Monetary policy is one of the tools that a national

Government uses to influence its economy. Using

its monetary authority to control the supply and
availablity of money, a government attempts to
influence the overall level of economic activity in
line with its political objectives. Usually this goal is
"macroeconomic stability" - low unemployment,
low inflation, economic growth, and a balance of
external payments

How is the Monetary Policy different from the Fiscal Policy?

The Monetary Policy is different from Fiscal Policy as the former brings
about a change in the economy by changing money supply and interest
rate, whereas fiscal policy is a broader tool with the government.

The Fiscal Policy can be used to overcome recession and control

inflation. It may be defined as a deliberate change in government
revenue and expenditure to influence the level of national output and
prices.

For instance, at the time of recession the government can increase

expenditures or cut taxes in order to generate demand.

On the other hand, the government can reduce its expenditures or raise
taxes during inflationary times. Fiscal policy aims at changing aggregate
demand by suitable changes in government spending and taxes

At the extremes, monetary policy is a potent force. In

countries such as the Russian Republic, Poland or Brazil
where the printing presses run full tilt to pay for
government operations, money supply is expanding
rapidly and the currency becomes rapidly worthless
compared to goods and services it can buy. Very high
levels of inflation or "hyperinflation" is the result. With
30-40% monthly inflation rates, citizens buy hard goods
as soon as they receive payment in the currency and
those on fixed income have their investments rendered
worthless.

At the other extreme, restrictive monetary policy has

shown its effectiveness with considerable force.
Germany, which experienced hyperinflation during the
Weimar Republic and never forgot, has maintained a very
stable monetary regime and resulting low levels of
inflation. When Chairman Paul Volcker of the U.S. Federal
Reserve applied the monetary brakes during the high
inflation 1980s, the result was an economic downturn
and a large drop in inflation

Operations of a Modern Central Bank

The Central Bank attempts to achieve economic stability

by varying the quantity of money in circulation, the cost
and availability of credit, and the composition of a
country's national debt. The Central Bank has three
instruments available to it in order to implement
monetary policy:

1. Open market operations

2. Reserve requirements
3. The 'Discount Window'
Open market operations are just that, the buying or
selling of Government bonds by the Central Bank in the
open market. If the Central Bank were to buy bonds, the
effect would be to expand the money supply and hence
lower interest rates, the opposite is true if bonds are sold

Reserve requirements are a percentage of commercial

banks', and other depository institutions', demand
deposit liabilities (i.e. chequing accounts) that must be
kept on deposit at the Central Bank as a requirement of
Banking Regulations

Discount Window is where the commercial banks, and

other depository institutions, are able to borrow reserves
from the Central Bank at a discount rate
QUANTITATIVE MEASURES: Measures which aim to control
the quantity of money supply directly such as Cash
Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Open
Market Operations (OMO)
Cash Reserve Ratio: It is a quantitative tool of monetary and
credit policy to regulate the money supply in the economy.
Cash reserve ratio (CRR) is that slice of a bank's deposits, which
the bank has to compulsorily deposit with RBI.
A CRR of six per cent means that out of every Rs 100, bank has to
deposit Rs. 6 with RBI. Interestingly, RBI does not pay
anyinterest on this money to banks. When RBI wants to reduce
liquidity from the system, like in times of high inflation, it
increasesthe CRR.
RBI by varying the CRR regulates the lendable funds of
commercial banks.
An increase in CRR would also mean that money is being sucked
out of the system. This would mean that funds are hard tocome by
and hence banks will have to pay more to depositors in order to
induce them to keep their funds with banks. This willpush up cost
of funds for banks. The banks therefore will also have to raise
lending rates in o
rder to meet the increased cost
while maintaining their margins. For example
RBI has increased the CRR of scheduled banks by 6% of their Net
Demand and Time Liabilities (NDTL). As a result of this
increase in the CRR, about 12,500 crore of excess liquidity will be
absorbed from the system.
Statutory Liquidity Ratio: It is a quantitative tool of monetary
and credit policy to regulate the money supply in the
economy. Under the provision of Banking Regulation Act
governing the banking operations, banks are required to hold
liquidassets such as government securities, or other
unencumbered approved securities, cash or gold, against their
demand and timeliabilities as on the last Friday of second
preceding fortnight in India. This is known as supplementary
reserve requirement orsecondary reserve requirement. The main
objective of this monetary policy instrument is to ensure solvency
of commercialbanks by compelling them to hold low risk assets up
to a stipulated extent. It also helps to regulate the pace of credit
expansionto commercial sector. SLR refers to the ratio of holdings
of the prescribed liquid assets to total time and demand liabilities.
Atpresent, SLR is 25%, means 25 out of 100 are invested in
prescribed liquid assets.
The objectives of SLR are:
1.To restrict the expansion of bank credit.
2.To augment the investment of the banks in Government
securities.
3.To ensure solvency of banks. A reduction of SLR rates looks
eminent to support the credit growth in India.
Open Market Operations: A monetary policy instrument
which is used by the Reserve Bank mainly with a view to affect
the reserve base of the banks and thereby the extent of monetary
expansion. It also, in the process, helps to create and maintaina
desired pattern of yield on government securities (G-Sec) and to
assist the government in raising resources from the capitalmarket.
Under the RBI Act, the RBI is authorized to purchase and sell the
securities of the Union Government and StateGovernments of any
maturity and the security specified by the Central Government on
the recommendation of Bank's CentralBoard. Presently the RBI
deals only in the securities issued by the Union Government.
Open market operations are by wayoutright sale and purchase of
securities through the Securities Department and repo and
reverse repo transactions.
When RBI buys the securities in the open market, It increases the
liquidity and reserves of commercial banks, making it
possible for banks to expand their loans and investments. If RBI
sells the securities, the effects are reversed.
QUALITATIVE MEASURES: They aim to control the quantity
of money supply indirectly through cost of credit. These
measures are Bank Rate, Repo & Reverse Repo Rates, and
Interest Rates etc.
Bank Rate:An instrument of general credit control and
represents the standard rate at which the RBI is prepared to buy
or
rediscount bills of exchange or other commercial paper eligible for
purchase under the provisions of the Act. In short, Bank rate
is the minimum rate at which the central bank provides loans to
the commercial banks. It is also called the discount rate.
Usually, an increase in bank rate results in commercial banks
increasing their lending rates. Changes in bank rate affect the
lending rates through altering the cost of credit. At present Bank
rate is 6%.
Repo Rate: Repo and Reverse Repo Rates are Liquidity
adjustment Facility (LAF) tools used by RBI. Repo is an
instrument
meant for injecting the funds required and Reverse Repo for
absorbing the excess liquidity out of system.
In bond markets, interest rates are the most important factor, and
the RBI controls interest rates. RBI uses various rates like
repo, reverse repo and CRR to give direction to interest rates in
the country. Take an example
Repo refers to 'repurchaseobligation'. In case of tight liquidity
conditions (as you saw in 2008), when banks need funding for
the short term, they approach the RBI and ask for a temporary
loan. RBI gives them a loan only after taking some collateral

Monetary Management

Issuer of Currency

Banker and Debt Manager to Government

Banker to Bank

Financial Regulation and Supervision

Foreign Exchange Reserves Management

Foreign Exchange Management

Market Operation

Payment and Settlement System

Monetary policy in international scene

With special reference to u.s stagflation and latin

American hyperinflation
The term "stagflation" -- an economic condition of both continuing inflation and stagnant business activity, together with an
increasing unemployment rate – in 1970s Inflation seemed to feed on itself. People began to expect continuous increases in the
price of goods, so they bought more. This increased demand pushed up prices, leading to demands for higher wages, which
pushed prices higher still in a continuing upward spiral.  The government's ever-rising need for funds swelled the budget deficit
and led to greater government borrowing, which in turn pushed upinterest rates and increased costs for businesses and consumers
even further. With energy costs and interest rates high, business investment languished and unemployment rose to uncomfortable
levels. n desperation, President Jimmy Carter (1977-1981) tried to combat economic weakness andunemployment by increasing
government spending, and he established voluntary wage and price guidelines to control inflation. Both were largely
unsuccessful. A perhaps more successful but less dramatic attack on inflation involved the "deregulation" of numerous industries,
including airlines, trucking, and railroads. These industries had been tightly regulated, with government controlling routes and
fares
But the most important element in the war against inflation was the Federal Reserve Board, which clamped down hard on the
money supply beginning in 1979. By refusing tosupply all the money an inflation-ravaged economy wanted, the Fed
caused interest ratesto rise. Federal Reserve chairman Paul Volcker very sharply increased interest rates from
1979-1983 in what was called a "disinflationary scenario." After U.S. prime interest rates had soared into
the double-digits, inflation did come down; these interest rates were the highest long-term prime interest
rates that had ever existed in modern capital marketsStarting in approximately 1983, growth began a
recovery. Both fiscal stimulus and money supply growth were policy at this time. A five-to-six-year jump in
unemployment during the Volcker disinflation suggests Volcker may have trusted unemployment to self-
correct and return to its natural rate within a reasonable period

Stagflation undermined faith in a Keynesian consensus, and placed renewed emphasis

on microeconomic behavior, particularly neoclassical economics with its attempt to root macroeconomics
in microeconomic formalisms. The rise of conservative theories of economics, including monetarism, can
be traced to the perceived failure of Keynesian policies to combat stagflation or explain it to the
satisfaction of economists and policy-maker
Latin American imbroglio:

THE ORIGINS OF THE DEBT CRISIS

The decades of the 1960s and 1970s saw real annual economic growth averaging 6.0 percent in Latin America.
Inflation ran between 30-45 percent per year. However, during the 1980s growth averaged barely 1 percent while
inflation soared toward 300 percent per year. In contrast, worldwide growth in the 1980s averaged 3 percent with 5
percent inflation. All the economies have huge income inequalities that have led to significant
political repercussions. Heavy public spending programs have meant sizeable government
budget deficits, which have approached 50 percent of GNP in some countries, induding
Argentina, Brazil and Mexico. as long as real interest rates on the debt remained below the
growth of real exports, the debt-export ratios were manageable and the borrowing could
continue. At the end of the 1970s both the period of strong export growth and low interest
rates came to an abrupt end. Funds could no longer be obtained to service debt without
sharply increasing debt-export ratios. As creditworthiness deteriorated, foreign borrowing all
but ceased. Increasingly, debt servicing had to come from domestic resources, which
contributed to an enormous capital flight. Net inflows of foreign capital during the 1970s
turned into net outflows during the 1980s.

 stabilization plans initiated in the mid-1980s, such as Argentina's Austral Plan and
Brazil's Cruzado Plan, attempted to stabilize the currency and rein in inflation by
using a fixed exchange rate as a nominal anchor. As a fixed exchange rate (if
successfully maintained) ties down the level of import prices, policymakers hoped that
this approach would stabilize inflation and inflation expectations more generally. The
new monetary approach in contrast to the structuralist past, the inflation-targeting
approach recognizes the key role of the central bank's monetary policies in
determining the inflation rate. No longer can the monetary authorities claim that
inflation is not under their control. No monetary-policy regime, including inflation
targeting, will succeed in reducing inflation permanently in the face of unsustainable
fiscal policies--large and growing deficits. In light of their painful experiences, Latin
American citizens certainly understand that unchecked deficits will eventually exhaust
the government's capacity to borrow, leading to excess money creation and a breakout
of inflation. Fiscal policy does seem to have become more conservative in the region
in the past decade, although there have been setbacks and variations across countries

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QUANTITATIVE MEASURES: Measures which aim to control
the quantity of money supply directly such as Cash
Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Open
Market Operations (OMO)
Cash Reserve Ratio: It is a quantitative tool of monetary and
credit policy to regulate the money supply in the economy.
Cash reserve ratio (CRR) is that slice of a bank's deposits, which
the bank has to compulsorily deposit with RBI.
A CRR of six per cent means that out of every Rs 100, bank has to
deposit Rs. 6 with RBI. Interestingly, RBI does not pay
anyinterest on this money to banks. When RBI wants to reduce
liquidity from the system, like in times of high inflation, it
increasesthe CRR.
RBI by varying the CRR regulates the lendable funds of
commercial banks.
An increase in CRR would also mean that money is being sucked
out of the system. This would mean that funds are hard tocome by
and hence banks will have to pay more to depositors in order to
induce them to keep their funds with banks. This willpush up cost
of funds for banks. The banks therefore will also have to raise
lending rates in o
rder to meet the increased cost
while maintaining their margins. For example
RBI has increased the CRR of scheduled banks by 6% of their Net
Demand and Time Liabilities (NDTL). As a result of this
increase in the CRR, about 12,500 crore of excess liquidity will be
absorbed from the system.
Statutory Liquidity Ratio: It is a quantitative tool of monetary
and credit policy to regulate the money supply in the
economy. Under the provision of Banking Regulation Act
governing the banking operations, banks are required to hold
liquidassets such as government securities, or other
unencumbered approved securities, cash or gold, against their
demand and timeliabilities as on the last Friday of second
preceding fortnight in India. This is known as supplementary
reserve requirement orsecondary reserve requirement. The main
objective of this monetary policy instrument is to ensure solvency
of commercialbanks by compelling them to hold low risk assets up
to a stipulated extent. It also helps to regulate the pace of credit
expansionto commercial sector. SLR refers to the ratio of holdings
of the prescribed liquid assets to total time and demand liabilities.
Atpresent, SLR is 25%, means 25 out of 100 are invested in
prescribed liquid assets.
The objectives of SLR are:
1.To restrict the expansion of bank credit.
2.To augment the investment of the banks in Government
securities.
3.To ensure solvency of banks. A reduction of SLR rates looks
eminent to support the credit growth in India.
Open Market Operations: A monetary policy instrument
which is used by the Reserve Bank mainly with a view to affect
the reserve base of the banks and thereby the extent of monetary
expansion. It also, in the process, helps to create and maintaina
desired pattern of yield on government securities (G-Sec) and to
assist the government in raising resources from the capitalmarket.
Under the RBI Act, the RBI is authorized to purchase and sell the
securities of the Union Government and StateGovernments of any
maturity and the security specified by the Central Government on
the recommendation of Bank's CentralBoard. Presently the RBI
deals only in the securities issued by the Union Government.
Open market operations are by wayoutright sale and purchase of
securities through the Securities Department and repo and
reverse repo transactions.
When RBI buys the securities in the open market, It increases the
liquidity and reserves of commercial banks, making it
possible for banks to expand their loans and investments. If RBI
sells the securities, the effects are reversed.
QUALITATIVE MEASURES: They aim to control the quantity
of money supply indirectly through cost of credit. These
measures are Bank Rate, Repo & Reverse Repo Rates, and
Interest Rates etc.
Bank Rate:An instrument of general credit control and
represents the standard rate at which the RBI is prepared to buy
or
rediscount bills of exchange or other commercial paper eligible for
purchase under the provisions of the Act. In short, Bank rate
is the minimum rate at which the central bank provides loans to
the commercial banks. It is also called the discount rate.
Usually, an increase in bank rate results in commercial banks
increasing their lending rates. Changes in bank rate affect the
lending rates through altering the cost of credit. At present Bank
rate is 6%.
Repo Rate: Repo and Reverse Repo Rates are Liquidity
adjustment Facility (LAF) tools used by RBI. Repo is an
instrument
meant for injecting the funds required and Reverse Repo for
absorbing the excess liquidity out of system.
In bond markets, interest rates are the most important factor, and
the RBI controls interest rates. RBI uses various rates like
repo, reverse repo and CRR to give direction to interest rates in
the country. Take an example
Repo refers to 'repurchaseobligation'. In case of tight liquidity
conditions (as you saw in 2008), when banks need funding for
the short term, they approach the RBI and ask for a temporary
loan. RBI gives them a loan only after taking some collateral.

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This collateral is Government Securities (G-Secs). So banks give
G-Secs to RBI and take money to meet their
temporaryrequirements. The interest rate which RBI charges to
banks for such short-term loan is known as the repo rate. After
the short-term period is over, banks have the obligation to repay
the money back to RBI, along with the interest and '' its
G-Secs, hence the word repurchase obligation. In short, Banks
borrow from RBI or RBI lends to banks at this rate.
It must be understood that when RBI does not want more money
to go into the economy, it will raise this rate. When repo
rateincreases, the cost of money for banks also increases. Banks in
turn increase the interest rates for their borrowers. This
preventsborrowers from taking loans from banks and thus RBI's
objective of controlling money supply is achieved.
Reverse Repo Rate: Reverse repo is that rate which RBI pays
to banks. When banks have surplus liquidity and there are
not enough borrowings from banks by consumers (as is the
condition now), banks park their surplus money with RBI and
earn
some minimum interest. The rate at which RBI pays interest is
known as reverse repo rate.
When RBI wants the economy to grow, it will reduce reverse repo
rate. By this By doing so, it
w
ill give a signal to banks thatinstead of deploying surplus money
with RBI for a low return they should deploy the same in projects
in the economy, whichwill help to kick-start the economy.
In times of ample liquidity, repo rate is practically redundant.
Hence you will observe RBI focusing more on cutting reverse
repo rates in times of slowdown, as was seen in the recent past.
Liquidity Adjustment Facility (LAF): LAF is a monetary
policy instrument introduced in 2000 to modulate liquidity
in the system in the short term and to send interest rate signals to
the market. LAF operates through repo and reverse
repotransactions. RBI conducts repo to inject liquidity into the
system through purchase of government securities with
anagreement to sell them at a predetermined date and repo rate.
In the reverse repo transaction RBI sells securities with a view to
absorb excess liquidity with a commitment to repurchase them at
a predetermined date and reverse repo rate.
Other instruments of liquidity management are Open Market
Operations (OMO) in the form of outright purchase/sale of
securities and Market Stabilisation Scheme (MSS). Under the
OMO, the RBI buys or sells government bonds in the secondary
market. By absorbing bonds, it drives up bond yields and injects
money into the market. When it sells bonds, it does so to suck
money out of the system.