Monetary Policy Operations

There is a close linkage between central bank and the government conducting their policies
taking into considerations several factors that may influence its operations. Let us look into
certain examples that are relevant in the current market scenario.

Demand-Supply Curve

The demand curve which is the quantity of money (or substitutes) demanded at each interest rate
keeping other factors constant for the money. Hence, if the interest rate increases, the money
demanded will decrease and vice-versa. It is, therefore, downward sloping. Let’s also discuss
some shifters of the demand curve. They could be -Real GDP, price level, expectations, transfer
costs and preferences. A positive jump in Real GDP increases the overall income of the country
and hence the money demanded will be more. Similarly, if the price of the good increases, the
money needed will be more. This will shift the demand curve away from origin. Speculations
tend to affect the demand curve either in a positive direction or negative. Say for example, if
there is an expectation that bond price will fall, so people will sell their bonds in exchange for
money .Thus, shifting the demand curve.

The supply curve is a vertical line at the given quantity that is because the money supplied is
independent of the interest rate. For example, a monetary policy in which government changes
the reserves affects the money supply. A perfectly inelastic curve indicates that the real quantity
of money (m1) does not vary with the interest rate.

Apart from maintaining liquidity and disposing off surplus funds of investors, developed money
market make it easier for RBI or other national banks to rule out monetary policies. Also, a
central bank looking for indirect methods to implement monetary policy, such as open market
operations, will require an effective interest rate transmission mechanism, which also calls for a
liquid money market.

Nash Equilibrium – Game Theory – Governments Fiscal Policy and Central Bank’s
Monetary Policy

The economy of a country is highly influenced by the interactions between the government’s
fiscal policy and the central bank’s monetary policy. These institutions have different goals like
protecting price stability in case of monetary policy and achieving high economic growth in case
of fiscal policy. Hence may conflict with each other at times while making important decisions.

It is important to reach a Nash Equilibrium between these two authorities. This will be achieved
by considering all the specific constraints and limitations that these institutions will have to
pertain to. They could be part of the game as in a co-operative model or non-cooperative model.
In a cooperative model, it is assumed that both parties operate under identical macroeconomic
situations and take decisions after considering the other parties’ decisions and considerations.
In a non-cooperative model, each authority will have to face several restrictions like budget
constraints, bands decisions, external macroeconomic conditions, inflation, etc. So non-
cooperation between these authorities may result in higher deficits and higher real interest rates
compared with the other model. In recent times, we have seen one such important decision that
was taken to tackle the economic condition we have now, related to repo rate.

Repo rate cut

Monetary authorities usually use the repo rate to control inflation. When inflation rises, the repo
rates are increased to prevent banks from lending funds from RBI, hence reducing the supply of
money in the market and reduces repo rate to have more supply in the market.[2]

There has been a reduction from 5.15% -> 4.40% -> 4% amidst the pandemic situation. [3] This
has been cleverly devised and implemented by the RBI as part of its monetary policies. This is in
collaboration with the governments’ policies too. The recent decisions made like the moratorium
period and this reduced repo rate, all are aimed at handling the economy from the verge of break
down. The authorities are trying to attain an equilibrium just like in game theory.

References:

[1] https://www.tandfonline.com/doi/full/10.1080/1331677X.2019.1669063

[2]https://economictimes.indiatimes.com/tdmc/your-money/rbi-cuts-repo-rate-by-25-basis-
points/tomorrowmakersshow/60189905.cms?query=Save#:~:text=The%20Reserve%20Bank
%20of%20India's,be%20lowest%20rate%20since%202010.

[3] https://www.myloancare.in/rbi-repo-rate/