Monetary Policy

What is monetary policy?

It is the process by which the monetary

authority controls (i) money supply (ii)
availability of money, and (iii) cost of
money or rate of interest to attain price
stability and economic growth

Monetary vs fiscal policy

How is monetary policy different from
fiscal policy?
Both are levers of government policy
Fiscal policy refers to government
borrowing, spending and taxation and is
purely in govt domain; monetary policy
is in central banks domain

Objectives of monetary policy

As with fiscal policy, it is growth, social
justice and price stability
Monetary policy best suited to achieving
price stability:Preamble of RBI Act
enjoins it to conduct operations with a
view to securing monetary stability and
generally to operate currency & credit
system of the country to its advantage

How is this best done?

By having an independent monetary
policy control over creation of reserve
money imp for regulating money ss
What are the perils of a monetary policy
that is subservient to fiscal policy
How do you ensure independence?

Sources of money ss
What is Reserve Money or high-powered
money? Currency+bank deposits with RBI
Called high-powered because an increase
in RM can result in a much larger increase
in bank money
Sources: Net RBI credit to govt

Net accretion to fx reserves

Banks & Monetary Policy

Banks are a key channel through which
monetary signals are transmitted
Quantum channel, Interest rate channel,
exchange rate channel, asset price
channel
Commonest modes in India quantum
and interest rate channel

Monetary Policy Tools

Three primary tools:
Varying Reserve Requirements this
affects the money multiplier
Varying Bank rate ie the discount rate at
which banks borrow from RBI but this is
not in use in India
OMO open market operations - buying
& selling GOI securities in open market

Monetary Policy: Theory

Relationship between money, output &
prices?
Quantity theory: increase in money supply
results in a proportionate increase in
prices so money per se has no impact on
output
Keynes : increase in money ss leads to a
fall in nominal and real rate of interest,
spurring invt and thru multiplier increase
in income

Reforms & Monetary Policy

Pre-reform: monetary policy had little
relevance because we had administered
interest rates
High SLR and CRR
Monetisation of deficit
All three features changed with reform

Recent Developments
Two major issues:
Is there a trade off between growth and
inflation? Recent Indian experience
What is the interplay between monetary
policy, interest rates and exchange rates

Monetary policy, interest rates

& exchange
Impossible
trinityrates
also called trilemma
Says you cant have all three
Open capital account
Pegged currency regime
Independent monetary policy
WHY?

What is Impossible Trinity?

Say you have inflation and so want a
contractionary monetary policy.
You raise interest rates.
Since the capital account is open, capital
flows in from abroad in response to the
higher interest rates.
This puts a pressure on the rupee to
appreciate

But exchange rate is pegged

The RBI buys dollars inflows to prevent
rupee appreciation.

When RBI buys $, it pays out Rs.

This means there is an increase in

money supply; this lowers interest
rates.

Impossible Trinity defined

Implication : You cannot raise rates,
and keep the exchange rate pegged
at the same time.
If you try to do then the result will
be a fall in interest rates
ie exactly the opposite of yr intent

More trouble ahead!

If the US hikes the Fed rate, other things
unchanged, capital will flow out and Re
fall
If RBI wants to prevent depreciation, it
will have to sell dollars/raise rates. Both
are contractionary.
Currency pegging forces RBI to also raise
rates: Thus having a peg means following
US monetary policy.

Whats the Bottomline?

A country with an open capital account
cannot hope to have an independent
monetary policy if it runs a pegged
exchange rate.
Pegging the exchange rate induces a
loss of monetary policy autonomy.

Dealing with volatility

When we have excess inflows RBI could
try to impact money supply through
OMO ie it could sterilise the impact of
forex intervention by absorbing Rs
This works only for a short while.
Why?

Limits to sterilisation
Run out of bonds
Mounting fiscal costs
Sterilisation means selling bonds, bond
prices fall ie interest rates go up and this
sucks in more capital flows.

Today problems are different

Monetary policy has to deal not so much
with excess inflows as with volatility
Also inflation is now the biggest challenge
How does RBI deal with it? Is there a trade
off between inflation & growth
Phillips curve postulates inverse relation
between growth & unemployment

Does the Phillips curve hold

In the very short term there might be a
trade off between growth & inflation but
not in the long-term
Attempts to spur growth beyond potential
growth rate can result in over-heating
There will be supply constraints & price
will start rising as is happening in India
now

Understanding monetary tools

CRR
Bank rate
Forex intervention
Open market operations
LAF Repos / Reverse Repos

Understanding OMOs
The RBI conducts OMOs by buying and
selling G-Secs from its investment
portfolio
These are outright sales / purchases
The rates at which it buys and sells
influence the shape of yield curve
RBI can buy and sell bonds of any
maturity

Repo & Reverse Repos

In a repo transaction, securities are sold
(exchanged for cash) with a simultaneous
agreement to buy them back at a price that is
agreed upon beforehand.
The difference between the two prices is
determined by the rate or interest for the
period of the repo (Repo Rate)
Used by banks in Inter-Bank Market and by
RBI for LAF

Explaining repo
Bank A does a 1m repo for Rs 100 with
Bank B
Bk A sells G sec to Bk B gets Rs 100
After 1m as per agreement Bank A buys
back same securites at Rs 101
Bk A borrows Rs 100 and pays Rs 101 after
1 month ie interest is Rs 1 per month or
12%pa

Reverse Repos
Rev repo is exactly the opposite of repo
A sale and buy back is repo
For counterpart it is reverse repo
When the RBI wishes to inject money it
uses the Repo (as seen from the
commercial banks point of view)
When it wants to absorb money it uses
the Reverse repo rate

What is the LAF

-liquidity adjustment facility ?
RBIs facility to banks
Daily Repo and Reverse Repo (from Banks point of
view)
At repo rate and reverse repo rate (monetary
policy)
The repo rate and reverse repo rate sets the LAF
Corridor
This corridor sets the ceiling and floor for inter-bank
money marketCurrently (August 2012) the repo
rate is 8% and the reverse repo rate is 7%

Banks respond to signals given by RBI

When Repo rate rises that means it becomes
more expensive for banks to borrow from RBI
When Reverse repo rate rises it means banks
will get more from RBI when they lend to it
However in all cases the repo rate will always
be more than the reverse repo rate why?
Otherwise banks will take RBI for a ride
borrow from RBI and lend back at higher rate

RBIs 2nd bi-monthly review

2015-16: Aug 2015
All policy rates unchanged ie Repo 7.25%,
Reverse repo 6.25%, bank rate 8.25%,
Marginal Stdg Facility 8.25%; CRR 4.0%
SLR unchanged at 21.5%
Growth projection lowered in July review to
7.6 from 7.8% inflation likely to be
lower

Rate the governor!