and financial y further build-up of inflationary pressures.
The market participants are already looking at an increase of around 100-150 bps by March 2011 end. financial stability. High interest rates could also lead to higher lending costs for the corporate sector. The concerns remain on future outlook of advanced economies which complicates the policy process further. It needs to manage high inflation without impacting the growth process. There are many trade-offs RBI has to manage. Maintain an interest rate consistent price. Other Development and Regulatory Policies In its Annual (in April) and Mid-term review (in October) of monetary policy. policy ahead is going to remain challenging. . Source: RBI Summary: Given the economic outlook. The higher interest rates would make it difficult to manage the government borrowing program and also invite more capital flows. The recent inflation numbers show rising demand side pressures on inflation. output regime with and y satisfied in a nondisruptive way. Maintain an interest rate consistent price.stability y liquidity to ensure monetary rate that the growth in demand for credit by both the private and public sectors is liquidity to ensure that the growth in demand for credit by both the private and public sectors is Maintain and interest regime with consistent price and financial and stability. of y satisfied in a nondisruptive way. output regime with and supportive the growth process financial stability. The challenges are not limited to domestic factors alone. RBI also covers developments and proposed policy changes in financial system.
y The activity in Commercial Papers and Certificates of deposit market is high but there is little transparency. This was subject to mark to market requirements. banks can classify such investments having a minimum maturity of seven years under held to maturity category. Interest rate futures contract is for 10 year security. 2010 announced that RBI was considering giving some additional banking licenses to private sector players. FIMMDA has been asked to develop a reporting platform for Commercial Papers and Certificates of deposit. y RBI has permitted recognized stock exchanges to introduce plain vanilla currency options on spot US Dollar/Rupee exchange rate for residents y Final guidelines for regulation of non. In line with the above announcement. RBI has proposed to introduce Interest rate futures for 2 year and 5 year maturities as well. banks could hold infrastructure bonds in either held for trading or available for sale category. However.convertible debentures of maturity less than one year by end-June 2010 y RBI had proposed to introduce plain vanilla Credit Default Swaps in October 2009 policy. y In 2004 seeing the financial health of urban cooperative banks. if they meet the Reserve Bank s eligibility criteria. NBFCs could also be considered.Some of the developments announced in this policy are: New Products/Changes in guidelines y Currently.July 2010 y Earlier. This should lead banks to buy higher amount of infrastructure bonds and push infrastructure activity. From now on. RBI would place a draft report on the same by end. in his budget speech on February 26. Since then the performance of these banks has improved. Setting up New Banks y Finance Minister. . RBI has decided to prepare a discussion paper on the issues by end-July 2010 for wider comments and feedback. most banks hold these bonds for a long period and are not traded. it was decided not to set up any new UCBs.
gradualist approach to increase presence of foreign banks in India. However. following the onemode presence criterion. y In February 2005.It has been decided to set up a committee to study whether licences for opening new UCBS can be done. foreign banks wishing to establish presence in India for the first time could either choose to operate through branch presence or set up a 100% wholly-owned subsidiary (WOS). the Reserve Bank had released the roadmap for presence of foreign banks in India . and the second phase after a review of the experience gained in the first phase. because of the global crisis the second phase which was due in April 2009 could not be started. The global financial crisis has also thrown some lessons for policymakers. The roadmap laid out a two-phase. . Drawing these lessons RBI would put up a discussion paper on the mode of presence of foreign banks through branch or WOS by September 2010. Foreign banks already operating in India were also allowed to convert their existing branches to WOS while following the one-mode presence criterion. The first phase was between the period March 2005 March 2009. In the first phase.
5%. the quantum of change in the policy rates. Dr D V Subbarao announced the first quarterly review of monetary policy today.50% with immediate effect. This is the fourth rate hike since March this year raising the Repo by a total of 100 bps and Reverse Repo by 125 bps. y RBI to undertake mid-quarter policy reviews starting September 2010. The measures taken were quite on the expected y y y Benchmark Repo rates hiked by 25 bps to 5. repo and reverse repo is different. Baseline estimate for GDP growth for 2010-11 revised to 8. . Bank deposit growth stood at 15. a change first time since November 2008. Bank deposit growth target of 18% maintained for FY2010-11. 2010. respectively. 2010. The interest rate corridor between the Repo and Reverse Repo window reduced to 125 bps from 150 bps. Bank credit growth stood at 22.3% year-on-year as on July 2. Baseline inflation projection for March 2010 increased to 6% from 5. y Bank credit growth target of 20% maintained for FY2010-11.0% year-on-year as on July 2.75% with immediate effect. Impact of monetary policy y As expected.First quarterly review of monetary policy 2010-11 RBI Governor. Benchmark Reverse Repo rates hiked by 50 bps to 4. The Liquidity Adjustment Facility (LAF) corridor has been shrunk to 125 bps.5% from 8%. SLR and Bank rate kept unchanged at 6%. RBI has raised the policy rates. Moving differently from earlier moves. 25% and 6%. y y y y CRR.
RBI has also raised the projection for end-March 2011 to 6%. y Since end-May. y Inflationary expectations have driven RBI to raise the rates.What this means? Short term interest rates. y Though RBI has not hinted at further rate hikes. in general will go up in order to protect net interest margin (NIM). RBI has noted that inflationary expectations have firmed up. interbank repo market rates hover in between the LAF corridor in order to prevent arbitrage opportunities for the banks. Accordingly. but its strong concern for inflation implies that good growth prospect along with continued high inflation will in make it imperative for RBI to increase rates. Because of tight liquidity conditions. Thus interest cost of banks will go up. . Policy stance of RBI has shifted to to containing inflation and anchoring inflationary expectations . banks have been borrowing from RBI through its LAF Repo window. particularly. y What would also hurt banks s profitability is that deposit rates have also risen. Out of four rate hikes since March. But the last two have come at a time when the liquidity conditions have tightened. Assuming that banks will borrow about Rs 50.000 cr for the year as whole from Repo. two were affected when there was ample liquidity in the system. short term rates have been quite volatile. RBI has commented that it will continue to take actions to counter inflationary expectation. the combined effect of the last two hikes will shave off about Rs 250 cr from banking sector s profits. This measure is aimed at containing this volatility in the rates. Thus lending rates.