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Monetary Policy

RBI and Monetary Policy in India

What is Monetary Policy?

The term monetary policy refers to actions taken by central banks to affect monetary magnitudes or other financial conditions. Monetary Policy operates on monetary magnitudes or variables such as money supply, interest rates and availability of credit. Monetary Policy ultimately operates through its influence on expenditure flows in the economy. In other words affects liquidity and by affecting liquidity, and thus credit, it affects total demand in the economy.

Credit Policy
Central Bank may directly affect the money supply to control its growth. Or it might act indirectly to affect cost and availability of credit in the economy. In modern times the bulk of money in developed economies consists of bank deposits rather than currencies and coins. So central banks today guide monetary developments with instruments that control over deposit creation and influence general financial conditions. Credit policy is concerned with changes in the supply of credit. Central Bank administers both the Credit and Monetary policy

Aims of Monetary policy

MP is a part of general economic policy of the govt. Thus MP contributes to the achievement of the goals of economic policy. Objective of MP may be: Full employment Stable exchange rate Healthy BoP Economic growth Reasonable Price Stability Greater equality in distribution of income & wealth Financial stability

Price Stability: The Dominant Objective

There is convergence of views in developed and developing economies, that price stability is the dominant objective of monetary policy. Price stability does not mean complete year-toyear price stability which is difficult to attain. Price stability refers to the long run average stability of prices. Price stability involves avoidance of both inflationary and deflationary pressures.

Price Stability contributes improvements in the standard of living of people. It promotes saving in the economy while discouraging unproductive investment. Stable prices enable exports to compete in international markets and contribute to the strengthening of BoP. Price stability leads to interest rate stability, and exchange rate stability (via export import stability). It contributes to the overall financial stability of the economy.

1. Discount Rate (Bank Rate) 2.Reserve Ratios 3. Open Market Operations

Operation of Monetary Policy

Operating Target
Monetary Base Bank Credit Interest Rates

Intermediate Target
Monetary Aggregates(M3) Long term interest rates

Ultimate Goals
Total Spending Price Stability Etc.

Instruments of Monetary Policy

Variations in Reserve Ratios Discount Rate (Bank Rate) (also called rediscount rate) Open Market Operations (OMOs) Other Instruments

Variations in Reserve Ratios

Banks are required to maintain a certain percentage of their deposits in the form of reserves or balances with the RBI It is called Cash Reserve Ratio or CRR Since reserves are high-powered money or base money, by varying CRR, RBI can reduce or add to the banks required reserves and thus affect banks ability to lend.

Discount Rate (Bank Rate)

Discount rate is the rate of interest charged by the central bank for providing funds or loans to the banking system. Funds are provided either through lending directly or rediscounting or buying commercial bills and treasury bills. Raising Bank Rate raises cost of borrowing by commercial banks, causing reduction in credit volume to the banks, and decline in money supply. Variation in Bank Rate has an effect on the domestic interest rate, especially the short term rates. Market regards the increase in Bank rate as the official signal for beginning of a tight money situation.

Open Market Operations (OMOs)

OMOs involve buying (outright or temporary) and selling of govt securities by the central bank, from or to the public and banks. RBI when purchases securities, pays the amount of money by crediting the reserve deposit account of the sellers bank, which in turn credits the sellers deposit account in that bank.

Money Supply
Currency issued by government fiduciary supply Money supply is expressed in two broad measures Narrow money and Broad Money

Monetary Magnitudes
Reserve Money (M0): Currency in circulation + Bankers deposits with the RBI + Other deposits with the RBI M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + Other deposits with the RBI). M2: M1 + Savings deposits with Post office savings banks. M3: M1+ Time deposits with the banking system M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).

Currency Growth

Money supply
how the banking system creates money three ways the RBI can control the money supply why the RBI cant control it precisely

Banks role in the money supply

The money supply equals currency plus demand (checking account) deposits: M = C + D Where C = Currency with Public D = Demand deposits with Public Since the money supply includes demand deposits, the banking system plays an important role.

A few preliminaries
Reserves (R ): the portion of deposits that banks have not lent. To a bank, liabilities include deposits,

assets include reserves and outstanding loans

100-percent-reserve banking: a system in which banks hold all deposits as reserves. Fractional-reserve banking: a system in which banks hold a fraction of their deposits as reserves.

SCENARIO 1: No Banks

With no banks, D = 0 and M = C = Rs.1000.

SCENARIO 2: Fractional-Reserve Banking

 Suppose banks hold 20% of deposits in reserve, making loans with
the rest.

 Firstbank will make Rs.800 in loans.

FIRSTBANKS balance sheet Assets Liabilities reserves deposits Rs.1000 reserves Rs.200 Rs.1000 loans Rs.800

The money supply now equals Rs.1800: The depositor still has Rs.1000 in demand deposits,

but now the borrower holds Rs.800 in currency.

SCENARIO 2: Fractional-Reserve Banking

Thus, in a fractional-reserve banking system, banks create money.

FIRSTBANKS balance sheet Assets Liabilities

reserves Rs.200 loans Rs.800 deposits Rs.1000

The money supply now equals Rs.1800: The depositor still has Rs.1000 in demand deposits,

but now the borrower holds Rs.800 in currency.

SCENARIO 2: Fractional-Reserve Banking

 Suppose the borrower deposits the Rs.800 in Secondbank.  Initially, Secondbank s balance sheet is:

SECONDBANKS balance sheet Assets Liabilities

reserves reserves loans loans Rs.160 Rs.800 Rs.640 Rs.0
deposits Rs.800

But then Secondbank will loan 80% of this deposit and its balance sheet will look like this:

SCENARIO 2: Fractional-Reserve Banking

 If this Rs.640 is eventually deposited in Thirdbank,  then Thirdbank will keep 20% of it in reserve, and loan the rest out:

THIRDBANKS balance sheet Assets Liabilities

reserves reserves loans loans Rs.128 Rs.640 Rs.512 Rs.0 deposits Rs.640

Finding the total amount of money:

+ + + + Original deposit Firstbank lending Secondbank lending Thirdbank lending other lending = Rs.1000 = Rs. 800 = Rs. 640 = Rs. 512

Total money supply = (1/rr ) v Rs.1000 where rr = ratio of reserves to deposits In our example, rr = 0.2, so M = Rs.5000

Money creation in the banking system

A fractional reserve banking system creates money, but it doesn t create wealth: bank loans give borrowers some new money and an equal amount of new debt.

A model of the money supply

exogenous variables
the monetary base, B = C + R controlled by the central bank C = Currency with Public R = Currency deposits fo Comm. Banks with RBI the reserve-deposit ratio, rr = R/D depends on regulations & bank policies the currency-deposit ratio, cr = C/D depends on households preferences

The H Theory of Money Supply

Currency with Public C Demand Deposits D

Currency with Public C

Cash Reserves R

B= C+R

The Money Multiplier

The supply of money is the multiples of cash reserves One rupee kept as bank reserves gives rise to much more amount of demand deposits The relation ship between Base money and money supply is determined by money multiplier(m) m=M/B Rearranging we have M = B.m

A model of the money supply

exogenous variables
the monetary base, B = C + R controlled by the central bank C = Currency with Public R = Currency deposits fo Comm. Banks with RBI the reserve-deposit ratio, rr = R/D depends on regulations & bank policies the currency-deposit ratio, cr = C/D depends on households preferences

Solving for the money supply:

C D M ! C D ! vB B

! m vB

C D m ! B

C D  D D ! cr  1 C D ! ! C R C D  R D cr  rr
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The money multiplier

M ! m vB, cr  1 where m ! cr  rr

If rr < 1, then m > 1 If monetary base changes by (B, then (M = m v (B m is called the money multiplier.

Money Supply

Rate of Interest

0 Money Supply

Money Demand
Y Md Rate of Interest i3 i2 i1 Md 0 M1 M2 M3 Quantity of Money X Two set economy 1.Currency in Hand + DD 2. Bonds If the interest rates are high high opportunity cost for holding cash bonds can earn higher returns than holding cash which does not pay any returns

Money Demand
Md2 Y Md1 Rate of Interest i3 i2 i1 Md1 0 M1 M2 M3 Quantity of Money X Md2 If the level of income increase the money demand curve will shift right

Money market Equilibrium

Money market is in equilibrium at a rate of interest when demand for money is equal to the fixed money supply MS = MD

Money Market Equilibrium

The amount of money demanded (held) depends on interest rates

Money supply

Excess money supply at a given interest rate people buys bonds raises bonds decreases interest rates Increases the quantity of money demanded will be equal to money supply and vice versa

Interest Rate

E3 9 7 5 E1 E2

M3 M1 M2 Quantity Of Money (Crores of Rupees)


If there is excess money supply at a given interest rate people buys bonds raises bonds decreases interest rates It increases the quantity of money demanded will be equal to money supply

Money Market Equilibrium

Money supply

Interest Rate

9 7

E2 E1

The amount of money demanded (held) depends on interest rates

M Quantity Of Money (Crores of Rupees)


Link between goods market and money market

Goods market Equilibrium Money market equilibrium IS LM Model

Goods market Equilibrium

Goods market Equilibrium

1. If interest rates decrease, Investments Increase and aggregate demand will increase Higher will be the equilibrium of national income 2. If the interest rates increases, investments will decrease , aggregate demand will decrease lower will be the equilibrium of national income 3. By joining points A, B & D we will get IS Curve 4. IS curve slopes downwards decrease in interest rates increases national Income and vise versa 5. IS curve may shift due government expenditure

Money Market Equilibrium

LM Curve
1. Is derived from Keynesian theory 2. Greater the level of income greater the money held for transaction motive, the money Demand curve will be higher 3. Money supply has to match the higher money demand 4. LM curve is derived by connecting intersections different money demand curves and money supply curves corresponding to different levels of income

Simultaneous equilibrium of Goods Market and money market

Point at which Goods market is in equilibrium and Money market is in equilibrium

IS-LM Curve
1. Investment demand function 2. Consumption function 3. Money demand function 4. Quantity of money Saving and investment, productivity of capital and propensity to consume and save, demand for money and supply of money all these factors determine the rate of interest and level of income. Changes in the factors will shift the equilibrium of IS-LM Curves

If supply of money is high, interest rates will fall, LM curve will shift right

In economics, inflation is a persistent rise in the general level of prices of goods and services in an economy over a period of time Inflation also reflects an erosion in the purchasing power of money a loss of real value A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

Negative effects - decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects - ensuring central banks can adjust nominal interest rates (intended to mitigate recessions),and encouraging investment in nonmonetary capital projects.

Inflation Price Inflation and Money inflation Excess money supply will lead to price inflation

Headline inflation is a measure of the total inflation within an economy and is affected by areas of the market which may experience sudden inflationary spikes such as food or energy Inflationary Spikes - sudden price rise in some commodities Hyperinflation is inflation that is very high or out of control. Hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth

Stagflation combination of stagnation and inflation Suppressed inflation govt. polices suppress inflation Disinflation keeping the inflation rates lower Deflation opposite to inflation prices fall persistently revenues for producers fall- low investments fall in demand fall in incomes An inflationary gap, in economics, is the amount by which the real Gross domestic product, or real GDP, exceeds potential GDP

Inflation rates around the world

Inflation rates in India

Causes of Inflation
The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply.

Keynesian view Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model Demand pull inflation Cost push inflation Built-in-inflation

Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion. increase in money supply increase in disposable income increase in aggregate spending increase in population of the country

Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Measuring Inflation
Generally the inflation is measured using price index Price index is a numerical measure that helps to compare prices of some class of goods and services between time periods Current years Price Price index = -----------------------------Base years Price

X 100

Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output consumer price index (CPI) measures changes in the price level of consumer goods and services purchased by households. Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. Some countries (like India and The Philippines) use WPI changes as a central measure of inflation.

Inflation rate
Inflation rate =

The percentage increase in the price of goods and services, usually annually.


Wage Price Spiral

Impact of inflation
Negatives Cost push Inflation wage spiral Hoarding Social unrests and revolts Hyperinflation Loss of allocative efficiency by producers Shoe leather costs more trips to banks Business cycles Positives Labor-market adjustments Room to maneuver to change interest rates Mundell-Tobin effect savers will be induced to lend portion of money reduces interest rates

Inflation and unemployment

An economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. According to the Phillips curve, the lower an economy's rate of unemployment, the more rapidly wages paid to labor increase in that economy. he theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

Philips Curve short Run

Philips Curve Long Run

Inflation Vs Unemployment Trade off