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Project Report on

Fiscal & monetary policy

[As a partial fulfillment for the requirement in project as a part of MBA programme]

Submitted To: Prof: K.M.JOSHI Submitted By: Mittali C. Shah Roll No: 31
[MBA-I , Batch: 2010-12]




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Where the mind is without fear and the head is held high
Where knowledge is free,

Where the world has not been broken up into fragments by narrow domestic walls,

Where the words come out from the depth of truth, Where tireless striving stretches its arms

towards perfection,

Where the clear stream of reason has not lost its way in the dreary desert sand of dead habits,

Where the mind is led forward by Thee into ever widening thought and action,


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Into that heaven of freedom, Father, let my country India awake.



1.1 1.2 1.3 1.4 1.5 1.6

PAGE NO. 4 4 6 7 8 9 10 12 14 18 18 21 23 24

Fiscal policy: History of fiscal policy How fiscal Policy Works : Balancing Act Stances of fiscal policy Methods of funding Economic effects of fiscal policy Who Does Fiscal Policy Affect? Monetary Policy : History of monetary policy Overview Theory of monetary policy Types of monetary policy Inflation targeting Monetary policy tools Review of Monetary Policy 2010-11: Part A. Monetary Policy

2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.7.1


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2.7.2 3 4 3.1 4.1

Part B. Development and Regulatory Policies Conclusion & Findings Bibliography

29 39 40


Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the money supply. The two main instruments of fiscal policy are government expenditure and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

Aggregate demand and the level of economic activity; The pattern of resource allocation; The distribution of income.

Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy. It is the sister strategy to monetary policy with which a central bank influences a nation's money supply. These two policies are used in various combinations in an effort to direct a country's economic goals. Here we take a look at how fiscal policy works, how it must be monitored and how its implementation may affect different people in an economy. Before the Great Depression in the United States, the government's approach to the economy was laissez faire. But following the Second World War, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mixture of both monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments are able to control economic phenomena

(1.2) How fiscal Policy Works

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to


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be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money.

Balancing Act
The idea, however, is to find a balance in exercising these influences. For example, stimulating a stagnant economy runs the risk of rising inflation. This is because an increase in the supply of money followed by an increase in consumer demand can result in a decrease in the value of money - meaning that it will take more money to buy something that has not changed in value. Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making any money. A government thus decides to fuel the economy's engine by decreasing taxation, giving consumers more spending money while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. Pumping money into the economy is also known as "pump priming". In the meantime, overall unemployment levels will fall. With more money in the economy and less taxes to pay, consumer demand for goods and services increases. This in turn rekindles businesses and turns the cycle around from stagnant to active. If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in supply decreases the value of money, while pushing up prices (because of the increase in demand for consumer products). Hence, inflation occurs. For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals. If not closely monitored, the line between an economy that is productive and one that is infected by inflation can be easily blurred.

And When The Economy Needs To Be Curbed

When inflation is too strong, the economy may need a slow down. In such a situation, a government can use fiscal policy to increase taxes in order to suck money out of the


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economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative effects of such a policy in the long run could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine tune spending and taxation levels, with the goal of evening out the business cycles. In economics, fiscal policy is the use of government expenditure and revenue collection to influence the economy. Fiscal policy: Tax policy Government revenue Government debt Government spending Budget deficit and surplus

(1.3) Stances of fiscal policy

The three possible stances of fiscal policy are neutral, expansionary and contractionary. The simplest definitions of these stances are as follows:

A neutral stance of fiscal policy implies a balanced economy. This results in a large tax revenue. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity. An expansionary stance of fiscal policy involves government spending exceeding tax revenue. A contractionary fiscal policy occurs when government spending is lower than tax revenue.

However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclical fluctuations of the economy cause cyclical fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions,


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"government spending and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance.

(1.4) Methods of funding

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:

Taxation Seigniorage, the benefit from printing money Borrowing money from the population or from abroad Consumption of fiscal reserves. Sale of fixed assets (e.g., land).

All of these except taxation are forms of deficit financing.


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A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-edged securities. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.

Consuming prior surpluses

A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring additional debt.

(1.5) Economic effects of fiscal policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting


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deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal. Governments can use a budget surplus to do two things: to slow the pace of strong economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices. Economists debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out, a phenomena where government borrowing leads to higher interest rates that offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal. Some classical and neoclassical economists argue that crowding out completely negatives any fiscal stimulus; this is known as the Treasury View[citation needed], which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present. In the classical view, expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand causes that country's currency to appreciate. Once the currency appreciates, goods originating from that


country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase. Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage inflation and therefore price inflation.

(1.6) Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same on everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class. Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers. A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do much to increase aggregate employment levels.

Fiscal Straitjacket
The concept of a fiscal straitjacket is a general economic principle that suggests strict constraints on government spending and public sector borrowing, to limit or regulate the budget deficit over a time period. The term probably originated from the definition of


straitjacket: anything that severely confines, constricts, or hinders. Various states in the United States have various forms of self-imposed fiscal straitjackets.



Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest 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 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.

Monetary policy:
Money supply Central bank Gold standard Fiat currency

[ (2.1) History of monetary policy

Monetary policy is primarily associated with interest rate and credit. For many centuries there were only two forms of monetary policy: (i)

Decisions about coinage; Decisions to print paper money to create credit.


Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price.With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. During the 1870-1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913. By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs.Monetarist macroeconomists have sometimes advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth. However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables. Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003. Therefore, monetary decisions today take into account a wider range of factors, such as:

short term interest rates; long term interest rates; velocity of money through the economy; exchange rates; credit quality; bonds and equities (corporate ownership and debt);


government versus private sector spending/savings; international capital flows of money on large scales; financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society to be perpetually in debt.In fact, many economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business easier and safer would be much more difficult if not impossible.

(2.2) Overview
Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends:


increasing interest rates by fiat; reducing the monetary base;and increasing reserve requirements.
All have the effect of contracting the money supply; and, if reversed, expand the money supply.

Since the 1970s, monetary policy has generally been formed separately from fiscal policy.
Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, and the Bank of Japan) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

The other primary means of conducting monetary policy include:



Discount window lending (lender of last resort); Fractional deposit lending (changes in the reserve requirement);




Moral suasion (cajoling certain market players to achieve specified outcomes); Open mouth operations" (talking monetary policy with the market).

Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic


growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). It is important for policymakers to make credible announcements, and deprecate interest rate targets as they are non-important and irrelevant in regarding to monetary policies. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages. To achieve this low level of inflation, policymakers must have


announcements; that is, private agents must believe that these announcements will
reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect. If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.


Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet targets (for example, larger budgets, a wage bonus for the head of the bank) to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much would markets believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued that to prevent some pathologies related to the time-inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations. Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.


Trends in central banking

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. A central bank can only operate a truly independent monetary policy when the exchange rate is floating. If the exchange rate is pegged or managed in any way, 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; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Accordingly, the management of the exchange rate will influence domestic monetary conditions. To maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. 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. In the 1980s, many economists began to believe that making a nation's central bank independent of the rest of executive government is the best way to ensure an optimal monetary policy, and those central banks which did not have independence began to gain it.


This is to avoid overt manipulation of the tools of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence. In the 1990s, central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. In other words, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank will typically have to submit an explanation. The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2% of CPI). The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). There is also the Austrian school of economics, which includes Friedrich von Hayek and Ludwig von Mises's arguments, but most economists fall into either the Keynesian or neoclassical camps on this issue.

Developing countries
Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation.


Recent attempts at liberalizing and reforming financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.

(2.4) Types of monetary policy

In practice, all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals. Monetary Policy: Inflation Targeting Price Level Targeting Monetary Aggregates Fixed Exchange Rate Gold Standard Mixed Policy Target Market Variable: Interest rate on overnight debt Interest rate on overnight debt The growth in money supply The spot price of the currency The spot price of gold Usually interest rates Long Term Objective: A given rate of change in the CPI A specific CPI number A given rate of change in the CPI The spot price of the currency Low inflation as measured by the gold price Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other


monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index).

(2.5) Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Eurozone, New Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.

Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called monetarism. While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the


fixed exchange rate is with the anchor nation. Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures. In this case there is a black market exchange rate where the currency trades at its market/unofficial rate. Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency. This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard currency. Under dollarization, foreign currency is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government. These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.

Gold standard
The gold standard is a system in which the price of the national currency is measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. The selling of gold is very important for economic growth and stability.The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world between the mid-19th century through 1971. Its major advantages were simplicity and transparency.The major disadvantage of a gold standard is that it induces deflation, which occurs whenever economies grow faster than the gold supply. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value. Deflation can cause economic problems, for instance, it tends to increase the ratio of debts to assets over time. As an example, the monthly cost of a fixed-rate home mortgage stays the same, but the dollar value of the house goes down, and the value of the dollars required to pay the mortgage goes up. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument


that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.

Policy of various nations

Australia - Inflation targeting Brazil - Inflation targeting Canada - Inflation targeting Chile - Inflation targeting China - Monetary targeting and targets a currency basket Colombia - Inflation targeting Eurozone - Inflation targeting Hong Kong - Currency board (fixed to US dollar) India - Multiple indicator approach New Zealand - Inflation targeting Norway - Inflation targeting Singapore - Exchange rate targeting South Africa - Inflation targeting Switzerland - Inflation targeting Turkey - Inflation targeting United Kingdom- Inflation targeting, alongside secondary targets on 'output and employment'. United States- Mixed policy (and since the 1980s it is well described by the "Taylor rule," which maintains that the Fed funds rate responds to shocks in inflation and output)

(2.6) Monetary policy tools

Monetary base
Monetary policy can be implemented by changing the size of the monetary base. 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. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base.

Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for


immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. 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.

Discount window lending

Discount window lending is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates. This enables the institutions to vary credit conditions, there by affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over. By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates ,and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. 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; one must choose which one to control. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.

Currency board
A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, 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. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the


local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are threefold: 1. To import monetary credibility of the anchor nation; 2. To maintain a fixed exchange rate with the anchor nation; 3. To establish credibility with the exchange rate In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened. A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as higher deposits of the exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners.

Unconventional monetary policy at the zero bound

Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include credit easing, quantitative easing, and signaling. In credit easing, a central bank purchases private sector assets, in order to improve liquidity and improve access to credit. Signaling can be used to lower market expectations for future interest rates. For example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an extended period, and the Bank of Canada made a conditional commitment to keep rates at the lower bound of 25 basis points (0.25%) until the end of the second quarter of 2010.

(2.7) Review of Monetary Policy 2010-11

The Monetary Policy for 2010-11 is set against a rather complex economic backdrop. Although the situation is more reassuring than it was a quarter ago, uncertainty about the


shape and pace of global recovery persists. Private spending in advanced economies continues to be constrained and inflation remains generally subdued making it likely that fiscal and monetary stimuli in these economies will continue for an extended period. Emerging market economies (EMEs) are significantly ahead on the recovery curve, but some of them are also facing inflationary pressures. Indias growth-inflation dynamics are in contrast to the overall global scenario. The economy is recovering rapidly from the growth slowdown but inflationary pressures, which were triggered by supply side factors, are now developing into a wider inflationary process. As the domestic balance of risks shifts from growth slowdown to inflation, our policy stance must recognise and respond to this transition. While global policy co-ordination was critical in dealing with a worldwide crisis, the exit process will necessarily be differentiated on the basis of the macroeconomic condition in each country. Indias rapid turnaround after the crisis induced slowdown evidences the resilience of our economy and our financial sector. However, this should not divert us from the need to bring back into focus the twin challenges of macroeconomic stability and financial sector development. This statement is organised in two parts. Part A covers Monetary Policy and is divided into four Sections: Section I provides an overview of global and domestic macroeconomic developments sets out the outlook and projections for growth, inflation and monetary

Section II aggregates;

SectionIII explains the stance of monetary policy; and Section IV specifies the monetary measures. Part B covers Developmental and Regulatory Policies and is organised into six sections: Section I: Financial Stability, Section II :Interest Rate Policy, Section III FinancialMarkets SectionIV Credit Delivery and Financial Inclusion Section V Regulatory and Supervisory Measures for Commercial Banks and Section VI Institutional Developments.


(2.7.1) Part A. Monetary Policy Section I The State of the Economy

(a) Global Economy
The global economy continues to recover amidst ongoing policy support and improving financial market conditions. The recovery process is led by EMEs, especially those in Asia, as growth remains weak in advanced economies. The global economy continues to face several challenges such as high levels of unemployment, which are close to 10 per cent in the US and the Euro area. Despite signs of renewed activity in manufacturing and initial improvement in retail sales, the prospects of economic recovery in Europe are clouded by the acute fiscal strains in some countries.

(b)Domestic Economy
The Reserve Bank had projected the real GDP growth for 2009-10 at 7.5 per cent. The advance estimates released by the Central Statistical Organisation (CSO) in early February 2010 placed the real GDP growth during 2009-10 at 7.2 per cent. The final real GDP growth for 2009-10 may settle between 7.2 and 7.5 per cent. A sharp recovery of growth during 2009-10 despite the worst south-west monsoon since 1972 attests to the resilience of the Indian economy. On the demand side, the contribution of various components to growth in 2009-10 was as follows: private consumption (36 per cent), government consumption (14 per cent), fixed investments (26 per cent) and net exports (20 per cent). The monetary and fiscal stimulus measures initiated in the wake of the global financial crisis played an important role, first in mitigating the adverse impact from contagion and then in ensuring that the economy recovered quickly. However, the developments on the inflation front are worrisome. The headline inflation, as measured by year-on-year variation in Wholesale Price Index (WPI), accelerated from 0.5 per cent in September 2009 to 9.9 per cent in March 2010, exceeding the Reserve Banks baseline projection of 8.5 per cent for March 2010 During 2009-10, the Central Government raised Rs.3,98,411 crore (net) through the market borrowing programme while the state governments mobilised Rs.1,14,883 crore (net). This large borrowing was managed in a non-disruptive manner through a combination of active liquidity management measures such as front-loading of the borrowing calendar, unwinding of securities under the market stabilisation scheme (MSS) and open market operation (OMO) purchases. The Union Budget for 2010-11 has begun the process of fiscal consolidation by budgeting lower fiscal deficit (5.5 per cent of GDP in 2010-11 as compared with 6.7 per cent in 2009-10) and revenue deficit (4.0 per cent of GDP in 2010-11 as compared with 5.3 per cent in 2009-10). As a result, the net market borrowing requirement of the Central


Government in 2010-11 is budgeted lower at Rs.3,45,010 crore as compared with that in the previous year. The current account deficit during April-December 2009 was US$ 30 billion as compared with US$ 28 billion for the corresponding period of 2008. Net capital inflows at US$ 42 billion were also substantially higher than US$ 7 billion in the corresponding period last year. Consequently, on a balance of payments basis (i.e., excluding valuation effects), foreign exchange reserves increased by US$ 11 billion as against a decline of US$ 20 billion during the corresponding period a year ago. Foreign exchange reserves stood at US$ 279 billion as on March 31, 2010. The six-currency trade-based real effective exchange rate (1993-94=100) appreciated by 15.5 per cent during 2009-10 up to February as against 10.4 per cent depreciation in the corresponding period of the previous year.

Section II Outlook and Projections

(a)Global Outlook
Globally, headline inflation rates rose between November 2009 and January 2010, softened in February 2010 on account of moderation of food, metal and crude prices and again rose marginally in some major economies in March 2010. Core inflation continued to decline in the US on account of substantial resource slack. Inflation expectations in advanced countries also remain stable. Though inflation has started rising in several EMEs, India is a significant outlier with inflation rates much higher than in other EMEs.

(b)Domestic Outlook
Surveys generally support the perception of a consolidating recovery. According to the Reserve Banks quarterly industrial outlook survey, although the business expectation index (BEI) showed seasonal moderation from 120.6 in Q4 of 2009-10 to 119.8 in Q1 of 2010-11, it was much higher in comparison with the level of 96.4 a year ago. The improved performance of the industrial sector is also reflected in the improved profitability in the corporate sector. Service sector activities have shown buoyancy, especially during the latter half of 2009-10. The leading indicators of various sectors such as tourist arrivals, commercial vehicles production and traffic at major ports show significant improvement. A sustained increase in bank credit and in the financial resources raised by the commercial sector from non-bank sources also suggest that the recovery is gaining momentum.On balance, under the assumption of a normal monsoon and sustenance of good performance of the industrial and services sectors on the back of rising domestic and external demand, for policy purposes the baseline projection of real GDP growth for 2010-11 is placed at 8.0 per cent with an upside bias


The Reserve Banks baseline projection of WPI inflation for March 2010 was 8.5 per cent. However, some subsequent developments on both supply and demand sides pushed up inflation. Enhancement of excise duty and restoration of the basic customs duty on crude petroleum and petroleum products and the increase in prices of iron ore and coal had a significant impact on WPI inflation. In addition, demand side pressures also re-emerged as reflected in the sharp increase in non-food manufactured products inflation from 0.7 per cent to 4.7 per cent between December 2009 and March 2010. Going forward, three major uncertainties cloud the outlook for inflation. First, the prospects of the monsoon in 2010-11 are not yet clear. Second, crude prices continue to be volatile. Third, there is evidence of demand side pressures building up. On balance, keeping in view domestic demand-supply balance and the global trend in commodity prices, the baseline projection for WPI inflation for March 2011 is placed at 5.5 per cent


Notwithstanding the current inflation scenario, it is important to recognise that in the last decade, the average inflation rate, measured both in terms of WPI and CPI, had moderated to about 5 per cent from the historical trend rate of about 7.5 per cent. Against this background, the conduct of monetary policy will continue to condition and contain perception of inflation in the range of 4.0-4.5 per cent. This will be in line with the mediumterm objective of 3.0 per cent inflation consistent with Indias broader integration into the global economy.

( c)Monetary Aggregates
During 2009-10, money supply (M3) growth decelerated from over 20.0 per cent at the beginning of the financial year to 16.4 per cent in February 2010 before increasing to 16.8 per cent by March 2010, slightly above the Reserve Banks indicative projection of 16.5 per cent. This was reflected in non-food credit growth of 16.9 per cent, above the indicative projection of 16.0 per cent. Keeping in view the need to balance the resource demand to meet credit offtake by the private sector and government borrowings, monetary projections have been made consistent with the growth and inflation outlook. For policy purposes, M3 growth for 2010-11 is placed at 17.0 per cent. Consistent with this, aggregate deposits of SCBs are projected to grow by 18.0 per cent. The growth in non-food credit of SCBs is placed at 20.0 per cent.

(d) Risk Factors

First, uncertainty persists about the pace and shape of global recovery. Fiscal stimulus measures played a major role in the recovery process in many countries by compensating for the fall in private demand. Private demand in major advanced economies continues to be weak due to high unemployment rates, weak income growth and tight credit conditions.


There is a risk that once the impact of public spending wanes, the recovery process will be stalled. Therefore, the prospects of sustaining the recovery hinge strongly on the revival of private consumption and investment. While recovery in India is expected to be driven predominantly by domestic demand, significant trade, financial and sentiment linkages indicate that a sluggish and uncertain global environment can adversely impact the Indian economy. (1) if the global recovery does gain momentum, commodity and energy prices, which have been on the rise during the last one year, may harden further. Increase in global commodity prices could, therefore, add to inflationary pressures. (2) from the perspective of both domestic demand and inflation management, the 2010 south-west monsoon is a critical factor. The current assessment of softening of domestic inflation around mid-2010 is contingent on a normal monsoon and moderation in food prices. Any unfavourable pattern in spatial and temporal distribution of rainfall could exacerbate food inflation. In the current context, an unfavourable monsoon could also impose a fiscal burden and dampen rural consumer and investment demand. (3 ) it is unlikely that the large monetary expansion in advanced economies will be unwound in the near future. Accommodative monetary policies in the advanced economies, coupled with better growth prospects in EMEs including India, are expected to trigger large capital flows into the EMEs. While the absorptive capacity of the Indian economy has been increasing, excessive flows pose a challenge for exchange rate and monetary management. The rupee has appreciated sharply in real terms over the past one year. Pressures from higher capital flows combined with the prevailing rate of inflation will only reinforce that tendency. Both exporters, whose prospects are just beginning to turn, and producers, who compete with imports in domestic markets, are getting increasingly concerned about the external sector dynamics.

SectionIII The Policy Stance

In the wake of the global economic crisis, the Reserve Bank pursued an accommodative monetary policy beginning mid-September 2008. This policy instilled confidence in market participants, mitigated the adverse impact of the global financial crisis on the economy and ensured that the economy started recovering ahead of most other economies. The process was carried forward by the second phase of exit when the Reserve Bank announced a 75 basis points increase in the CRR in the Third Quarter Review of January 2010. As inflation continued to increase, driven significantly by the prices of non-food manufactured goods, and exceeded the Reserve Banks baseline projection of 8.5 per cent for March 2010, the Reserve Bank responded expeditiously with a mid-cycle increase of 25 basis points each in the policy repo rate and the reverse repo rate under the LAF on March 19, 2010. Despite the increase of 25 basis points each in the repo rate and the reverse repo rate, our real policy rates are still negative. With the recovery now firmly in place, we need to move in a calibrated manner in the direction of normalising our policy instruments. notwithstanding lower budgeted government borrowings in 2010-11 than in the year before, fresh issuance


of securities will be 36.3 per cent higher than in the previous year. This presents a dilemma for the Reserve Bank.. . Against this backdrop, the stance of monetary policy of the Reserve Bank is intended to:

Anchor inflation expectations, while being prepared to respond appropriately, swiftly and effectively to further build-up of inflationary pressures. Actively manage liquidity to ensure that the growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way. Maintain an interest rate regime consistent with price, output and financial stability.

Section IV. Monetary Measures

1) Bank Rate 2) Repo Rate

The Bank Rate has been retained at 6.0 per cent. Increase the repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points from 5.0 per cent to 5.25 per cent with immediate effect. 3) Reverse Repo Rate Increase the reverse repo rate under the LAF by 25 basis points from 3.5 per cent to 3.75 per cent with immediate effect. 4) Cash Reserve Ratio Increase the cash reserve ratio (CRR) of scheduled banks by 25 basis points from 5.75 per cent to 6.0 per cent of their net demand and time liabilities (NDTL) effective the fortnight beginning April 24, 2010. . As a result of the increase in the CRR, about Rs. 12,500 crore of excess liquidity will be absorbed from the system.

(2.7.2) Part B. Development and Regulatory Policies

Over the last several years, the Reserve Bank has undertaken wide-ranging financial sector reforms to improve financial intermediation and maintain financial stability. This process has now become more intensive with a focus on drawing appropriate lessons from the global financial crisis and putting in place a regulatory regime that is alert to possible buildup of financial imbalances. The focus of the Reserve Banks regulation will continue to be to improve the efficiency of the banking sector while maintaining financial stability. Simultaneously, it will vigorously pursue the financial inclusion agenda to make financial sector development more inclusive.


SectionI. Financial Stability

The first Financial Stability Report (FSR) was released on March 25, 2010. This Report is an attempt at institutionalising the focus on financial stability and making it an integral part of the policy framework. The first FSR makes an assessment of the strength of the financial sector, with particular focus on banks, and has raised some concerns, including rising inflation, high government borrowings and likely surge in capital flows, from the financial stability standpoint. The FSR observed that the banks remained well-capitalised with higher core capital and sustainable financial leverage. Further, stress tests for credit and market risk confirmed banks resilience to withstand high stress. The FSR also emphasised the need for evolving a stronger supervisory regime for systemically important non-deposit taking non-banking financial companies (NBFCs-ND-SI) and strengthening the monitoring and oversight framework for systemically important financial conglomerates. Overall risk to financial stability was found to be limited. However, the recent financial turmoil has clearly demonstrated that financial stability cannot be taken for granted, and that the maintenance of financial stability requires constant vigilance, especially during normal times to detect and mitigate any incipient signs of instability. Going forward, the Financial Stability Reports will be published half-yearly.

SectionII. Interest Rate Policy

As indicated in the Annual Policy Statement of April 2009, the Reserve Bank constituted a Working Group on Benchmark Prime Lending Rate (Chairman: Shri Deepak Mohanty) to review the present benchmark prime lending rate (BPLR) system and suggest changes to make credit pricing more transparent. The Working Group submitted its report in October 2009 and the same was placed on the Reserve Banks website for public comments. Based on the recommendations of the Group and the suggestions from various stakeholders, the draft guidelines on Base Rate were placed on the Reserve Banks website in February 2010. In the light of the comments/suggestions received, it has been decided to mandate banks to switch over to the system of Base Rate from July 1, 2010. Guidelines on the Base Rate system were issued on April 9, 2010. It is expected that the Base Rate system will facilitate better pricing of loans, enhance transparency in lending rates and improve the assessment of transmission of monetary policy.

SectionIII. Financial Markets

1) The Interest Rate


The Interest Rate Futures contract on 10-year notional coupon bearing Government of India security was introduced on August 31, 2009. Based on the market feedback and the recommendations of the Technical Advisory Committee (TAC) on the Money, Foreign Exchange and Government Securities Markets, it is proposed:

to introduce Interest Rate Futures on 5-year and 2-year notional coupon bearing securities and 91-day Treasury Bills. The RBI-SEBI Standing Technical Committee will finalise the product design and operational modalities for introduction of these products on the exchanges.

2) Regulation of Non-Convertible Debentures (NCDs) of Maturity of Less than One Year

As indicated in the Second Quarter Review of October 2009, the draft guidelines on the regulation of non-convertible debentures (NCDs) of maturity of less than one year were placed on the Reserve Banks website on November 3, 2009 for comments/feedback. The comments/feedback received were examined and also deliberated by the TAC on the Money, Foreign Exchange and Government Securities Markets. Accordingly, it is proposed:

3) Introduction of Credit Default Swaps (CDS)

As indicated in the Second Quarter Review of October 2009, the Reserve Bank constituted an internal Working Group to finalise the operational framework for introduction of plain vanilla over-the-counter (OTC) single-name CDS for corporate bonds for resident entities subject to appropriate safeguards. The Group is in the process of finalising a framework suitable for the Indian market, based on consultations with market participants/experts and study of international experience. .

4) Introduction of Exchange-Traded Currency Option Contracts

Currently, residents in India are permitted to trade in futures contracts in four currency pairs on two recognised stock exchanges. In order to expand the menu of tools for hedging currency risk, it has been decided,to permit the recognised stock exchanges to introduce plain vanilla currency options on spot US Dollar/Rupee exchange rate for residents. .

Separate Trading for Registered Interest and Principal of Securities (STRIPS): Status


As indicated in the Annual Policy Statement for 2009-10, the draft guidelines on stripping/reconstitution of government securities prepared in consultation with market participants were placed on the Reserve Banks website on May 14, 2009 for comments and feedback. Taking into consideration the feedback received on the draft guidelines, the final guidelines on stripping/reconstitution of government securities were issued on March 25, 2010. The guidelines, which came into effect from April 1, 2010, will enable market participants to strip/reconstitute eligible Government of India dated securities through the negotiated dealing system (NDS) subject to certain terms and conditions.

6) Corporate Bond Market

To facilitate settlement of secondary market trades in corporate bonds on a delivery versus payment-1 (DVP-1) basis on the Real Time Gross Settlement (RTGS) system, the National Securities Clearing Corporation Limited (NSCCL) and the Indian Clearing Corporation Limited (ICCL) have been permitted to maintain transitory pooling accounts with the Reserve Bank. Further, guidelines have been issued to all Reserve Bank regulated entities to mandatorily clear and settle all OTC trades in corporate bonds using the above arrangement with effect from December 1, 2009. To facilitate the development of an active repo market in corporate bonds, the guidelines for repo transactions in corporate debt securities were issued on January 8, 2010. The guidelines, which came into force with effect from March 1, 2010, will enable repo in listed corporate debt securities rated AA or above. Fixed Income Money Market and Derivatives Association of India (FIMMDA) is working on the development of reporting platform and also on the Global Master Repo Agreement to operationalise the repo in corporate bonds.

Non-SLR Bonds of companies engaged in infrastructure: Valuation

At present, banks investments in non-SLR bonds are classified either under held for trading (HFT) or available for sale (AFS) category and subjected to mark to market requirements. Considering that the long-term bonds issued by companies engaged in infrastructure activities are generally held by banks for a long period and not traded and also with a view to incentivising banks to invest in such bonds, it is proposed:to allow banks to classify their investments in non-SLR bonds issued by companies engaged in infrastructure activities and having a minimum residual maturity of seven years under the held to maturity (HTM) category.

8) Investment in Unlisted Non-SLR Securities

investment in non-SLR debt securities (both primary and secondary market) by banks where the security is proposed to be listed on the Exchange may be considered as investment in listed security at the time of making investment.


If such security, however, is not listed within the period specified, the same will be reckoned for the 10 per cent limit specified for unlisted non-SLR securities. In case such investment included under unlisted non-SLR securities lead to a breach of the 10 per cent limit, the bank would not be allowed to make further investment in non-SLR securities (both primary and secondary market, including unrated bonds issued for financing infrastructure activities) till such time the limit is reached.

SectionIV. Credit Delivery and Financial Inclusion

1. Credit Flow to the MSE Secto
To mandate banks not to insist on collateral security in case of loans up to Rs.10 lakh as against the present limit of Rs.5 lakh extended to all units of the micro and small enterprises sector. Banks are urged to keep in view the recommendations made by the Task Force and take effective steps to increase the flow of credit to the MSE sector, particularly to micro enterprises. The Reserve Bank will monitor the performance of banks in this regard.

2. Rural Co-operative Banks

Based on the recommendations of the Task Force on Revival of Rural Co-operative Credit Institutions and in consultation with the state governments, the Government of India had approved a package for revival of the short-term rural co-operative credit structure. As envisaged in the package, so far 25 States have entered into Memoranda of Understanding with the Government of India and the National Bank for Agriculture and Rural Development. Fourteen States have made necessary amendments to their respective Cooperative Societies Acts. As on December 31, 2009, an aggregate amount of about Rs.7,000 crore was released by the NABARD as Government of Indias share under the package to primary agricultural credit societies in 11 States.

3. Financial Inclusion Plan for Banks

With a view to increasing banking penetration and promoting financial inclusion, domestic commercial banks, both in the public and private sectors, were advised to take some specific actions. First, banks were required to put in place a Board-approved Financial Inclusion Plan in order to roll them out over the next three years and submit the same to the Reserve Bank by March 2010. Banks were advised to devise FIPs congruent with their business strategy and to make it an integral part of their corporate plans. The Reserve Bank has deliberately not imposed a uniform model so that each bank is able to build its own strategy in line with its business model and comparative advantage. Second, banks were required to include criteria on financial inclusion in the performance evaluation of their field staff. Third, banks were advised to draw up a roadmap by March 2010 to provide


banking services in every village having a population of over 2,000. The Reserve Bank will discuss FIPs with individual banks and monitor their implementation.

4. Priority Sector Lending Certificates: Working Group

a Working Group on Introduction of Priority Sector Lending Certificates was constituted by the Reserve Bank in November 2009 to examine the pros and cons of the recommendation made by the Committee on Financial Sector Reforms to PSLCs and make suitable recommendations on its introduction and their trading in the open market. In this context. To expand the terms of reference of the Working Group to also review the pros and cons of inclusion of bank lending to micro-finance institutions under priority sector lending. The Group is expected to submit its Report by end-June 2010.

5. Urban Co-operative Banks

Taking into account the systemic financial health of urban co-operative banks, it was decided in 2004 not to set up any new UCBs. With a view to improving the financial soundness of the UCB sector, memoranda of understanding were signed with all State Governments. Following the consolidation, the financial condition of the UCB sector has improved considerably and UCBs have also been allowed to enter into new areas of business. With a view to increasing the coverage of banking services amongst local communities, it is proposed:

6. Liberalisation of Off-site ATMs by UCBs

Under the extant policy of branch authorisation, UCBs, which are well-managed and meet the regulatory criteria, are required to submit annual business plans, based on which centres are allotted to them according to their choice for opening of branches. Centres where UCBs desire to open off-site ATMs are also required to be included in their annual business plan. In order to further improve the banking infrastructure, it has been decided to liberalise the approach to setting up of off-site ATMs by UCBs. Accordingly, it is proposed: 8.Customer Service The issue of treating customers fairly is assuming critical importance as the experience shows that consumers interests are often not accorded full protection and properly attended to. The Reserve Bank and the Banking Ombudsmans offices have been receiving several complaints regarding levying of excessive interest rates and charges on certain loans and advances. The Reserve Bank has, over the years, undertaken a number of initiatives for ensuring fair treatment to customers. This has taken the form of both regulatory fiats as also moral suasion and class action. However, within the domain of necessary freedom to banks to choose the types of services to be offered to the customers and related costs, concerted


efforts need to be made to further develop a credible and effective functional system of attending to customer complaints.

SectionV. Regulatory and Supervisory Measures for Commercial Banks

1) Strengthening the Resilience of the Banking Sector In December 2009, the Basel Committee on Banking Supervision had issued two consultative documents for public comments. The document on Strengthening the Resilience of the Banking Sector contains proposals for raising the quality, consistency and transparency of the capital base, enhancing risk coverage, prescribing leverage ratio and containing pro-cyclicality. The second document on International Framework for Liquidity Risk Measurement Standards and Monitoring focuses on measures for further elevating the resilience of internationally active banks to liquidity stress across the globe as well as increasing international harmonisation of liquidity risk supervision. The Basel Committee is presently undertaking a Quantitative Impact Study of these proposals. The QIS will form the basis for calibrating reforms proposed in the above two documents to arrive at an appropriate level and quality of capital and liquidity. The fully calibrated set of standards is expected to be developed by end-2010 with the aim of implementation by end of 2012. Ten large Indian banks are participating in the QIS. 2) Working Group on Valuation Adjustment and Treatment of Illiquid Positions In the Second Quarter Review of October 2009, it was proposed to issue appropriate guidelines to banks for implementation of enhancements and revisions to Basel-II framework finalised by the Basel Committee in July 2009. Accordingly, the Reserve Bank issued guidelines to banks in February 2010. These guidelines require banks to make specified valuation adjustments for various risks/costs in their portfolios including derivatives, which are subject to mark to market requirement and also for illiquidity of these positions. These guidelines also permit banks to follow any recognised models/methods for computing the amount of valuation adjustment. In order to ensure that a consistent methodology is adopted by banks for the purpose, it is proposed: 3) Convergence of Indian Accounting Standards with International Financial Reporting Standards 92. As part of the efforts to ensure convergence of the Indian Accounting Standards with the International Financial Reporting Standards, the roadmap for banking companies and non-banking financial companies has been finalised by the Ministry of Corporate Affairs in consultation with the Reserve Bank. As per the roadmap, all scheduled commercial banks will convert their opening balance sheet as at April 1, 2013 in compliance with the IFRS


converged IASs. Considering the amount of work involved in the convergence process, it is expected that banks and other entities concurrently initiate appropriate measures to upgrade their skills, management information system and information technology capabilities to manage the complexities and challenges of IFRSs. The implementation poses additional challenge as certain aspects of IFRSs, especially the standards on financial instruments, are under review and would take some time before they are finalised. In order to facilitate smooth migration to IFRSs, it is proposed: 4) Infrastructure Financing With a view to meeting the increasing financing needs of infrastructure development, the Reserve Bank has taken a number of measures to facilitate adequate flow of bank credit to this sector. In order to give a further thrust to infrastructure financing by banks, some further measures are felt necessary. In terms of extant instructions, rights, licenses and authorisations of borrowers, charged to banks as collateral in respect of project loans are not eligible for being reckoned as tangible security for the purpose of classifying an advance as secured loan. As toll collection rights and annuities in the case of road/highway projects confer certain material benefits to lenders, Till June 2004, the Reserve Bank had prescribed a limit on banks unsecured exposures. infrastructure loan accounts classified as substandard will attract a provisioning of 15 per cent instead of the current prescription of 20 per cent. To avail of this benefit of lower provisioning, banks should have in place an appropriate mechanism to escrow the cash flows and also have a clear and legal first claim on such cash flows. 5) Presence of Foreign Banks In February 2005, the Reserve Bank had released the roadmap for presence of foreign banks in India laying out a two-track and gradualist approach aimed at increasing the efficiency and stability of the banking sector in India. The first track was the consolidation of the domestic banking system, both in the private and public sectors, and the second track was the gradual enhancement of foreign banks in a synchronised manner. The roadmap was divided into two phases, the first phase spanning the period March 2005 March 2009, and the second phase beginning after a review of the experience gained in the first phase. 6) Licensing of New Banks The Finance Minister, in his budget speech on February 26, 2010 announced that the Reserve Bank was considering giving some additional banking licenses to private sector players. NBFCs could also be considered, if they meet the Reserve Banks eligibility criteria. In line with the above announcement, it is proposed: Thereafter, detailed discussions will be held with all stakeholders on the discussion paper and guidelines will be finalised based on the feedback. All applications received in this regard would be referred to


an external expert group for examination and recommendations to the Reserve Bank for granting licenses. 7) Introduction of Bank Holding Company (BHC)/Financial Holding Company (FHC) in India The Reserve Bank placed a Discussion Paper on Holding Companies in Banking Groups on its website in August 2007 for public comments. The feedback received on the Discussion Paper underscored the need for introduction of bank holding companies, financial holding companies in India to ensure an orderly growth of financial conglomerates and better insulation of a bank from the reputational and other risks of the subsidiaries/affiliates within the group. The Committee on Financial Sector Assessment, in its report issued in March 2009, observed that given the lack of clarity in the existing statutes relating to the regulation and supervision of financial holding companies, the holding company structure as prevalent in the US for financial conglomerates is not currently in use in India. The Committee noted that the absence of the holding company structure in financial conglomerates exposes investors, depositors and the parent company to risks, strains the parent companys ability to fund its own core business and could restrict the growth of the subsidiary business. 8) Conversion of Term Deposits, Daily Deposits or Recurring Deposits for Reinvestment in Term Deposits As per extant guidelines, banks should allow conversion of term deposits, daily deposits or recurring deposits to enable depositors to immediately reinvest the amount lying in the aforesaid deposits with the same bank in another term deposit. Banks are required to pay interest in respect of such term deposits without reducing the interest by way of penalty, provided that the deposit remains with the bank after reinvestment for a period longer than the remaining period of the original contract. On a review of the extant regulatory norms and in order to facilitate better asset-liability management. 9) Cross-border Supervision As indicated in the Mid-Term Review of October 2008, an Internal Working Group examined the legal position on cross-border supervision arrangements and also explored the feasibility of executing memoranda of understanding with overseas supervisors. Subsequent to the submission of the recommendations of the Group, the Reserve Bank has comprehensively reviewed its existing practices for cross-border supervisory co-operation. With a view to ensuring effective cross-border supervision and supervisory co-operation.

Information Technology and Related Issues: Enhancement to the Guidelines


Information technology) risk assessment and management are required to be made a part of the risk management framework of a bank, while internal audit/information system audit needs to independently provide assurance that the IT-related processes and controls are working as intended. Given the increased incidents of cyber frauds in banks in the recent period, it is necessary to improve controls and examine the need for a pro-active fraud risk assessment and management processes in commercial banks. With the increase in transactions in electronic mode, it is also critical to examine the legal implications for banks arising out of IT-related legislations and other legislations such as IT Act 2000, IT Amendment Act 2008 and Prevention of Money Laundering Act, 2002 and also steps that are required to be taken to suitably mitigate the legal risks arising from such transactions.

11) Credit Information Companies: Grant of Certificate of Registration In April 2009, the Reserve Bank had issued in-principle approval to four entities to set up credit information companies. Out of the four companies, Experian Credit Information Company of India Private Ltd. and Equifax Credit Information Services Private Ltd. have been granted Certificate of Registration to commence the business of credit information on February 17, 2010 and March 26, 2010, respectively.

SectionVI. Institutional Developments

1) Non-Banking Financial Companies
A. Core Investment Companies (CICs): Regulatory Framework The regulatory framework for NBFCs has evolved in the recent past with particular focus on inter-connectedness and systemic risk. Under this approach, access to public funds has been perceived as a systemic issue necessitating close regulation and monitoring of NBFCs, including systemically important non- deposit taking NBFCs However, companies which have their assets predominantly as investments in shares not for trading but for holding stakes in group companies and also do not carry on any other financial activity justifiably deserve a differential treatment in the regulatory prescription applicable to NBFCs-ND-SI. In order to rationalise the policy approach for CICs, and based on feedback received from such companies, it is proposed to:treat CICs having an asset size of Rs.100 crore and above as systemically important core investment companies. Such companies will be required to register with the Reserve Bank. B. Securitisation Companies/Reconstruction Companies set up under the SARFAESI Act, 2002: Changes in Regulations


SCs/RCs can acquire the assets either in their own books or directly in the books of the trusts set up by them.The period for realisation of assets acquired by SCs/RCs can be extended from five years to eight years by their Boards of Directors, subject to certain conditions. Asset/Security Receipts, which remain unresolved/not redeemed as at the end of five years or eight years, as the case may be, will henceforth be treated as loss assets.It will be mandatory for SCs/RCs to invest an amount not less than 5 per cent of each class of SRs issued under a particular scheme and continue to hold the investments till the time all the SRs issued under that class are redeemed completely.With a view to bringing transparency and market discipline in the functioning of SCs/RCs, additional disclosures relating to assets realised during the year, value of financial assets unresolved as at the end of the year, value of SRs pending redemption, among others, are being prescribed.

2) Payment and Settlement Systems

i. Payment System Vision Document 2009-12 Keeping in view the significant developments in payment systems and the Reserve Banks responsibility with regard to regulation and supervision of payment systems, the Vision Document for the period 2009-12 was released on February 16, 2010. The scope of the Vision Document has been enhanced to ensure that all the payment and settlement systems operating in the country are safe, secure, sound, efficient, accessible and authorised. ii. Membership to the Committee on Payment and Settlement Systems The Committee on Payment and Settlement Systems (CPSS), constituted under the aegis of the Bank for International Settlements (BIS), was recently broadened to include India and also nine other countries as members. The Reserve Bank is also represented on three Working Groups of the CPSS set up for drawing up standards/guidelines towards efficient functioning of the payment and settlement systems and supporting market infrastructure across the world. iii. Standardisation of Security Features on Cheque Forms Cheques continue to be a predominant instrument for retail payments. To act as a deterrent to cheque frauds and to bring about uniformity across cheques issued/used by the banking industry, it was decided to examine the need for standardisation of security features on cheque forms. A Working Group was accordingly constituted and based on its recommendations and the industrys feedback, cheque truncation system (CTS)2010 Standard with benchmark specifications for security features on cheques and field placements on cheque forms has been prescribed.



Operationalisation of National Payments Corporation of India

The National Payments Corporation of India, set up in December 2008 as an umbrella organisation for operating and managing retail payment systems, has the envisioned role to look at future innovations in the retail payment space in the country. Effective December 14, 2009, NPCI has taken over operations of the National Financial Switch from Institute for Development and Research in Banking Technology. NPCI is also expected to take the lead role in rolling out the proposed CTS project at Chennai. v. Phased Discontinuation of High Value Clearing

It has been the endeavour of the Reserve Bank to migrate from paper-based payments to electronic payment systems by creating the appropriate technological infrastructure. As a step towards encouraging migration of paper-based high value payments to more secure electronic modes, it was decided to discontinue high value clearing in a phased and nondisruptive manner by March 31, 2010. This process has been completed as per schedule. vi. Enhancements in National Electronic Funds Transfer System

To further strengthen the National Electronic Funds Transfer system in terms of availability, convenience, efficiency and speed, significant enhancements were introduced in the operational procedures and process flow, effective March 1, 2010. These included: (i) increasing the operating window by two hours on weekdays and one hour on Saturdays; (ii) introducing the concept of hourly settlements; (iii) shortening the time window for return of uncredited transactions; and (iv) enabling positive confirmation to the remitter through SMS or e-mail about the time and date of actual credit of funds to the beneficiarys account with the destination bank. The concept of positive confirmation to the remitter is perhaps unique across all retail electronic payment systems world-wide.As at end-March 2010, over 66,500 branches of 95 banks had participated in NEFT and the volume of transactions processed increased with a record volume of 8.3 million transactions in March 2010. vii. Mobile Banking in India The use of mobile phone channels for initiation and execution of banking transactions has been gaining significance the world over. The significance of this channel has been recognised by the Reserve Bank. Accordingly, regulatory guidelines for enabling mobile banking were notified in October 2008. The transaction limits were further relaxed in December 2009. Banks were also permitted to enable small value transactions up to Rs.1,000 without end-to-end encryption. Currently, this channel is used to settle on an average 1.9 lakh transactions of average value 12 crore in a month. To further encourage the development of other mobile-based products, non-bank entities were also permitted in


August 2009 to issue mobile-based, semi-closed prepaid payment instruments, up to Rs.5,000.

(3.1) Conclusion & findings

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment One of the biggest obstacles facing policymakers is deciding how much

involvement the government should have in the economy. Indeed, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to sustain a vibrant economy, on which the economic well being of the population depends.
Monetary policy is the management of money supply and interest rates by central

banks to influence prices and employment. Monetary policy works through expansion or contraction of investment and consumption expenditure. Monetary policy cannot change long-term trend growth. There is no long-term tradeoff between growth and inflation. (Highinflation can only hurt growth). What monetary policy at its best can deliver is low and stableinflation, and thereby reduce the volatility of the business cycle. When inflationary pressures build up: raise the short-term interest rate (the policy rate) which raises real rates across the economy which squeezes consumption and investment. The pain is not concentrated at a few points, as is the case withgovernment interventions in commodity markets. Monetary policy is supposed to be about pinning down the shortrate so as to achieve an inflation target, and thus stabilise themacroeconomy

Expected Outcomes
(i) Inflation will be contained and inflationary expectations will be anchored.

(ii) The recovery process will be sustained.



Government borrowing requirements and the private credit demand will be met. Policy instruments will be further aligned in a manner consistent with the evolving state of the economy.

(4.1) Bibliography
Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002): The Economic Way of Thinking (10th ed). Prentice Hall. Larch, M. and J. Nogueira Martins (2009): Fiscal Policy Making in the European Union - An Assessment of Current Practice and Challenges. Routledge.