Monetary Policy

Objectives of monetary policy
1. Maximum feasible output 2. High rate of economic growth 3. Fuller employment

4. Price stability
5. Greater equality in the distribution of income and wealth 6. Healthy balance of payments

. to control and regulate the supply of money with the public and flow of credit with a view to achieve predetermined macroeconomic goals.Monetary policy • MP is a programme of action taken by the monetary authorities generally the central bank.

Limitations of monetary policy • Time lag • Problems in forecasting : Some units of an economy are beyond the scope of monetary policy (unorganized markets. parallel economy) • Underdeveloped money and capital market .

  .  It is designed to oversee the banking system. It was created in 1935 to restore confidence in the nation’s banking system. It regulates the quantity of money in the economy.The Reserve Bank • The Reserve Bank serves as the nation’s central bank.

Three Primary Functions of the RBI • Regulates banks to ensure they follow central laws intended to promote safe and sound banking practices. . Acts as a banker’s bank. • • Conducts monetary policy by controlling the money supply. making loans to banks and as a lender of last resort.

Reserve Requirement changes • Selective / Qualitative Credit Control:1.Instruments of monetary policy • Quantitative credit control:- 1. Direct Action 2. Moral suasion . Changes in margin requirements 3. Open market operations 2. Regulation of consumer credit 4. Bank Rate Policy 3.

Open-Market Operations • Open-Market Operations • The money supply is the quantity of money available in the economy. • The primary way in which the RBI changes the money supply is through open-market operations. . • The RBI purchases and sells government securities.

the RBI buys government bonds from the public. the RBI sells government bonds to the public.Open-Market Operations • Open-Market Operations • To increase the money supply. • To decrease the money supply. .

the money supply increases The reserve ratio is the fraction of deposits that banks hold as reserves. banks hold a fraction of the money deposited as reserves and lend out the rest. In a fractional reserve banking system. When a bank makes a loan from its reserves. • • • .Banks and The Money Supply • Reserves are deposits that banks have received but have not loaned out.

 Deposits into a bank are recorded as both assets and liabilities.   Loans become an asset to the bank.Money Creation • The money supply is affected by the amount deposited in banks and the amount that banks loan. The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. .

Money Creation •This T-Account shows a bank that… accepts deposits.00 Rs 1000.00 Loans Rs 900. •It assumes a reserve ratio of 10%.00 Total Liabilities Rs 1000.00 .00 Total Assets Rs 1000. First National Bank Assets Liabilities Reserves Deposits Rs 100. keeps a portion as reserves. and lends out the rest.

• The money multiplier is the amount of money the banking system generates with each rupee of reserves. that money is generally deposited into another bank.Money Creation with Fractional-Reserve Banking • When one bank loans money. • When a bank makes a loan from its reserves. the money supply increases. • This creates more deposits and more reserves to be lent out. .

00 Rs1000.00 Loans Rs900.00 Reserves Deposits Reserves Rs100.00 Rs900.00 Money Supply = Rs1900.00 Total Assets Total Liabilities Total Assets Total Liabilities Rs100.00 Rs90.00 Rs900.00 Loans Rs810.00! .Money Creation First National Bank Assets Liabilities Second National Bank Assets Liabilities Deposits Rs900.00 Rs1000.

00 [=0.00] = Rs 810.The Money Multiplier How much money is eventually created in this economy? Original deposit First National lending Second National lending Third National lending   Total money supply = Rs 1000.000 .9 x 810.00]   = Rs 10.00 = Rs 900.9 x 900.00 [=0.9 x 1000.90 [=0.00] = Rs 720.

R = 20% or 1/5.The Money Multiplier The money multiplier is the reciprocal of the reserve ratio: M = 1/R •With •The a reserve requirement. multiplier is 5. .

. • Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.Tools of Monetary Control • Reserve Requirements • The RBI also influences the money supply with reserve requirements.

.Tools of Monetary Control • Changing the Reserve Requirement • The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. • Decreasing the reserve requirement increases the money supply. • Increasing the reserve requirement decreases the money supply.

. • Increasing the discount rate decreases the money supply.Tools of Monetary Control • Changing the Discount Rate • The discount rate is the interest rate the RBI charges banks for loans. • Decreasing the discount rate increases the money supply.

Selective Control • Qualitative Tools / Selective credit control: 1. Direct action 3 Fixation of maximum limit on advances to individual borrowers. . Moral suasion 2.

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