Monetary

Policy
Goals of Monetary Policy

…to assist the economy in

achieving a full-employment,
noninflationary level of total
output
Tools Of Monetary Policy
Open-Market Operations
Buying Securities
From commercial banks...

• Bank gives up securities

• RBI pays bank
• Banks have increased reserves
From the public...
• Public gives up securities
• Public deposits check in bank
• Banks have increased reserves
Tools Of Monetary Policy
Open-Market Operations
Selling Securities
To commercial banks...

• RBI gives up securities

• Bank pays for securities
• Banks have decreased reserves

To the public...
• RBI gives up securities
• Public pays by check from bank
• Banks have decreased reserves
Tools Of Monetary Policy

Open-Market Operations
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
• Banks decrease lending
• Money supply decreases
Lowering the Reserve Ratio
• Banks may hold less reserves
• Banks increase lending
• Money supply increases
Tools Of Monetary Policy
Open-Market Operations

The Discount Rate

Easy Money Policy
• Buy Securities
• Decrease Reserve Ratio
• Lower Discount Rate
Tight Money Policy
• Sell Securities
• Increase Reserve Ratio
• Raise Discount Rate
Monetary Policy, Real GDP,
And The Price Level
Cause-Effect Chain

• Money supply impacts interest rates

• Interest rates affect investment
• Investment is a component of AD
• Equilibrium GDP is changed
Causes of Inflation

The main cause behind inflation is the

increase of money supply than the demand
for money. Alternatively, it can be said that
when the supply of money per unit of output
increases, inflation occurs. The supply of
money per unit of output increases, when
"velocity" of money circulation increases. The
demand for money depends on the overall
economic activities of a country.
 Relationship between Monetary policy and Inflation

 The Fisher's equation depicts that proportional relation that exists

between money supply and the price level. Monetary policy is a
regulation of a central bank or any regulatory authority, that
ascertains the size and growth rate of the money supply.
Monetary policy directly influence the interest rates which in turn
has a negative relation with the price level.
 In the face of inflation the central bank of the country generally
resorts to a rise in the cash reserve ratio, repo rate and reverse
repo rate. So the basic idea is to reduce the money supply in the
economy. To this end government securities are also issued so
as to mop up the excess money supply from the mass. This
would reduce aggregate demand . This reduction would again
help reduce the price level.