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THE MONETARY POLICY OF
INDIA
�FY BFM 1
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INTRODUCTION
Monetary policy is the process by which the monetaryauthority controls
the money supply
availability of money
cost of money or rate of interest
to ensure growth and stability of the economy.
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Monetary policy is referred to as either being an
� expansionary , or a� contractionary policy,
where an expansionary policy increases the total
supply of money in the economy, and acontractionary decreases the money supply.
Expansionary policy is used to combat
unemployment in recession by lowering the interest
rates, while contractionary policy involves raisinginterest rates in order to combat inflation.
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Objectives of Monetary Policy
� Price stability
� Ensure adequate flow of credit to the productive sectors of
the economy
� Stability for the national currency
� Growth in employment and income
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Instruments to Regulate Monetary Policy
QUANTITATIVE METHODS
� Discount Rate (Bank Rate): The discount rate is the interest
charged by Central Banks to member banks, other depository
institutions, and the government for loans.
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Higher interest
rates
Less
borrowing
Lower
aggregate
demand
Higher
aggregate
demand
More
borrowing
Lower interest
rates
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� Open Market Operations: Open market operations is the buying
and selling of government securities by the government (Central
Bank).
�
Reserve Requirement: The reserve requirement is the amount of money that banks must hold as vault cash or keep on deposit
with their Central Banks.
FY BFM 6
Sells govt.
securities
Pumps
money into
the economy
Buys govt.
securities
Withdraws
money from
the economy
Increase reserve
requirement
Less loanable
funds to offer Less borrowing
Decrease
reserve
requirement
More loanable
funds to offerMore borrowing
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Reserve Requirements are of 2 types:
1. Cash Reserve Ratio (CRR) refers to that portion of total deposits of
commercial banks that it has to keep with the reserve bank of india as cash
reserves.2. Statutory Liquidity Requirements (SLR) refers to that portion of the total
deposits of a commercial bank which it has to keep with itself in the form of
liquid assets.
� Reverse Repo Rate: The rate at which the Central
Bank borrows money from the banks (or banks lend
money to the CB) is termed the reverse repo rate. The
CB uses this tool when it feels there is too much
money floating in the banking system.
FY BFM 7
RRR increasedMember Banks
lend money to CB
Less money with
member banks
to lend to
consumers
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� P rime Lending Rate ( P LR): The rate at which the commercial
banks lend money to their regular clients with high credit
worthiness. This particular class borrows huge amounts of money and hence, there is lot of fluctuation in the monetary
supply even with small changes in the PLR. It is one of the only
rates controlled by the commercial banks. The below shows
the lending rates given by the commercial banks in the last 10
years.
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QUALITATIVE METHODS
� Regulation of Consumer Credit: It is an important instrument of
selective credit control which aims at regulating the consumerinstalment credit on higher purchase. Finance is the method of
using bank credit by consumers to buy expensive durable goods
like motor cars, houses, computer, etc. A certain percentage of
the price of the durable goods paid by the consumers as the cash
down payment in the remaining portion is financed by the bank.
FY BFM 9
Higher bank creditReduce
downpayment
Maximise period
of payment
Increase
downpaymentLower bank credit
Minimize period
of payment
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� Marginal Requirement: Its one of the most important
instruments. The commercial banks give loans to their customers
against some securities, however, they do not give loans
equivalent to the full amount of the security, but of an amount
which is less than its value. This difference between the value of
the security and the amount of loan granted is known as marginal
requirements.
FY BFM 10
If marginal
requirements is 10%
Bank would give a
loan of Rs.9000
against a security of
Rs.10000
Higher the rate less is the money
supply and vice versa. Thus,
money supply can be regulated by
increasing or decreasing the
marginal requirement.
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� Moral Suasion: It is the method of persuasion, request, informal
suggestions and advice towards member banks by the central
bank. The central bank relies upon this instrument to influence
its member banks as the head and leader of the financial
institutions.
� P ublicity: It is the method selective credit control. The central
bank expresses its views about various monetary and banking
policies. The central bank uses this method for influencing credit
policies as well as the public opinion in the country.
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Contractionary Monetary PolicyIntroduction
Contractionary monetary policy seeks to reduce the size of the money supply.
They are fiscal policies, like lower spending and higher taxes, that reduce
economic growth. In India, monetary policy is controlled by the RBI.
Tools for Implementation
Monetary Base: The contractionary policy can be implemented by reducing
the size of the monetary base. A central bank uses open market
operations by typically selling bonds in exchange for hard currency. When
the central bank collects this hard currency payment, it removes that
amount of currency from the economy, thus reducing the total amount of
money circulating in the economy.
13FY BFM
CB sells
bonds
Collects
payment in
hard
currency
Reduces
the money
circulation
Contracts
the
monetary
base
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Reserve Requirements: It can be implemented by requiring banks to
hold a higher portion of their total assets in reserve. By doing so,
the central bank reduces the availability of loanable funds. This
acts as a reduction in the money supply.
Interest Rates: In this method, the nominal interest rates are
increased. By raising the interest rate, a monetary authority can
contract the money supply, because higher interest rates
encourage savings and discourage lending.
How can monetary policy be used to control inflation?
Inflation is defined as continuing increase in price levels. Since price
level is a monetary variable, contractionary policy reduces
inflation by reducing upward pressure on price levels.
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Effects of Contractionary Policy
Contractionary monetary policy causes a decrease in bond prices and anincrease in interest rates.
Higher interest rates lead to lower levels of capital investment.
The higher interest rates make domestic bonds more attractive, so thedemand for domestic bonds rises and the demand for foreign bondsfalls.
The demand for domestic currency rises and the demand for foreign
currency falls, causing an increase in the exchange rate. (T
he value of the domestic currency is now higher relative to foreign currencies)
A higher exchange rate causes exports to decrease, imports to increaseand the balance of trade to decrease.
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Expansionary Monetary Policy
Introduction
Expansionary monetary policy seeks to increase the size of the money supply.
Tools for Implementation
Monetary Base: Expansionary policy can be implemented by increasing the size of the monetary base. This directly increases the total amount of money
circulating in the economy. The RBI would buy bonds in exchange for hard
currency. When the RBI disburses this hard currency payment, it adds that
amount of currency to the money supply, thus increasing the monetary base.
FY BFM 16
RBI buys
bonds
Disburses
payment in
hard
currency
Increases
money
circulation
Expands the
monetary
base
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Reserve Requirements: It can be implemented by requiringbanks to hold a lower portion of their total assets in reserve.By doing so, the central bank increases the availability of
loanable funds. This acts as a increase in the money supply.
Interest Rates: In this method, the nominal interest rates aredecreased. By lowering the interest rate, a monetary authoritycan expand the money supply, because lower interest rates
discourage savings and encourage lending.
How does monetary policy affect the real economy?
Expansionary monetary policy should not be confused with an
increase in economic output in the real economy. Any changeto the real economy resulting from an expansionary monetarypolicy is subject to time lags and effects from other economicvariables; in addition, there are possible side effects of expansion, including inflation.
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Effects of Expansionary Policy
Expansionary monetary policy causes an increase in bond prices and areduction in interest rates.
Lower interest rates lead to higher levels of capital investment.
The lower interest rates make domestic bonds less attractive, so thedemand for domestic bonds falls and the demand for foreign bondsrises.
The demand for domestic currency falls and the demand for foreigncurrency rises, causing a decrease in the exchange rate. (The value of
the domestic currency is now lower relative to foreign currencies)
A lower exchange rate causes exports to increase, imports to decreaseand the balance of trade to increase.
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Monetary Policys Impact on
the Economy
The monetary policy not only impacts financing conditions in the
economy but also influences the expectations about economic
activity and inflation. Monetary policy can affect the prices of
goods, asset prices, exchange rates as well as consumption and
investment in the following ways:
Interest rate cuts lead to lower cost of borrowing, which results in higher
investment activity and the purchase of consumer durables.
The expectation that economic activity will strengthen may also prompt banks to
ease lending policy, which in turn enables businesses and households to boost
spending.
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In a low interest-rate environment, shares become a more attractive buy, raising
households· financial assets.
This may also contribute to higher consumer spending, and makes companies·
investment projects more attractive.
Lower interest rates also tend to cause currencies to depreciate: Demand fordomestic goods rises when imported goods become more expensive.
All of these factors raise output and employment as well as investment and
consumer spending.
However, this stepped-up demand may cause prices and wages to
rise if goods and labor markets are fully utilized.
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The Monetary Policy Transmission
Mechanism
The process throughwhich monetarypolicy decisionsimpact on aneconomy in
general and theprice level inparticular isknown as themonetary policytransmissionmechanism. Themain channels of
monetary policytransmission areset out in asimplified,schematic form inthe chart on thenext page.
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� Interest rate channel: An expansion of the money supply by the central bank feedsthrough to a reduction of short-term market rates through this channel. As aresult, the real interest rate and capital costs decline, raisinginvestment. Additionally, consumers save less and opt for current consumptionover future consumption. This, in turn, causes demand to strengthen. However,this stepped-up demand may cause prices and wages to rise if goods and labormarkets are fully utilized.
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� Credit channel: Central banks monetary policy decisions influencecommercial banks refinancing costs; banks are inclined to pass thechanges on to their customers. If financing costs diminish,investment and consumer spending rise, contributing to an
acceleration of growth and inflation.
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� Exchange rate channel: Expansionary monetary policyaffects exchange rates because deposits denominated indomestic currency become less attractive than deposits
denominated in foreign currencies when interest rates arecut. As a consequence, the value of deposits denominatedin domestic currency declines relative to that of foreigncurrency-denominated deposits and the currencydepreciates. This depreciation makes domestic goodscheaper than imported goods, causing demand for domestic
goods to expand and aggregate output to augment.
� Wealth channel: Monetary policy impulses are alsotransmitted through the price of assets such as stocks andreal estate. The expansionary monetary policy effects of
lower interest rates make bonds less attractive than stocksand result in increased demand for stocks, which bids upstock prices. Conversely, interest rate reductions make itcheaper to finance housing, causing real estate prices to goup.
FY BFM 24