Economics Assignment 2003

8/3/2019 Economics Assignment 2003

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Monetary Policy

Monetary policy is the process by which the monetary authority of acountry controls the supply of money, often targeting a rate of interest forthe purpose of promoting economic growth and stability. The official goals

usually include relatively stable prices and low unemployment. Monetarytheory provides insight into how to craft optimal monetary policy. It isreferred to as either being expansionary or contractionary, where anexpansionary policy increases the total supply of money in the economymore rapidly than usual, and contractionary policy expands the moneysupply more slowly than usual or even shrinks it. Expansionary policy istraditionally used to try to combat unemployment in a recession bylowering interest rates in the hope that easy credit will entice businessesinto expanding. Contractionary policy is intended to slow inflation in hopesof avoiding the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation,government spending, and associated borrowing.

Introduction

Monetary policy rests on the relationship between the rates of interest inan economy, that is, the price at which money can be borrowed, and thetotal supply of money. Monetary policy uses a variety of tools to controlone or both of these, to influence outcomes like economic growth,inflation, exchange rates with other currencies and unemployment. Wherecurrency is under a monopoly of issuance, or where there is a regulated

system of issuing currency through banks which are tied to a central bank,the monetary authority has the ability to alter the money supply and thusinfluence the interest rate (to achieve policy goals). The beginning ofmonetary policy as such comes from the late 19th century, where it wasused to maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the moneysupply or increases it only slowly, or if it raises the interest rate. Anexpansionary policy increases the size of the money supply more rapidly,or decreases the interest rate. Furthermore, monetary policies aredescribed as follows: accommodative, if the interest rate set by the

central monetary authority is intended to create economic growth;neutral, if it is intended neither to create growth nor combat inflation; ortight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends:increasing interest rates by fiat; reducing the monetary base; andincreasing reserve requirements. All have the effect of contracting themoney supply; and, if reversed, expand the money supply. Since the1970s, monetary policy has generally been formed separately from fiscalpolicy. Even prior to the 1970s, the Bretton Woods system still ensuredthat most nations would form the two policies separately.


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Within almost all modern nations, special institutions (such as the FederalReserve System in the United States, the Bank of England, the EuropeanCentral Bank, the People's Bank of China, and the Bank of Japan) existwhich have the task of executing the monetary policy and oftenindependently of the executive. In general, these institutions are called

central banks and often have other responsibilities such as supervisingthe smooth operation of the financial system.

The primary tool of monetary policy is open market operations. Thisentails managing the quantity of money in circulation through the buyingand selling of various financial instruments, such as treasury bills,company bonds, or foreign currencies. All of these purchases or salesresult in more or less base currency entering or leaving marketcirculation.

Usually, the short term goal of open market operations is to achieve a

specific short term interest rate target. In other instances, monetarypolicy might instead entail the targeting of a specific exchange raterelative to some foreign currency or else relative to gold. For example, inthe case of the USA the Federal Reserve targets the federal funds rate,the rate at which member banks lend to one another overnight; however,the monetary policy of China is to target the exchange rate between theChinese renminbi and a basket of foreign currencies.

The other primary means of conducting monetary policy include: (i)Discount window lending (lender of last resort); (ii) Fractional depositlending (changes in the reserve requirement); (iii) Moral suasion (cajoling

certain market players to achieve specified outcomes); (iv) "Open mouthoperations" (talking monetary policy with the market).

Theory

Monetary policy is the process by which the government, central bank, ormonetary authority of a country controls (i) the supply of money, (ii)availability of money, and (iii) cost of money or rate of interest to attain aset of objectives oriented towards the growth and stability of theeconomy. Monetary theory provides insight into how to craft optimalmonetary policy.

Monetary policy rests on the relationship between the rates of interest inan economy, that is the price at which money can be borrowed, and thetotal supply of money. Monetary policy uses a variety of tools to controlone or both of these, to influence outcomes like economic growth,inflation, exchange rates with other currencies and unemployment. Wherecurrency is under a monopoly of issuance, or where there is a regulatedsystem of issuing currency through banks which are tied to a central bank,the monetary authority has the ability to alter the money supply and thusinfluence the interest rate (to achieve policy goals).

It is important for policymakers to make credible announcements. Ifprivate agents (consumers and firms) believe that policymakers are


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committed to lowering inflation, they will anticipate future prices to belower than otherwise (how those expectations are formed is an entirelydifferent matter; compare for instance rational expectations with adaptiveexpectations). If an employee expects prices to be high in the future, heor she will draw up a wage contract with a high wage to match these

prices.[citation needed] Hence, the expectation of lower wages isreflected in wage-setting behavior between employees and employers(lower wages since prices are expected to be lower) and since wages arein fact lower there is no demand pull inflation because employees arereceiving a smaller wage and there is no cost push inflation becauseemployers are paying out less in wages.

To achieve this low level of inflation, policymakers must have credibleannouncements; that is, private agents must believe that theseannouncements will reflect actual future policy. If an announcement aboutlow-level inflation targets is made but not believed by private agents,

wage-setting will anticipate high-level inflation and so wages will behigher and inflation will rise. A high wage will increase a consumer'sdemand (demand pull inflation) and a firm's costs (cost push inflation), soinflation rises. Hence, if a policymaker's announcements regardingmonetary policy are not credible, policy will not have the desired effect.

If policymakers believe that private agents anticipate low inflation, theyhave an incentive to adopt an expansionist monetary policy (where themarginal benefit of increasing economic output outweighs the marginalcost of inflation); however, assuming private agents have rationalexpectations, they know that policymakers have this incentive. Hence,

private agents know that if they anticipate low inflation, an expansionistpolicy will be adopted that causes a rise in inflation. Consequently, (unlesspolicymakers can make their announcement of low inflation credible),private agents expect high inflation. This anticipation is fulfilled throughadaptive expectation (wage-setting behavior); so, there is higher inflation(without the benefit of increased output). Hence, unless credibleannouncements can be made, expansionary monetary policy will fail.

Announcements can be made credible in various ways. One is to establishan independent central bank with low inflation targets (but no outputtargets). Hence, private agents know that inflation will be low because it isset by an independent body. Central banks can be given incentives tomeet targets (for example, larger budgets, a wage bonus for the head ofthe bank) to increase their reputation and signal a strong commitment toa policy goal. Reputation is an important element in monetary policyimplementation. But the idea of reputation should not be confused withcommitment.

While a central bank might have a favorable reputation due to goodperformance in conducting monetary policy, the same central bank mightnot have chosen any particular form of commitment (such as targeting acertain range for inflation). Reputation plays a crucial role in determininghow much markets would believe the announcement of a particular


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commitment to a policy goal but both concepts should not be assimilated.Also, note that under rational expectations, it is not necessary for thepolicymaker to have established its reputation through past policy actions;as an example, the reputation of the head of the central bank might bederived entirely from his or her ideology, professional background, public

statements, etc.

In fact it has been argued that to prevent some pathologies related to thetime inconsistency of monetary policy implementation (in particularexcessive inflation), the head of a central bank should have a largerdistaste for inflation than the rest of the economy on average. Hence thereputation of a particular central bank is not necessary tied to pastperformance, but rather to particular institutional arrangements that themarkets can use to form inflation expectations.

Despite the frequent discussion of credibility as it relates to monetary

policy, the exact meaning of credibility is rarely defined. Such lack ofclarity can serve to lead policy away from what is believed to be the mostbeneficial. For example, capability to serve the public interest is onedefinition of credibility often associated with central banks. The reliabilitywith which a central bank keeps its promises is also a common definition.While everyone most likely agrees a central bank should not lie to thepublic, wide disagreement exists on how a central bank can best serve thepublic interest. Therefore, lack of definition can lead people to believethey are supporting one particular policy of credibility when they arereally supporting another.

Types of monetary policy

In practice, to implement any type of monetary policy the main tool usedis modifying the amount of base money in circulation. The monetaryauthority does this by buying or selling financial assets (usuallygovernment obligations). These open market operations change either theamount of money or its liquidity (if less liquid forms of money are boughtor sold). The multiplier effect of fractional reserve banking amplifies theeffects of these actions.

Constant market transactions by the monetary authority modify the

supply of currency and this impacts other market variables such as shortterm interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarilywith the set of instruments and target variables that are used by themonetary authority to achieve their goals.

Monetary Policy Target MarketVariable

Long Term Objective

Inflation Targeting Interest rate onovernight debt

A given rate of changein the CPI

Price LevelTargeting Interest rate onovernight debt A specific CPI number


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Monetary Aggregates The growth in moneysupply

A given rate of changein the CPI

Fixed Exchange Rate The spot price of thecurrency

The spot price of thecurrency

Gold Standard The spot price of gold Low inflation as

measured by the goldprice

Mixed Policy Usually interest rates Usually unemployment +CPI change

The different types of policy are also called monetary regimes, in parallelto exchange rate regimes. A fixed exchange rate is also an exchange rateregime; The Gold standard results in a relatively fixed regime towards thecurrency of other countries on the gold standard and a floating regimetowards those that are not. Targeting inflation, the price level or other

monetary aggregates implies floating exchange rate unless themanagement of the relevant foreign currencies is tracking exactly thesame variables (such as a harmonized consumer price index).

1.) Inflation targeting

Under this policy approach the target is to keep inflation, under aparticular definition such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to theCentral Bank interest rate target. The interest rate used is generally theinterbank rate at which banks lend to each other overnight for cash flowpurposes. Depending on the country this particular interest rate might becalled the cash rate or something similar.

The interest rate target is maintained for a specific duration using openmarket operations. Typically the duration that the interest rate target iskept constant will vary between months and years. This interest ratetarget is usually reviewed on a monthly or quarterly basis by a policycommittee.

Changes to the interest rate target are made in response to variousmarket indicators in an attempt to forecast economic trends and in so

doing keep the market on track towards achieving the defined inflationtarget. For example, one simple method of inflation targeting called theTaylor rule adjusts the interest rate in response to changes in the inflationrate and the output gap. The rule was proposed by John B. Taylor ofStanford University.

2.) Price level targeting

Price level targeting is similar to inflation targeting except that CPI growthin one year over or under the long term price level target is offset insubsequent years such that a targeted price-level is reached over time,

e.g. five years, giving more certainty about future price increases toconsumers. Under inflation targeting what happened in the immediate


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past years is not taken into account or adjusted for in the current andfuture years.

3.) Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreigncurrency. There are varying degrees of fixed exchange rates, which canbe ranked in relation to how rigid the fixed exchange rate is with theanchor nation.

Under a system of fiat fixed rates, the local government or monetaryauthority declares a fixed exchange rate but does not actively buy or sellcurrency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.).In this case there is a black market exchange rate where the currencytrades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by thecentral bank or monetary authority on a daily basis to achieve the targetexchange rate. This target rate may be a fixed level or a fixed band withinwhich the exchange rate may fluctuate until the monetary authorityintervenes to buy or sell as necessary to maintain the exchange ratewithin the band. (In this case, the fixed exchange rate with a fixed levelcan be seen as a special case of the fixed exchange rate with bandswhere the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency boardevery unit of local currency must be backed by a unit of foreign currency(correcting for the exchange rate). This ensures that the local monetarybase does not inflate without being backed by hard currency andeliminates any worries about a run on the local currency by those wishingto convert the local currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence theterm "dollarization") is used freely as the medium of exchange eitherexclusively or in parallel with local currency. This outcome can comeabout because the local population has lost all faith in the local currency,or it may also be a policy of the government (usually to rein in inflationand import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetaryauthority or government as monetary policy in the pegging nation mustalign with monetary policy in the anchor nation to maintain the exchangerate. The degree to which local monetary policy becomes dependent onthe anchor nation depends on factors such as capital mobility, openness,credit channels and other economic factors.

4.) Gold standard

The gold standard is a system under which the price of the national

currency is measured in units of gold bars and is kept constant by thegovernment's promise to buy or sell gold at a fixed price in terms of the


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base currency. The gold standard might be regarded as a special case of"fixed exchange rate" policy, or as a special type of commodity price leveltargeting.

The minimal gold standard would be a long-term commitment to tighten

monetary policy enough to prevent the price of gold from permanentlyrising above parity. A full gold standard would be a commitment to sellunlimited amounts of gold at parity and maintain a reserve of goldsufficient to redeem the entire monetary base.

Today this type of monetary policy is no longer used by any country,although the gold standard was widely used across the world between themid-19th century through 1971. Its major advantages were simplicity andtransparency. The gold standard was abandoned during the GreatDepression, as countries sought to reinvigorate their economies byincreasing their money supply. The Bretton Woods system, which was a

modified gold standard, replaced it in the aftermath of World War II.However, this system too broke down during the Nixon shock of 1971.

The gold standard induces deflation, as the economy usually grows fasterthan the supply of gold. When an economy grows faster than its moneysupply, the same amount of money is used to execute a larger number oftransactions. The only way to make this possible is to lower the nominalcost of each transaction, which means that prices of goods and servicesfall, and each unit of money increases in value. Absent precautionarymeasures, deflation would tend to increase the ratio of the real value ofnominal debts to physical assets over time. For example, during deflation,

nominal debt and the monthly nominal cost of a fixed-rate homemortgage stays the same, even while the dollar value of the house falls,and the value of the dollars required to pay the mortgage goes up.Mainstream economics considers such deflation to be a majordisadvantage of the gold standard. Unsustainable (i.e. excessive) deflationcan cause problems during recessions and financial crisis lengthening theamount of time an economy spends in recession. William Jennings Bryanrose to national prominence when he built his historic (thoughunsuccessful) 1896 presidential campaign around the argument thatdeflation caused by the gold standard made it harder for everydaycitizens to start new businesses, expand their farms, or build new homes.

Monetary Policy tools

1.) Monetary base

Monetary policy can be implemented by changing the size of themonetary base. Central banks use open market operations to change themonetary base. The central bank buys or sells reserve assets (usuallyfinancial instruments such as bonds) in exchange for money on deposit atthe central bank. Those deposits are convertible to currency. Togethersuch currency and deposits constitute the monetary base which is the

general liabilities of the central bank in its own monetary unit. Usually


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other banks can use base money as a fractional reserve and expand thecirculating money supply by a larger amount.

2.) Reserve requirements

The monetary authority exerts regulatory control over banks. Monetarypolicy can be implemented by changing the proportion of total assets thatbanks must hold in reserve with the central bank. Banks only maintain asmall portion of their assets as cash available for immediate withdrawal;the rest is invested in illiquid assets like mortgages and loans. Bychanging the proportion of total assets to be held as liquid cash, theFederal Reserve changes the availability of loanable funds. This acts as achange in the money supply. Central banks typically do not change thereserve requirements often because it creates very volatile changes in themoney supply due to the lending multiplier.

3.) Discount window lendingDiscount window lending is where the commercial banks, and otherdepository institutions, are able to borrow reserves from the Central Bankat a discount rate. This rate is usually set below short term market rates(T-bills). This enables the institutions to vary credit conditions (i.e., theamount of money they have to loan out), thereby affecting the moneysupply. It is of note that the Discount Window is the only instrument whichthe Central Banks do not have total control over.

By affecting the money supply, it is theorized, that monetary policy canestablish ranges for inflation, unemployment, interest rates ,and economicgrowth. A stable financial environment is created in which savings andinvestment can occur, allowing for the growth of the economy as a whole.

4.) Interest rates

The contraction of the monetary supply can be achieved indirectly byincreasing the nominal interest rates. Monetary authorities in differentnations have differing levels of control of economy-wide interest rates. Inthe United States, the Federal Reserve can set the discount rate, as wellas achieve the desired Federal funds rate by open market operations. Thisrate has significant effect on other market interest rates, but there is no

perfect relationship. In the United States open market operations are arelatively small part of the total volume in the bond market. One cannotset independent targets for both the monetary base and the interest ratebecause they are both modified by a single tool open marketoperations; one must choose which one to control.

In other nations, the monetary authority may be able to mandate specificinterest rates on loans, savings accounts or other financial assets. Byraising the interest rate(s) under its control, a monetary authority cancontract the money supply, because higher interest rates encouragesavings and discourage borrowing. Both of these effects reduce the size of

the money supply.


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5.) Currency board

A currency board is a monetary arrangement that pegs the monetary baseof one country to another, the anchor nation. As such, it essentiallyoperates as a hard fixed exchange rate, whereby local currency incirculation is backed by foreign currency from the anchor nation at a fixedrate. Thus, to grow the local monetary base an equivalent amount offoreign currency must be held in reserves with the currency board. Thislimits the possibility for the local monetary authority to inflate or pursueother objectives. The principal rationales behind a currency board arethreefold:

To import monetary credibility of the anchor nation;

To maintain a fixed exchange rate with the anchor nation;

To establish credibility with the exchange rate (the currency boardarrangement is the hardest form of fixed exchange rates outside ofdollarization).

In theory, it is possible that a country may peg the local currency to morethan one foreign currency; although, in practice this has never happened(and it would be a more complicated to run than a simple single-currencycurrency board). A gold standard is a special case of a currency board

where the value of the national currency is linked to the value of goldinstead of a foreign currency.

The currency board in question will no longer issue fiat money but insteadwill only issue a set number of units of local currency for each unit offoreign currency it has in its vault. The surplus on the balance ofpayments of that country is reflected by higher deposits local banks holdat the central bank as well as (initially) higher deposits of the (net)exporting firms at their local banks. The growth of the domestic moneysupply can now be coupled to the additional deposits of the banks at thecentral bank that equals additional hard foreign exchange reserves in the

hands of the central bank. The virtue of this system is that questions ofcurrency stability no longer apply. The drawbacks are that the country nolonger has the ability to set monetary policy according to other domesticconsiderations, and that the fixed exchange rate will, to a large extent,also fix a country's terms of trade, irrespective of economic differencesbetween it and its trading partners.

Hong Kong operates a currency board, as does Bulgaria. Estoniaestablished a currency board pegged to the Deutschmark in 1992 aftergaining independence, and this policy is seen as a mainstay of thatcountry's subsequent economic success (see Economy of Estonia for a

detailed description of the Estonian currency board). Argentinaabandoned its currency board in January 2002 after a severe recession.


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This emphasized the fact that currency boards are not irrevocable, andhence may be abandoned in the face of speculation by foreign exchangetraders. Following the signing of the Dayton Peace Agreement in 1995,Bosnia and Herzegovina established a currency board pegged to theDeutschmark (since 2002 replaced by the Euro).

Currency boards have advantages for small, open economies that wouldfind independent monetary policy difficult to sustain. They can also form acredible commitment to low inflation.

6.) Unconventional monetary policy at the zero bound

Other forms of monetary policy, particularly used when interest rates are

at or near 0% and there are concerns about deflation or deflation isoccurring, are referred to as unconventional monetary policy. Theseinclude credit easing, quantitative easing, and signaling. In credit easing,a central bank purchases private sector assets, in order to improveliquidity and improve access to credit. Signaling can be used to lowermarket expectations for future interest rates. For example, during thecredit crisis of 2008, the US Federal Reserve indicated rates would be lowfor an extended period, and the Bank of Canada made a conditionalcommitment to keep rates at the lower bound of 25 basis points (0.25%)until the end of the second quarter of 2010.

Evolution of monetary policy framework in India

In India also, monetary policy framework has undergone significanttransformation over time. In the 1960s, as inflation was considered to bestructural and inflation volatility was mainly caused by agriculturalfailures, there was greater reliance on selective credit controls. The aimwas to regulate bank advances to sensitive commodities to influenceproduction outlays, on the one hand and to limit possibilities ofspeculation, on the other. In the 1970s, there was a surge in inflation onaccount of monetary expansion induced by expansionary fiscal policiesbesides the oil price shocks. By the early 1980s, there was a broad

agreement on the primary causes of inflation. It was argued that whilefluctuations in agricultural prices and oil price shocks did affect prices,sustained inflation since the early 1960s could not have occurred unless itwas supported by the continuous excessive monetary expansiongenerated by the large-scale monetisation of the fiscal deficit.

Against the backdrop, the Committee to Review the Working of theMonetary System (Chairman: Prof. Sukhamoy Chakravarty; 1985), set upby the Reserve Bank, recommended a monetary targeting framework totarget an acceptable order of inflation in line with desired output growth.It also recommended for limiting monetary expansion through the process

of monetisation of fiscal deficit by an agreement between the ReserveBank and the Government. With empirical evidence supporting reasonable


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stability in the demand function for money, broad money formallyemerged as an intermediate target. Under this approach, a monetaryprojection is made consistent with the expected real GDP growth and atolerable level of inflation. The framework was, however, a flexible oneallowing for various feedback effects. Moreover, money supply target was

relatively well understood by the public at large.

With the pace of trade and financial liberalization gaining momentumfollowing the initiation of structural reforms in the early 1990s, theefficacy of broad money as an intermediate target of monetary policycame under question. The Reserve Banks Monetary and Credit Policy forthe First Half of 199899 observed that financial innovations emerging inthe economy provided some evidence that the dominant effect on thedemand for money in the near future need not necessarily be real income,as in the past.

Since the mid-1990s, apart from dealing with the usual supply shocks,monetary policy had to increasingly contend with external shocksemanating from swings in capital flows, volatility in the exchange rate andglobal business cycles. Subsequently, increase in liquidity emanating fromcapital inflows raised the ratio of net foreign assets (NFA) to ReserveMoney (Chart 1). This rendered the control of monetary aggregates moredifficult. Consequently, there was also increasing evidence of changes inthe underlying transmission mechanism of monetary policy with interestrate and the exchange rate gaining importance vis--vis quantityvariables. Bank credit to private sector as a per cent of GDP also startedrising, though it still remains low as compared to advanced economies

and many EMEs underscoring the potential for greater credit penetration(Table 1). These developments necessitated refinements in the conduct ofmonetary policy.

Chart 1: Financial Development and Money Multiplier


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Table 1: Domestic Credit to Private Sector


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Against this backdrop, the Reserve Bank formally adopted a multipleindicators approach in April 1998 with a greater emphasis on ratechannels for monetary policy formulation. As a part of this approach,information content from a host of quantity variables such as money,credit, output, trade, capital flows and fiscal position as well as from ratevariables such as rates of return in different markets, inflation rate andexchange rate are analyzed for drawing monetary policy perspectives.The multiple-indicators approach, as conceptualised when Dr. Bimal Jalanwas the Governor, continued to evolve and was augmented by forward

looking indicators and a panel of parsimonious time series models. Theforward looking indicators are drawn from the Reserve Banks industrialoutlook survey, capacity utilization survey, professional forecasterssurvey and inflation expectations survey9. The assessment from theseindicators and models feed into the projection of growth and inflation.Simultaneously, the Reserve Bank also gives the projection for broadmoney, which serves as an important information variable, so as to makethe resource balance in the economy consistent with the credit needs ofthe government and the private sector. Thus, the current framework ofmonetary policy can be termed as an augmented multiple indicatorsapproach as illustrated below (Exhibit 1).


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Exhibit 1: Augmented Multiple Indicator Approach

This large panel of indicators is at times criticised as a check listapproach, as it does not provide for a clearly defined nominal anchor formonetary policy. However, given the level of financial marketdevelopment, the evolving nature of monetary transmission and the needto maintain the resource balance between the government and theprivate sector, monetary policy assessment becomes inherently complex.

Globally, it is now recognised that the task of monetary management hasbecome more challenging. In view of central banks operating in anenvironment of high uncertainty regarding the functioning of the economyas well as its prevailing state and future developments, a single model ora limited set of indicators may not be a sufficient guide for monetary

policy. Instead, an encompassing and integrated set of data is required.This reinforces the usefulness of monitoring a number of macroeconomicindicators in the conduct of monetary policy. In the context of the recentcrisis, it is argued that monitoring money and credit may helppolicymakers interpret asset market developments and draw implicationsfrom them for the economic and financial outlook. There is a need to raiseawareness in the central banking community of the importance ofmonetary analysis and its implications, both for economies individuallyand globally. Thus, there is now increasing support for a broad-basedapproach to monetary policy.

Experience with monetary targeting approach


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Despite the adoption of formal monetary targeting, no specific moneytargets were set during the period 198590 except for fixing a ceilinglinked to average growth of broad money in previous year(s). This wasbecause there continued to be large overhang of excess liquidity due toprimary money creation. The biggest impediment to explicit monetary

targeting was the fact that the Reserve Bank had no controls over itscredit to the central government, which accounted for the bulk of thecreation of reserve money. The Reserve Bank could at best set limits onthe secondary expansion of money through instruments such as cashreserve ratio (CRR), statutory liquidity ratio (SLR) and selective creditcontrols. As a result, CRR reached its prescribed ceiling of 15 per cent ofnet demand and time liabilities (NDTL) of banks in July 1989 and the SLRreached the peak of 38.5 per cent in September 1990. Despite thesemeasures, however, money supply growth remained high, whichcontributed to inflation. The setting of monetary targets and actualachievements during the monetary targeting period is presented below inTable 2.


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The process of financial liberalization and deregulation of interest ratesintroduced since the early 1990s enhanced the role of market forces inthe determination of interest rates and the exchange rate. Accordingly,the Reserve Bank placed greater emphasis on the money market as thefocal point for the conduct of monetary policy and for fostering itsintegration with other market segments. Following the NarsimhamCommittee (1998) recommendations, the Reserve Bank introduced theliquidity adjustment facility (LAF) in June 2000 to manage market liquidityon a daily basis and also to transmit interest rate signals to the market.

Collateralized borrowing and lending operations (CBLO) was introduced asa new money market instrument in January 2003. The call money market


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was transformed into a pure inter-bank market by August 2005 in aphased manner.

As a result, the money market developed significantly over the years asreflected in increased turnover in various market segments (Table 3).

Along with developing money markets, the Reserve Bank has alsoundertaken various measures to develop the government securities andforeign exchange market, increasing the depth of the financial markets(Chart 2).


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All these reforms have also led to improvements in liquidity managementoperations by the Reserve Bank as reflected in general containment of callrates within the LAF corridor except occasional volatility. Apart fromimparting stability in call money rates, this has also resulted in greatermarket integration as reflected in close co-movement of rates in various

segments of the money market (Chart 3). The rule-based fiscal policypursued under the Financial Responsibility and Budget Management(FRBM) Act, by easing fiscal dominance, contributed to overallimprovement in monetary management.


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During the recent period, the issue of managing large and persistentcapital inflows in excess of the absorptive capacity of the economy addedanother dimension to the liquidity management operations. Initially, theliquidity impact of large capital inflows were sterilised through openmarket operation (OMO) sales and LAF operations. Given the finite stock

ofgovernment securities in the Reserve Banks portfolio and the legalrestrictions on issuance of its own paper, additional instruments otherthan LAF were needed to contain liquidity of a more enduring nature. Thisled to the introduction of the market stabilisation scheme (MSS) in April2004. Under this scheme, short term government securities were issuedbut the amount remained impounded in the Reserve Banks balance sheetfor sterilisation purposes. Interestingly, in the face of reversal of capitalflows during the recent crisis, unwinding of such sterilised liquidity underthe MSS helped to ease liquidity conditions (Chart 4).

The efficient conduct of monetary policy is judged ultimately in terms ofits ability to stabilise real economic activity and inflation and also ensuringfinancial stability consistent with the policy objectives. An assessment ofthe multiple indicators approach for the period 199899 to 200809reveals that actual outcome of GDP growth has been generally higherthan the projections indicated in the monetary policy statements, while ithas generally been lower in case of inflation (Table 4).


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Overall Scenario

The monetary policy framework in India has undergone significant shiftsfrom a monetary targeting regime to a multiple indicators regime. Such atransition was conditioned by the developments of financial markets,increasing integration of the Indian economy with the global economy andchanging transmission of monetary policy. The multiple indicatorsapproach, conceptualized in 1998, has since been augmented by forward

looking indicators from surveys and a panel of time series models.Moreover, the multiple indicators approach continues to evolve. Thoughthe multiple indicators approach is subject to criticism for the absence of aclearly defined anchor, in the wake of the recent global financial crisisthere is recognition of the usefulness of a broad indicators-basedassessment of monetary policy.

On the basis of the above assessment, I will give a comparison of therelative performance of the monetary regimes in terms of keymacroeconomic variables over three periods: (i) the decade preceding the

monetary targeting period (197685); (ii) monetary targeting period(198698) and (iii) multiple indicators period so far (19992009) (Table 5).


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28. From this overall assessment, the following broad conclusions can bedrawn.

1.) First, real GDP growth, on an average, has improved successivelyfrom 4.6 per cent in the decade prior to the monetary targetingperiod to 5.5 per cent in the monetary targeting period and furtherto 7.1 per cent in the multiple indicators period. Not only growth hasimproved but it has become more stable under the multipleindicators approach.

2.) Second, headline WPI inflation, on an average, increased during themonetary targeting regime alongside significant increase in fiscaldeficit, although there was a reduction in volatility in inflation13.Under the multiple indicators approach, both WPI and CPI inflationfell significantly. The fall in inflation was accompanied by substantialreduction in fiscal deficit. This underscores the importance of fiscalconsolidation to sustain higher levels of growth with price stability.

3.) Third, while the volatility of WPI inflation reduced during the multipleindicators period, it increased for CPI inflation reflecting higher


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volatility in food prices. This underlines the importance of supplymanagement and a greater focus on agricultural development tocontain food price inflation.

4.) Fourth, money supply (M3) growth declined over the regimesthough volatility of M3 increased slightly during the multipleindicators regime reflecting emerging importance of interest rate inmonetary transmission. The shift in operating objective to stabiliseovernight interest rate so that it transmits through the termstructure is reflected in a discernible reduction in the overnightinterest rate with lower volatility.

5.) Fifth, exchange rate, on an average, has depreciated successivelyboth in nominal and real terms. However, it has become more stableduring the multiple indicators approach than the monetary targeting

regime. This could be partly attributed to accumulation of reservesand management of exchange rate to contain volatility.

6.) Sixth, the improved performance of monetary policy was facilitatedby supportive fiscal policy discontinuation of the practice ofautomatic monetisation and rule-based deficit reduction programmeunder the Fiscal Responsibility and Budget Management (FRBM) Act which enhanced instrument independence of the Reserve Bank.

7.) Finally, the recent overall improvement in macroeconomic

performance cannot be ascribed to monetary policy alone. Apartfrom a rule-based fiscal policy, productivity enhancing structuralreforms, sharp increase in saving and investment, increasingintegration with the global economy, a low global inflationenvironment and the unleashing of the entrepreneurial spirit of theprivate sector played an important role.

Economics Assignment 2003

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Transcript of Economics Assignment 2003