Monetary Policy and money market in India.Group 3

Group MembersHardik Shah 81Virag Parekh 87Karan Shrimankar 92Heena Vaishnav 95Danish Bansari 102Shekhar MehtaVeena Kapta 158

Definition Of Monetary PolicyA macroeconomic policy tool

used to influence interest rates, inflation, and credit availability through changes in the supply of money available in the economy. In India it is also called the Reserve Bank of India’s ‘Credit Policy’ as the stress is primarily on directing credit.

Monetary PolicyMonetary policy is the process a

government, central bank, or monetary authority of a country uses to control

(i) the supply of money, (ii) availability of money, (iii) cost of money or rate of interest to

attain a set of objectives oriented towards the growth and stability of the economy.

Conti… Monetary theory provides insight into how to

craft optimal monetary policy.

Monetary policy is referred to:- Expansionary policy - It increases the total

supply of money in the economy and is traditionally used to combat unemployment in a recession by lowering interest rates.

Contractionary policy - It decreases the total money supply, and also involves raising interest rates to combat inflation.

Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

Need for Monetary Policy In today's global trade it is very necessary to have a monetary

policy which directly affects the growth of a country's economy and inflation.

International monetary policy coordination based on considerations of structural asymmetries across countries.

In a two-country world with a traded and a non-traded sector in each country, optimal independent monetary policy cannot replicate the natural-rate allocations.

There are potential welfare gains from coordination since the planner under a cooperating regime internalizes a terms-of-trade externality that independent central banks tend to overlook. Yet, with symmetric structures across countries, the gains are quantitatively small.

If the size of the traded sector differs across countries, the gains can be sizable and increase with the degree of asymmetry.

The planner's optimal policy not only internalizes the terms-of-trade externality, it also creates a terms-of-trade bias in favor the country with a larger traded sector.

The planner tries to balance the terms-of-trade bias against the need tostabilize fluctuations in the terms-of-trade gap.

Theory of Monetary PolicyMonetary policy rests on the relationship between the

rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money.

Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment.

Where currency 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 thus influence the interest rate

In practice, all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.

Types of monetary policyThe distinction between the

various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation TargetingInterest rate on overnight debt

A given rate of change in the CPI

Price Level TargetingInterest rate on overnight debt A specific CPI number

Monetary AggregatesThe growth in money supply

A given rate of change in the CPI

Fixed Exchange RateThe spot price of the currency

The spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the gold price

Mixed Policy Usually interest ratesUsually unemployment + CPI change

Achieving low level of inflationPolicymakers must have credible

announcements; 1) Private agents must believe that these

announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect.

2) If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy; however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.

Various Ways of AnnouncementsTo establish an independent

central bank with low inflation targets.

Reputation

Monetary decisions today take into account a wider range of factors:

short term interest rates; long term interest rates;velocity of money through the economy;exchange rates;credit quality;bonds and equities (corporate ownership and

debt);government versus private sector

spending/savings; international capital flows of money on large

scales;financial derivatives such as options, swaps,

futures contracts, etc.

Inflation targeting under Monetary policy This policy approach the target is to keep

inflation, under a particular definition such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target.

The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate.

Price level targetingPrice level targeting is similar to

inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.

Monetary aggregatesThis approach is also sometimes

called monetarism.

While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

Fixed exchange rateThis policy is based on maintaining a

fixed exchange rate with a foreign currency.

There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.

The local government or monetary authority declares a fixed exchange rate

Fixed-convertibility System

Gold standard The gold standard is a system in which the price of the

national currency as measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals.

The selling of gold is very important for economic growth and stability.

The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".

Today this type of monetary policy is not used anywhere in the world

Monetary policy toolsMonetary baseReserve requirementsDiscount window lendingInterest ratesCurrency board

Monetary Policy of RBICONTROLLED EXPANSION

Speed up economic development in the country to raise national income and standard of living.

To prevent heavy depreciation of the rupee.

Maintaining the momentum of economic growth. To consider measures in a calibrated manner to respond to evolving circumstances with a view to stabilizing inflationary expectations.

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RBI’s ANTI-INFLATIONARY POLICY

• Economic aims given above were nearly the same but policy of CONTROLLED EXPANSION was changed to CREDIT RESTRAINT.

TOOLS OF MONETARY POLICY

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There are two kinds of tools:

Quantitative tools –control the volume of credit and inflation, indirectly.

Qualitative tools –they control the supply of money in selective sectors of the economy.

Quantitative ToolsBank Rate

Bank Rate is the rate at which RBI allows finance to commercial banks. Bank Rate is a tool, which RBI uses for short-term purposes. Any revision in Bank Rate by RBI is a signal to banks to revise deposit rates as well as Prime Lending Rate.

Role of bank rate is limited in India because

The structure of interest rates is administered by RBI

Commercial banks enjoy specific refinance facilities.

CRRAll scheduled commercial banks are required to maintain a fortnightly minimum average daily cash reserve equivalent with RBI .The apex bank is empowered to vary this ratio between 3 and 15 per cent. RBI uses CRR either to impound the excess liquidity or to release funds needed for the economy from time to time.

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SLR

Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold etc, in addition to cash reserve requirements. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). Present SLR is 25%.

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• Repos and Reverse Repo

RBI is empowered to enter a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price. Such a transaction is called a Repo when viewed from the prospective of the seller of securities (the party acquiring fund) and Reverse Repo when described from the point of view of the supplier of funds. Thus, whether a given agreement is termed as Repo or a Reverse Repo depends on which party initiated the transaction.

An instrument of monetary policyIt involves buying and selling of govt. securities by the

RBI to influence the volume of cash reserves with commercial banks and thus influence their loans and advances

To contract the flow of credit ,RBI starts selling govt securities

To increase the credit flow RBI starts purchasing the govt securities.

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OPEN MARKET OPERATIONS

Selective and Direct Credit Control Or Qualitative MeasuresThe main objective is to check speculation

and rising pricesThe RBI issues directives to banks relating to the purpose for which advances may or may

not be madeThe margins to be maintained in respect of

secured advancesThe maximum amount of advance to any

borrowerThe maximum amt. of guarantee that can be

given on behalf of any firm 27/20

Monetary Policy 2009-10Key FiguresReverse Repo Rate

3.25%Repo Rate changed at 4.75%Bank Rate Unchanged at 6%CRR Unchanged at 5%Inflation 9-

9.5%GDP

6.1%28/20

SUMMARY OF THE MONETARY POLICY AS ON Feb 16, 20101. Consumer prices increased by 1.85 percent in

January, driving annual inflation up by 1.66 percentage points to 8.19 percent and this was due to the administered price and tax adjustments

2. In January, unprocessed food prices picked up at a slower pace than the seasonal norm.

3. Energy prices were up 3.94 percent in January owing to adjustments in Special Consumption Tax and administered prices. Thus, the annual rate of increase in energy prices rose to 8.13 percent. Annual energy inflation is likely to increase further in coming months due to base effects.

4. 22 percent increase in tobacco prices; but excluding tobacco, it slowed down from a month earlier.

5. Rate of increase in the prices of services, excluding transport and catering, remained modest.

6. Due to tax adjustments, unprocessed food price increases and base effects, annual inflation would continue to rise markedly in February and hover above the target for some time.

Factors Affecting Inflation7. Industrial production grew by a robust

25.2 percent year-on-year in December, which seemingly points to a vigorous recovery.

8. Production and imports data indicate that private consumption demand increased quarter-on-quarter during the fourth quarter but remained at low levels.

9. Production and imports data for capital goods suggest that the recovery in private investment demand continued into the final quarter.

10. Uncertainty regarding foreign demand remains. The Committee noted that the pace of recovery in real exports (excluding gold) is far below the pre-crisis level.

11. Although there has been a mild improvement in employment conditions, unemployment rates remain at high levels.

12. Inflation would display a declining trend once the temporary factors, such as unprocessed food price volatility and tax hikes, taper off.

Monetary Policy and Risks13. Credit markets have continued to

improve due to lagged effects of the monetary easing. The tightness in credit conditions have been moderating since the publication of the July Inflation Report.

14. Inflation is expected to exceed the levels envisaged for February; however, as vegetable prices normalize during March, inflation would revert back to the levels consistent with the January Inflation Report forecast.

Effect on Interest Rate

Another major factor in interest rate changes is the "monetary policy" of governments. If a government "loosens monetary policy", this means that it has "printed more money". Simply put, the Central Bank creates more money by printing it. This makes interest rates lower, because more money is available to lenders and borrowers alike.

If the supply of money is lowered, this "tightens" monetary policy and causes interest rates to rise. Governments alter the "money supply" to try and manage the economy. The trouble is, no one is quite sure how much money is necessary and how it is actually used once it is available. This causes economists endless debate.

Effect on Inflation Rate

Another very important factor is inflation. Investors want to preserve the "purchasing power" of their money. If inflation is high and risks going higher, investors will need a higher interest rate to consider lending their money for more than the shortest term. After the very high inflation years of the 1970s and early 1980s, lenders had to receive a very high interest rate compared to inflation to lend their money.

As inflation dropped, investors then demanded lower rates as their expectations become lower. Imagine the plight of the long-term bond investor in the high inflation period. After lending money at 5-6%, inflation moved from the 2-3% range to above 12%! The investor was receiving 7% less than inflation, effectively reducing the investor's wealth in real terms by 7% each year!

Money Market In IndiaThe India money market is a monetary

system that involves the lending and borrowing of short-term funds

India money market has seen exponential growth just after the globalization initiative in 1992

It has been observed that financial institutions do employ money market instruments for financing short-term monetary requirements of various sectors such as agriculture, finance and manufacturing.

The performance of the India money market has been outstanding in the past 20 years.

Central bank of the country - the Reserve Bank of India (RBI) has always been playing the major role in regulating and controlling the India money market.

The intervention of RBI is varied - curbing crisis situations by reducing the cash reserve ratio (CRR) or infusing more money in the economy.

Types of Money Market instruments in India -Treasury Bills (T-Bills)Repurchase AgreementsCommercial PapersCertificate of DepositBanker's Acceptance

In a recent initiative, for overcoming the liquidity crunch in the Indian money market, the RBI infused more than Rs 75,000 crore along with reductions in the CRR.