Monetary Policy

Monetary Policy

RBI and Monetary Policy in India

Monetary Magnitudes

•M₁ = Currency with public+ Demand deposits with banks+  Other Deposits with RBI

•M₂ = M₁+ Post Office Deposits

•M₃ = M₁+ Time Deposits with Banks

•M₄ = M₃+ Total Post Office Deposits

M1 and M2 are Narrow Money.

M3 and M4 are Broad Money.

Aggregate Monetary Resource  (AMR)

M3 is Moetary Base or AMR

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-to-year 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.(balance of payment)

•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.

Operation of Monetary Policy

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 bank’s required reserves and thus affect bank’s 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 seller’s bank, which in turn credits the seller’s deposit account in that bank.