Art and Science of Central Banking and Monetary Policy

Sarat Dhal

Monetary Policy Transmission Mechanism

Objective

Targets Instruments

Monetary Policy Transmission Mechanism

economic assessment

Fiscal Policy coordination

Objective

Instruments

Policy Instrument Repo / CRR

Financial Market

• Market interest rates • Credit • Asset prices • Exchange rate • Confidence / expectation

Aggregate demand • Domestic demand

(consumption, investment) • External demand

(export/import

Output / employment

Inflation

Central Bank Objective- generalised perspectives

• Monetary stability or Price stability

– low, moderate inflation

• Economic stability: – rapid and sustained economic

growth/progress

– potential growth / full capacity output

• Full employment

– low unemployment

• Stable exchange rate – sustainable and stable

external sector – CAD must be financed by

non-debt, non-volatile capital flows

• Financial stability (latest entry) – Nobody knows what it is? – Operationally, sound, stable

and efficient banks and financial institutions, and markets

– Debate: trade-off between financial stability, growth and inflation

MP Objectives

• Many advanced central banks focus on – single objective: price or monetary

stability; – Some have legal mandate (Bank of

England has legislative mandate to keep inflation low around 2 per cent)

• United States: Fed has dual

mandate: price stability and low unemployment; no legal mandate for price stability or growth.

• Developing and emerging economies (India): – multiple objectives and instruments

Single Objective: Monetary (Price) stability

• Inflation is a monetary phenomenon;

• Monetary instruments can have control over nominal indicators;

• Neutrality of money and policy: no real effects

• Single objective and single instrument-effective operational framework;

• Feasible and Realistic for MP to target Price stability.

• Comparative advantage of MP to inflation than real growth

• Rule bound policy and Predictable outcome

• No long-run relationship between inflation and unemployment or growth

• Short-run trade-off: uncertainty and dangerous

• Clarity, Transparency

• Boost Credibility, accountability and avoid time inconsistency problem

• Independence from political authorities

• Financial stability : Inflation risk premium low, interest rate volatility low

• Economic stability : promote investment and ensure economic stability

Single Objective: demerits

• Inflation ‘nutter’

• Very Low inflation-MP instrument may not work

• Inflexibility of MP

• Ignore unforeseen events

Central bank objective

“Focusing on a single objective—low and stable inflation—is ultimately the best way that monetary policy can promote macroeconomic and financial stability. This does not mean sacrificing or ignoring growth. Indeed, well-anchored inflationary expectations may well be the best tonic that monetary policy can provide for growth. Contrary to what some commentators seem to believe, there is no long-run trade-off between growth and inflation, and for monetary policy to try and engineer a short-run trade-off can be dangerous. In short, the inflation objective would in fact make monetary policy more effective and strengthen RBI’s hands rather than pinning them down.”

(Raghuram Rajan, Mint, Aug 07 2013)

Monetary Policy Instruments

• Direct instrument – Cash reserve requirement,

– SLR

• Indirect instruments – Interest rate

– Exchange rate

– Financial sector regulation

– Prudential regulation / structural measures

– Moral suasion

Direct instrument: CRR 𝐾 + 𝐷 = 𝐿 + 𝐺 + 𝑅

𝑅 = 𝜃𝐷 𝐺 = 𝑠𝐷

𝐾 + 𝐷 = 𝐿 + 𝑠𝐷 + 𝑎𝐷 𝐿 = 1 − 𝑠 − 𝑎 𝐷 + 𝐾 𝐿 = 1 − 𝑠 − 𝑎 𝐷 + 𝑘𝐿

𝐿 = 1 − 𝑠 − 𝑎 𝐷/(1 − 𝑘∗ − 𝑑𝑘) Higher the regulatory requirement through 𝒔, 𝜽, lower is the loan supply by banks. Regulatory requirements directly interfere with banks’ balance sheet management. Since balance sheet affected, it can shown that regulatory requirements can affect banks’ deposits and loan interest rates and profitability.

Liabilities Assets

Capital (K) Loans and advances (L)

Deposits (D) Investment (G)

Others (O) Bank Reserves (R)

Total Liabilities

Total Assets

Indirect instrument: Interest rate

• Policy rate (repo rate): central banks do not fund private sector. They provide short-term liquidity to banks in case of their balance sheet mismatch. It is only when banks borrow from the central bank that their balance sheet is affected by cost of borrowing.

• Because of temporary funding, borrowing from the central bank is not major source of funds for commercial banks. The cost of borrowing may not account for a major share of total cost. Therefore, even if central bank increases its policy rate, banks do not respond by way of deposit and loan interest rate revisions.

Indirect Instrument: Role of Financial Markets’ Integration

• Policy rate short-end of the financial markets (money market including interbank and treasury bills, commercial paper, certificates of deposits)

• Medium-longer segments affected through

–TERM STRUCTURE OF FINANCIAL MARKETS

Monetary Policy Operating Framework

• Monetary policy instruments cannot have direct connect with ultimate objectives (inflation, growth, unemployment)

• Connect through intermediate targets:

– Monetary indicators

– Money supply, bank credit, interest rates, exchange rate, asset prices

MP Intermediate targets

• Price stability: – Inflation rate around threshold level, core inflation

• Stability in money and gilt market – Interbank money market bound by repo rate

• Adequate flow of credit to producing sectors for stimulating investment – Growth rate of monetary aggregate, Bank credit growth

• Appropriate deposit and loan interest rates • Stability in financial markets (money, credit, treasury

bonds, foreign exchange)

Intermediate Targeting

• Targeting monetary aggregates and bank credit through direct instruments (CRR)

• Targeting money market interest rates through indirect instruments, mainly, short-term policy interest rate (repo/reverse repo)

• Both money, credit and interests rates

Intermediate Targeting of Money and Credit Aggregates

• Money Supply = Money Demand

• Money Market Equilibrium

• All genuine demand for money and credit requirements for productive purpose are fulfilled without consequences for inflation

What is money

• Money is what money does – (Walker, Francis Amasa, 1879, Money

in its relations to trade and industry, Henry Holt and Company, New York).

• Anything that is generally acceptable as a means of exchange and which at the same time acts as a measure and store of value

– (G Crowther, 1940, An Outline of Money, Thomas Nelson and Sons Ltd, London)

What is Money?

• Coins – (Issued by Government of

India)

• Paper money: • Bank notes Reserve Bank of

India(5, 10, 20, 50, 100, 500, 1000)

– Government of India issues 1 Rs notes (signature of finance secretary).

• Bank deposits (chequable)

• Post office savings

Money functions • Medium of exchange

– Overcomes the inefficiency of barter system; coincidence of wants

• Unit of account (common measure of value) – Divisible, fungible, countable

(verifiable)

• Standard of value (deferred payment) – Settle debt

• Store of value – Saving; stable value, purchasing

power

MUSS / SUMS

Motives for Holding Money

• Transaction demand (unit of account, medium of exchange)

• Precautionary demand (contingent needs, insurance against risk)

• Speculative demand (Store of value, wealth)

Stock of assets

Used for transactions

A type of wealth

As a medium of exchange, money is used to buy goods and services. The ease at which an asset can be converted into a medium of exchange and used to buy other things is sometimes called an asset’s liquidity. Money is the economy’s most liquid asset.

Monetary indicators

• Base Money Reserve Money / Fiat Money

• Narrow Money:

• 𝑀1 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 +𝐷𝑒𝑚𝑎𝑛𝑑 𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑠

• Transaction Purpose

• Broad Money:

• 𝑀3 = 𝐶𝑈𝑅 + 𝐷𝐷 + 𝑇𝐷

• TD: interest earning

• Transaction as well as speculative

Money Supply Process

For all countries money supply is managed by central banks. In India, it is Reserve Bank of India.

Why do not they print enough money so that people can be rich?

How does RBI decides money supply?

Money Supply process

• Imagine you are placed in an isolated Island with a truck load of money. What good money will do to you since you cannot buy goods not available in the Island.

• Too much money chasing too few goods. Increasing money supply without a matching increase in production can lead to inflation.

Money Supply Process: Base Money Hypothesis

Base Money Hypothesis: 𝐻 = 𝐶 + 𝑅 𝑀 = 𝐶 + 𝐷

Money multiplier:

𝑚 =𝑀

𝐻=

𝐶 + 𝐷

𝐶 + 𝑅

Let us have: 𝐶 = 𝑐𝐷 𝑅 = 𝑟𝐷

𝑚 =𝑐𝐷 + 𝐷

𝑐𝐷 + 𝑟𝐷 =

1 + 𝑐

𝑐 + 𝑟

𝜕𝑚

𝜕𝑐< 0,

𝜕𝑚

𝜕𝑟< 0

• H: Reserve/Base Money • M: Broad Money Aggregate • C: Currency with the public • R: banks’ reserves (deposits of banks

held with the central bank due to reserve requirement)

• Aggregate Deposits (demand, saving and time deposits) held with banks

• 𝑐: 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑡𝑜 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑟𝑎𝑡𝑖𝑜

• 𝑟: 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 (𝐶𝑅𝑅) • CRR: fraction of net demand and

time liabilities of banks required to be held with RBI

• m: money multiplier; ratio of Broad money supply to reserve money

Money Multiplier

𝑚 =1 + 𝑐

𝑐 + 𝑟

𝜕𝑚

𝜕𝑐< 0,

𝜕𝑚

𝜕𝑟< 0

Notation: c and r not for consumption propensity and interest rate

• Higher currency-deposit ratio (c) for given reserve requirement (r) will lead to a lower money multiplier and money supply.

• Higher reserve requirement, for a given currency-deposit ratio, leads to lower money multiplier and money supply.

Money Supply

𝑀 = 𝑚𝐻

𝑙𝑛𝑀 = ln 𝑚 + ln (𝐻) Differentiating both sides and assuming constant/ stable money multiplier:

𝑔𝑚 = 𝑔ℎ Central bank can control money supply growth by controlling the growth rate of its base money, provided the money multiplier is stable. we know money multiplier is determined by currency-deposit ratio (c) and cash reserve requirement or CRR (r); central bank has control over the CRR but not currency-deposit ratio (c).

Money Multiplier

• Money multiplier can be unstable due to currency deposit ratio (CDR).

• What determines CDR? – Preference for currency to deposits – Transaction motive

• (income, inflation)

– Interest on deposits – Technological changes

• Payment and settlement system (credit, debit cards, ATM)

– Social factors – Taxes and government policies – Seasonal demand

Money demand function

• Classical Quantity Theory of Money

• 𝑀𝑉 = 𝑃𝑇

• Cambridge Version

• 𝑀 = 𝑘𝑃𝑌

• Keynesian

• 𝑀/𝑃 = 𝐹(𝑌, 𝑟)

Money demand function: QTM

Fisher QTM 𝑀𝑉 = 𝑃𝑇

• Cambridge Version: if T=Y, k =1/v

𝑀 = 𝑘𝑃𝑌

• As long as v is a constant, k also constant. From the Cambridge version, we can derive

𝑔𝑚 = 𝜋 + 𝑔𝑦

• Thus, central bank can set money supply growth equal to money demand growth as a sum of inflation rate 𝜋 and real GDP growth 𝑔𝑦.

Money demand function

𝑀 = 𝑘𝑃𝑌𝛼

𝑀

𝑃= 𝑘𝑌𝛼

𝑔𝑚 = 𝜋 + 𝛼𝑔𝑦

• Note here the difference from QTM (Cambridge version 𝛼 = 1).

• In India, RBI uses 𝛼 = 1.5

Money demand: Keynes

𝑀

𝑃= 𝑘∗𝑌𝛼𝑒−𝑏𝑟

𝑙𝑛𝑀 − 𝐿𝑛𝑃 = 𝑙𝑛𝑘∗ + 𝛼𝑙𝑛𝑌 − 𝑏𝑟 • Keynes: 𝑏 = ∞,

• 𝑝𝑒𝑟𝑓𝑒𝑐𝑡𝑙𝑦 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑙𝑎𝑠𝑡𝑖𝑐 𝑑𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑚𝑜𝑛𝑒𝑦 𝑖𝑛 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑡𝑟𝑎𝑝 • Classical: b=0, Interest rate inelastic demand for money (vertical

LM Curve)

Friedman’s Money Demand

•𝑀

𝑃= 𝐹(𝑌, 𝑟𝑏 , 𝑟𝑒 , 𝑟𝑑)

• Income, return on bonds, return on equities and return on consumer durables

• The role of 𝑟𝑏 , 𝑟𝑒 , 𝑟𝑑 small and transitory effect; it is primarily the income, which will determine the demand for real money balance largely for transaction purpose in the long-run.

Baumol-Tobin Transaction demand

• Even if money is demand for transaction purposes, it can also be influenced by interest rate.

• 𝑀 =𝑌

2𝑁= √(

𝑌𝐹

2𝑖)

• 𝑁 = √(𝑖𝑌

2𝐹)

• M: average demand for money • N: cost minimising number of

tips • Y: total spending • F: cost of trip to banks • i: Interest rate

𝑌

Time

𝑌/2N

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑚𝑜𝑛𝑒𝑦 ℎ𝑜𝑙𝑑𝑖𝑛𝑔: 𝑌/2𝑁

Monetary Targeting

• From quantity theory, we can

• 𝑔𝑚𝑇 = 𝜋𝑇 + 𝛼𝑔𝑦

𝑇

• For some central banks, inflation target has a legal mandate

(Bank of England: 𝜋𝑇 = 2%)

• For many others, inflation target is informal set around a tolerable rate (threshold/optimal level) based on some research work.

• In India: 𝝅𝑻 = 𝟓% 𝒕𝒐 𝟔% (Vasudevan, Bhoi and Dhal, 1997 and others later)

Monetary Targeting

• What about growth rate?

• For full employment, it could be set at potential growth.

• How do we know the potential growth which is unobserved?

• Useful here are theoretical and empirical insights.

• Recall the Harrod-Domar model.

• Potential growth can be determined at warranted growth rate: 𝑔𝑦 = 𝑠/𝑣

• If we know saving rate s and capital output ratio v in the medium-longer horizons, we can set growth target and accordingly, money supply growth target.

Monetary Targeting

• Alternatively, we have seen that in a neoclassical framework (Solow growth model), we can derive potential growth on the basis of a production function with constant return to scale.

• 𝑌 = 𝐴𝐾𝜃𝐿1−𝜃

• 𝑔𝑦 = 𝑔𝐴 + 𝜃𝑔𝐾 + (1 − 𝜃)𝑔𝐿

• In the Indian context, we do not have appropriate

employment and work hours data.

Monetary Targeting

• Business Cycle approach: we can estimate potential growth using some univariate and multivariate trend-cycle decomposition techniques:

𝑔𝑦 = 𝑔𝑇 + c

• Note: in the case of univariate approach, we do not require information about saving, capital formation and technological progress.

Instability in Demand for Money

• Like money-multiplier, money demand can be unstable process. – Instability due to changes in velocity and income and

interest rate elasticity parameters.

– Structural shifts / regime changes

• Thus, monetary targeting can fail. A large empirical literature pointed to the failure of monetary targeting.

• Some countries have abandoned monetary aggregates.

• Move on to indirect instruments of monetary policy through market mode: interest rate

Interest rate Instrument: role of term structure

Policy rate (repo)

Market short

interest rates

Market long

interest rate

Consumption, Saving,

investment

Output & Inflation

Effectiveness of Interest Rate Policy

• Benchmark risk free instrument

• Existence of term structure

• Integration of Financial market segments

• Liquidity and depth of various segments

• Operating and allocation efficiency of banks and financial institutions in terms pricing and quantity decisions

– Efficient market hypothesis

Term structure of interest

Term structure hypothesis: • Long rate is a combination of current and future short

rates. Suppose you have 1 rupee to invest for two years. You have two options. Option 1: • Invest for 1-year and earn interest 𝑟1 and then reinvest in

the second year. • But for the second year, you do not know what will be the

interest rate. You have some expected rate: 𝑟1𝑒

• Total income from investment

• 𝑅1 = (1 + 𝑟1)(1 + 𝑟1𝑒)

Term structure

• Option 2: Invest in a two year bond offering 𝑟2 𝑅2 = 1 + 𝑟2 1 + 𝑟2 = 1 + 𝑟2

2

• No-arbitrage

• 𝑅1 = 𝑅2

• 1 + 𝑟1 1 + 𝑟1𝑒 = 1 + 𝑟2

2

• Natural logarithm transformation

• 𝑟1 + 𝑟1𝑒 = 2𝑟2

• 𝑟2 =1

2(𝑟1 + 𝑟1

𝑒)

Term structure and CAPM • 𝑟𝐿 = 𝛼 + 𝛽𝑟𝑠

• 𝛼: liquidity/term premium

• 𝛽=1; perfectly integrated markets

• Market (private) interest rates : CAPM

• 𝑟𝐶,𝐿 = 𝛾 + 𝜃𝑟𝐿 = γ + 𝜃 𝛼 + 𝛽𝑟𝑠 = 𝜏 + 𝜗𝑟𝑠

• 𝜏: risk premium (liquidity, credit etc)

• 𝛽=1, 𝜃=1 , market fully integrated

• 𝑟𝑠: benchmark – (treasury bills; interest rate on risk free liquid short-

term instrument)

Reserve Bank of India

• Established in 1935 (RBI Act 1934); Nationalised in 1949

• (Government Share capital of Rs 5 crore)

• Preamble: – Regulate the issue of

banknotes,

– Maintain reserves with a view to securing monetary stability and

– Operate the credit and currency system of the country to its advantage.

Transmission Channels

• Money & Credit (Quantity Channel)

• Interest rate (Price Chanel)

• Exchange rate

• Asset prices

• Confidence / Animal Spirit

• Financial stability

Mishkin, F: Monetary Transmision mechanism, JEP, 1994 Bernanke, B and Gertler, M. (1994), Credit Channel: Inside the Black Box

MTM: Money and Credit 1 Bank lending

↓ 𝑀 ⇒↓ 𝐷& 𝐿 ⇒↓ 𝐶 & 𝐼 ⇒↓ 𝑌 & 𝑃 2 Balance sheet of firms

↓ 𝑀 ⇒↓ 𝑃𝑒 ⇒↓ 𝑛𝑒𝑡 𝑤𝑜𝑟𝑡ℎ ⇒↑ 𝑎𝑑𝑣𝑒𝑟𝑠𝑒 𝑠𝑒𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑚𝑜𝑟𝑎𝑙 ℎ𝑎𝑧𝑎𝑟𝑑 ⇒↓ 𝐿 ⇒↓ 𝐼 ⇒

↓ 𝑌 & 𝑃

↓ 𝑀 ⇒↑ 𝑟𝑚 ⇒↓ 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 ⇒↑ 𝑎𝑑𝑣𝑒𝑟𝑠𝑒 𝑠𝑒𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑚𝑜𝑟𝑎𝑙 ℎ𝑎𝑧𝑎𝑟𝑑 ⇒↓ 𝐿 ⇒↓ 𝐼 ⇒

↓ 𝑌 & 𝑃

MTM Channels: Interest rate

↓ 𝑀(𝑟𝑝) ⇒↓ 𝑟𝑚 ⇒↑ 𝐶 & 𝐼 ⇒↑ 𝑌 & 𝑃

Fall in policy rate (repo), fall in market interest rate, increase in consumption and investment, increase in output and price

2. Effectiveness of interest rate channels will depend term structure of interest rates and the linkages among various financial market segments.

MTM Channels: Exchange rate

↓ 𝑀(𝑟𝑝) ⇒↓ 𝑟𝑚 ⇒↑ 𝐸 ⇒↑ 𝑁𝑋 ⇒↑ 𝑌 & 𝑃

Fall in policy rate (repo), fall in market interest rate, depreciation of exchange rate, improvement in trade balance (net exports goes up), increase in output and price

MTM Channels: Asset Prices

: Two theories

3.1 Tobin’s ‘q’ theory investment ↓ 𝑀 ⇒↓ 𝑃𝑒 ⇒↓ 𝐼 ⇒↓ 𝑌 & 𝑃

3.2 Wealth effect on Consumption ↓ 𝑀 ⇒↓ 𝑃𝑒 ⇒↓ 𝑊 ⇒↓ 𝐶 ⇒↓ 𝑌 & 𝑃

Evaluating MTM

• Macro Variables:

– Output (Y)

– Money supply (M)

– Price level (P)

– Interest rate (r)

– Asset prices

– Exchange rate

• Dynamic interaction

• Long run and short-run dynamics may be different

• Identification problem enormous

• Lags in transmission mechanism

– Long and variable lags

Mishkin, F: Monetary Transmision mechanism, JEP, 1994 Bernanke, B and Gertler, M. (1994), Credit Channel: Inside the Black Box

Evaluating MTM

• Dynamic Interaction: increase in output can lead to increase in demand for money, which in turn may increase aggregate demand and lead to increase in prices and interest rates. All variables are endogenous.

• The adjustment process involve lags: an increase money supply may lead to increase in output with a time lag and the impact may percolate over a period of time.

• Long run: the interaction among monetary and macro variables may follow an equilibrium path which can be interpreted in terms of theoretical postulates in macroeconomics

• Long-run: we have seen that theoretical postulates in macroeconomics are not unique.

• Short-run: variation in all variables may adjust to the deviation from the common long-run path. The speed of adjustment to equilibrium is important for policy analysis.

Monetary Policy Debate: Rules or Discretion

• How to set instruments?

– Rules: passive / automatic pilot

– Discretion: active / judgments

• Popular Rules:

• Friedman: constant money growth rule;

• Taylor rule for interest rate setting

• McCallum’s rule for quantity of base money setting

Policy Rules

Taylor Rule 𝒊𝒕 = 𝒓 + 𝝅𝒕 + 𝜶 𝒚𝒕 − 𝒚𝑻 + 𝜷(𝝅𝒕 − 𝝅𝑻)

McCallum Rule base money growth 𝒈𝑯 = 𝒈∗ − 𝒈𝒗 + 𝝎(𝒈∗ − 𝒈𝒕)

• 𝒊𝒕: nominal interest; 𝝅𝒕: observed inflation; 𝝅𝑻: target inflation; 𝒚𝒕: actual output; 𝒚𝑻: potential output; 𝜶, 𝜷 parameters or weight assigned to growth inflation objectives

• 𝒈𝑯: growth rate of base money; 𝒈𝒕: real GDP growth; 𝒈∗: potential growth; 𝒈𝒗: changes in income velocity of base money; 𝝎: weight to growth gap.

Rules vs Discretion

• Rules

– Clarity, transparency, Stability,

– Time consistency,

– No political interference

– Unbiased

– Low expectation

• Discretion

– Judgments

– Flexibility

– Rise to the occasion

– Market Imperfection

– Practicality

– Time inconsistency (short-run vs. long-run)

Reserve Bank of India

• Multi-purpose central bank

• Multiple objectives, instruments

• Conflicting objectives and stakeholders

• Balance of risk perspective

RBI Objective

RBI

Price stability

sound, stable

external sector

Financial stability

Sustained Growth

Reserve Bank of India: Functions

• Monetary Authority – Monetary policy – Issue of Bank Notes – Public interest (depositor

protection)

• Banker to Government – Normal Transactions – Debt management

• Banker to Banks – Lender of last resort

• Banking regulator and supervisor (BR Act) – Banks and NBFCs – Financial sector stability

• Payment and settlement system – Clearing service

• Institutional development – LIC, EXIM, NABARD, SIDBI,

NHB, UTI, IDBI, SBI – IGIDR, IDRBT, NIBM, IIBM

• Development banking – Priority sector lending,

Cooperative banks – Financial inclusion

• Manage Foreign exchange – External sector stability

RBI : an arms house of monetary instruments

MP Instruments

• Direct instruments – Cash reserve requirement

(CRR) – Open market operation

(Liquidity adjustment facility-LAF)

– Marginal standing facility (MSF)

• Indirect instruments – Interest rate (repo / reverse

repo rates)

• Others: – Statutory liquidity

requirement (SLR) – Priority sector lending (40%) – Benchmark loan interest rate – Moral suasion

• Systemic risk and stability – Prudential regulation of banks

and NBFCs – CAMELS (capital adequacy,

asset quality, managerial efficiency, earnings, liquidity, and systems)

Monetary Aggregates Indicators

• Base/Reserve/High powered/ Fiat money (created by central banks)

• M0 = Currency + bank reserves – Currency: bank notes and

coins held by the public – Bank reserves: commercial

banks hold a fraction of net demand and time liabilities such as deposits with the central bank: cash reserve requirement (CRR)

• Narrow money (M1): – Currency (C) plus demand

deposits (DD)- Transaction purpose

• Broad money (M3):

– M1+Time deposits (TD)

• Liquidity aggregates:

– includes financial institutions, post office savings etc.

• Banking aggregates

MP Intermediate targets

• Price stability: – Inflation rate around threshold level, core inflation

• Stability in money and gilt market – Interbank money market bound by repo rate

• Adequate flow of credit to producing sectors for stimulating investment – Growth rate of monetary aggregate, Bank credit growth

• Appropriate deposit and loan interest rates • Stability in financial markets (money, credit, treasury

bonds, foreign exchange)

RBI Operating Framework for Policy: Paradigm Shift

Pre-reform

• Objective – Price stability, adequate flow of

credit

– Ambiguity in price stability, growth

• Instruments – Emphasis on direct instruments

– CRR, SLR, additional CRR; Bank rate

• Intermediate target: – Quantity of money and credit

channel of transmission; targeting broad money growth, bank credit growth

Reform

• Objective (same as before) – Less ambiguity in Price stability,

and growth objectives; Threshold inflation, potential growth, forecasts and projections

• Instruments – Emphasis on indirect

– Short-term Interest rate (repo/reverse repo rates)

– OMO, LAF/MSF

• Multiple indicators – Intermediate targeting abolished

– Emphasis on financial markets stability / money market

RBI Policy: Paradigm Shift

Pre-reform

• Heavily Regulated banking sector – Regulation of Interest rates

on deposits and loans,

– Credit deployment across sectors (Priority sector lending)

• Fiscal dominance – Automatic monetisation of

government deficit and debt

• Banking regulation (annual onsite inspection)

Reform

• Deregulated banking – Banks free to determine deposit

and lending rates

– Credit deployment (Priority sector norm continues but list expanded and flexible)

• Fiscal dominance abolished

• Banking regulation – Prudential regulation; Basel

Norm; onsite and off-site surveillance

RBI Policy: Paradigm Shift

Pre-reform

• Annual Credit Policy – Busy season (Kharif)

• Half-yearly policy – Slack season

• Credit policy cell

• Macroeconomic assessment – Ambiguous,

– Lacked rigour

– Secrecy

Reform • Annual (Monetary and credit)

Policy

• Quarterly, bi-monthly policy review

• Monetary policy department

• Macroeconomic Assessment – More in-depth analysis

(forecast, projections) – Fan charts – Public disclosure (released one-

day before policy)

RBI Policy: Paradigm Shift

Pre-reform

• Pre-policy Consultation

– Government

– Banking sector,

• Internal experts

• Policy Communication

– Media release: press statement

Reform • Pre-policy Consultation

– Government – Banking sector; Academic experts;

Industry experts; Market experts

• Internal Team

• Technical Advisory Group (minutes disclosed)

• Policy Communication – Real –time Media coverage of policy

announcement – Enhanced Communication (town hall, media

briefing, video conferencing – Seminars, lectures, speeches across the country

LAF

• Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements. LAF is used to aid banks in adjusting the day to day mismatches in liquidity. LAF consists of repo and reverse repo operations.

• Liquidity adjustment facility has emerged as the principal operating instrument for modulating short term liquidity in the economy. Repo rate has become the key policy rate which signals the monetary policy stance of the economy.

Repo vs. reverse repo

Repo

Repo or repurchase option is a collaterised lending i.e. banks borrow money from Reserve bank of India to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date. The rate charged by RBI for this transaction is called the repo rate. Repo operations therefore inject liquidity into the system.

Reverse repo

Reverse repo operation is when RBI borrows money from banks by lending securities. The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo operation therefore absorbs the liquidity in the system. The collateral used for repo and reverse repo operations are Government of India securities. Oil bonds have been also suggested to be included as collateral for Liquidity adjustment facility.

MSF

• The Marginal Standing Facility Scheme was introduced on the lines of the existing Liquidity Adjustment Facility – Repo Scheme (LAF – Repo).

• All Scheduled Commercial Banks having Current Account and SGL Account with Reserve Bank, Mumbai will be eligible to participate in the MSF Scheme.

LAF & MSF

• Under LAF - Repo rate, Banks can borrow from RBI at the Repo -rate by pledging government securities over and above the statutory liquidity requirements.

• However, in case of borrowing from the marginal standing facility, banks can borrow funds up to two percentage of their net demand and time liabilities, at the rates announced by RBI and this can be within the statutory liquidity ratio of 23%.

RBI Balance sheet: Base Money Supply

Liabilities (Components)

Assets (Sources)

1. Currency in circulation 1. Domestic Assets

2. Bankers reserves • Credit to Government

(Reserve requirement) • Credit to Commercial sector

3. Other deposits 2. Foreign Assets

• Foreign currency

• Gold

3. Less Non-monetary liabilities

Total: Reserve Money Reserve Money

Composition of Reserve Money

-20%

0%

20%

40%

60%

80%

100%1

97

1

19

74

19

77

19

80

19

83

19

86

19

89

19

92

19

95

19

98

20

01

20

04

20

07

20

10

20

13

domestic credit foreign assets

Indian Context

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

19

51

-52

19

54

-55

19

57

-58

19

60

-61

19

63

-64

19

66

-67

19

69

-70

19

72

-73

19

75

-76

19

78

-79

19

81

-82

19

84

-85

19

87

-88

19

90

-91

19

93

-94

19

96

-97

19

99

-00

20

02

-03

20

05

-06

20

08

-09

20

11

-12

Currency Deposit Ratio

0.00

1.00

2.00

3.00

4.00

5.00

6.00

19

51

-52

19

54

-55

19

57

-58

19

60

-61

19

63

-64

19

66

-67

19

69

-70

19

72

-73

19

75

-76

19

78

-79

19

81

-82

19

84

-85

19

87

-88

19

90

-91

19

93

-94

19

96

-97

19

99

-00

20

02

-03

20

05

-06

20

08

-09

20

11

-12

Money Multiplier

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

CRR

RBI: Monetary analysis

• Money demand

• 𝑄𝑇𝑀: 𝑀3 = 𝑘𝑃𝑌𝛼𝑒𝑏𝑟

• 𝑔𝑚3,𝑓 = 𝜋𝑓 + 1.5𝑔𝑦,𝑓

• Interest rate = F(inflation

gap, output gap, other indicators)

• No rule followed

• Judgment plays a critical role

• Domestic assessment – Threshold inflation, Core

inflation, Inflation projection, Potential growth, Growth projection, Currency demand, Bank aggregates (deposits, credit), Sectoral credit, Trade deficit, capital flows, BOP projections, Fiscal indicators

• Global developments (global trade and growth, oil price, commodity price movements)

RBI Forecasting / Projections

• Univariate time series econometric models

• Multivariate time series models (VAR, VECM) – Suits of VAR models with 3-four

variables

• Trend-cycle-seasonal

decomposition (HP trend)

• Fan charts – probabilistic assessment of

growth and inflation

• There is no structural macro model!

• No DSGE model

Monetary Targeting Regime

2009-10 7.5 8.5 16.5 8.6 3.8 16.9

2010-11 8.0 5.5 17.0 9.3 9.6 16.1

2011-12 7.4-8.5/8.0 6.0 16 6.2 8.9 13.2

2012-13 7.3 6.5 15 5 7.4 13.8

2013-14 5.7 5.5 13

Multiple Indicators Regime

Evolution of RBI Operating Procedure Period Focus Intermediate target instrument

1935-50 (formative years)

Financial intermediation Regulate supply of and demand for credit

Bank rate, OMO

1951-70 (Development phase)

Support five year Plan financing, accommodate government deficit, Contain inflationary pressures

Quantitative control measures: selective credit control, credit authorisation scheme, social banking (priority sector)

Bank rate frequently used

1971-90 (Fiscal dominance)

Credit planning, Fiscal dominance, Statutory pre-emption of funds for supporting government budget

Monetary targeting (reserve money growth operating target, broad money growth intermediate target)

High SLR, high CRR SLR: 25 to 38.5 CRR: 3 to 15 Money market instruments (IBPCs, CDs, CPs)

1990s: reform Reduce fiscal dominance, Market based policy;

market determined interest rate and exchange rate

CRR and SLR reduced; Bank rate, repo rate, LAF

2011 (new OP) Single policy rate, financial market stability

Overnight call money rate stability within a band of 200 basis points

Repo rate , MSF

Interest rate

Monetary Policy Effectiveness: Role of Financial Markets

Financial Markets

• Long-end – Loan interest rate, Government bonds, capital

market

– Affect investment, consumption of durables and thus, growth

• Short-end – Call money, treasury bills, certificates of deposits,

commercial paper, deposit interest rate

– Consumption non-durables, some effect on demand

Financial Market Integration

• For successful conduct of monetary policy through interest rate channel, financial market integration is critically important.

• Integrated markets: policy shocks can have wide-spread effect across market

Managing Liquidity & Money Market

0

2

4

6

8

10

12

14

16

03 04 05 06 07 08 09 10 11 12 13

CALL REPO RREPO

Assignment

• Which graph could best describe the relationship between money multiplier on the one hand and currency deposit ratio and reserve requirement ratio on the other hand. Support your answer with a numerical simulation for hypothetical values of currency-deposit ratio and reserve requirement ratio.

Assignment

(a) (b)

Assignment

(c) (d)

Assignment

(e) (f)

Assignment 2

• Another country’s multiplier just equals to the inverse of central bank’s reserve requirement. Analyse such an economy.

Numerical problems

• For a developing economy, like India, the central bank has the target for broad money supply growth at 13% in tune with optimal inflation rate at 5% and potential real GDP growth rate 8%. What is the implied income elasticity of demand for money consistent with money supply target? Discuss the theoretical insights underlying the money demand function.

• A central bank has inflation target of 4 % and its estimate of

income elasticity of money demand at 1.5 % and potential growth at 6%. Its money supply growth is set at 15%. Explain the central bank’s decision using quantity theory of money.