2012icsalecture8

8/22/2019 2012icsalecture8

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Prof. S. Maitra,

iasstudymat.blogspot.com


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What is Monetary Policy? The term monetary policy refers to actions taken by

central banks to affect monetary magnitudes or other

financial conditions.

It is concerned with the changing the supply of

money stock and rate of interest for the purpose of

stabilizing the economy at full employment or

potential output level by influencing the level ofaggregate demand.

ICSA 2012 GS Indian Economics/Prof. S.Maitra8/6/2013 2


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Monetary Policy during recession

At times of recession monetary

policy involves the adoption of

some monetary tools which tends

to increase the money supply and

lower interest rate so as tostimulate aggregate demand in

the economy.ICSA 2012 GS Indian Economics/Prof. S.Maitra8/6/2013 3


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Monetary Policy during inflationAt the time of inflation

monetary policy seeks tocontract aggregate spendingby tightening the money

supply or raising the rate ofreturn.



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Three objectivesTo ensure the economic stability at full

employment or potential level of

output.

To achieve price stability by controlling

inflation and deflation.To promote and encourage economic

growth in the economy.



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Tools of Monetary PolicyBank rate policy

Open market operationsChanging cash reserve ratio

Undertaking selective creditcontrols.



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Bank Rate Policy Bank rate is the minimum rate at which the central

bank of a country provides loan to the commercial

bank of the country.

Bank rate is also called discount rate because bank

provide finance to the commercial bank by

rediscounting the bills of exchange.

When general bank raises the bank rate, thecommercial bank raises their lending rates, it results

in less borrowings and reduces money supply in the

economy.



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LimitationsWell organized money marketshould exist in the economy. It

is not present in IndiaIt is useful during the times ofinflation but it does not fullfil itspurpose during the time ofrecession or depression.



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Open Market OperationsIt means the purchase and sale of

securities by central bank of the

country.It is useful for the developed

countries.

The sale of security by the centralbank leads to contraction of credit andpurchase there of to credit expansion.



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Limitations When the central bank purchases the securities the cash

reserve of member bank will be increased and viceversa.

The bank will expand and contract credit according toprevailing economic and political circumstances and notmerely with reference to their cash reserves.

When the commercial bank cash balance increase thedemand for loan and advance should increase. This maynot happen due to economic and political uncertainty.

The circulation of bank credit should have a constantvelocity.



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What is CRR?

CRR means Cash Reserve Ratio.

Banks in India are required to hold a certain proportion of their

deposits in the form of cash. However, actually Banks dont holdthese as cash with themselves, but deposit such cash with Reserve

Bank of India (RBI). This minimum ratio (that is the part of the total

deposits to be held as cash) is stipulated by the RBI and is known as

the CRR or Cash Reserve Ratio.

Thus, When a banks deposits increase by Rs100, and if the cashreserve ratio is 6%, the banks will have to hold additional Rs 6

with RBI and Bank will be able to use only Rs 94 for investments and

lending / credit purpose. Therefore, higher the ratio (i.e. CRR), the

lower is the amount that banks will be able to use for lending and

investment.

This power of RBI to reduce the lendable amount by increasing theCRR, makes it an instrument in the hands of a central bank through

which it can control the amount that banks lend. Thus, it is a tool used

by RBI to control liquidity in the banking system.

8/6/2013 ICSA 2012 GS Indian Economics/Prof. S.Maitra 11


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What is CRR? Consequent upon amendment to RBI act in 2006, RBI can

prescribe Cash Reserve Ratio (CRR) for scheduled banks

without any floor rate or ceiling rate ( Before this enactment, theReserve Bank could prescribe CRR for scheduled banks between 3

per cent and 20 per cent of total of their demand and time liabilities).

RBI uses CRR either to drain excess liquidity or to release funds

needed for the growth of the economy from time to time. Increase in

CRR means that banks have less funds available and money issucked out of circulation. Thus we can say that this serves duel

purposes i.e.(a) ensures that a portion of bank deposits is kept with

RBI and is totally risk-free, (b) enables RBI to control liquidity in the

system, and thereby, inflation by tying the hands of the banks in

lending money



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What is SLR? Every bank is required to maintain at the close of

business every day, a minimum proportion of theirNet Demand and Time Liabilities as liquid assets in

the form of cash, gold and un-encumbered approved

securities. The ratio of liquid assets to demand and

time liabilities is known as Statutory Liquidity Ratio(SLR). RBI is empowered to increase this ratio up to

40%. An increase in SLR also restrict the banks

leverage position to pump more money into the

economy.



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Repo Rate

Repo (Repurchase) rate is the rate at

which the RBI lends shot-term money tothe banks against securities. When the

repo rate increases borrowing from RBI

becomes more expensive. Therefore, wecan say that in case, RBI wants to make it

more expensive for the banks to borrow

money, it increases the repo rate; similarly,if it wants to make it cheaper for banks to

borrow money, it reduces the repo rate



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Reverse Repo Rate

Reverse Repo rate is the rate at which banks park

their short-term excess liquidity with the RBI. The

banks use this tool when they feel that they are stuck

with excess funds and are not able to investanywhere for reasonable returns. An increase in

the reverse repo rate means that the RBI is ready to

borrow money from the banks at a higher rate of

interest. As a result, banks would prefer to keepmore and more surplus funds with RBI.



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Repo Rate signifies the rate at

which liquidity is injected in the

banking system by RBI, whereas

Reverse repo rate signifies the

rate at which the central bankabsorbs liquidity from the banks



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The policy announcements on 03/05/2011,

indicates that now repo rate has become the only

independent variable policy rate, marking a shift

from earlier method of calibrating various policy

rates separately. The reverse repo rate -- the rate

at which RBI borrows will be kept 100 basis

points lower than the repo rate. On the other

hand Marginal Standing Facility (MSF) rate willbe kept 100 basis points higher than the repo

rate.



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Marginal Standing Facility

Under this scheme, Banks will be able

to borrow upto 1% of their respectiveNet Demand and Time Liabilities". The

rate of interest on the amount accessed

from this facility will be 100 basis points(i.e. 1%) above the repo rate. This

scheme is likely to reduce volatility in

the overnight rates and improvemonetary transmission. This facility has

become effective from May 9, 2011



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Expansionary Monetary Policy Problem: Recession and unemployment

Measures:

(1) Central bank buys securities through open marketoperation(2) It reduces cash reserves ratio(3) It lowers the bank rate

Money supply increases InvestmentincreasesAggregate demand increases Aggregateoutput increases by a multiple of the increase ininvestment



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Tight Monetary Policy Problem: Inflation

Measures: (1) Central bank sells securities through open

market operation (2) It raises cash reserve ratio and statutory liquidity

(3) It raises bank rate(4) It raises maximum margin against holding of stocks ofgoods

Money supply decreases Interest rate raisesInvestment expenditure declines

Aggregate demand declines Price level falls



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Sources of Monetary Mismanagement

Variable time lags concerning theeffect of money supply on the

national income.Treating Interest rate as the targetof monetary policy for influencinginvestment demand for stabilizingthe economy.



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Role of Monetary Policy in

Economic GrowthMonetary policy and savings.

Monetary policy and investment.

Cost of credit..i) Monetary policy and publicinvestment.

ii) Monetary policy and privateinvestment.

iii)Allocation of investment funds.ICSA 2012 GS Indian Economics/Prof. S.Maitra8/6/2013 22


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Monetary Policy of RBI In recent years starting from the mid-nineties

promoting economic growth is being given greater

emphasis in monetary policy of RBI.

Three sub-periods:

Monetary policy of controlled expansion(1951-1972).

Monetary policy in the pre-reforms period(1972-

1991) .

Monetary policy in the post-reforms period(1991-

2011).



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Monetary Policy of Controlled

Expansion Reserve banks responsibility in the circumstances is

mainly to moderate the expansion of credit andmoney supply in such a way as to ensure the

legitimate requirements of industry and trade andcurb the use of credit for unproductive andspeculative purposes.

To ensure controlled expansion, RBI used the

instruments: Changes in bank rate

Changes in cash reserve ratioSelective credit control



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Monetary Policy in the pre

Reform Period (19721991)Price situation worsened during

the years of 1972- 1974. to

contain inflationary pressures RBI

further tightened its monetary

policy.It is similar to tight monetary policy



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Easy and Liberal Monetary

PolicyLiberal monetary policy adopted for

encouraging private sector since

1996.

Two instrument for monetary

management BY RBI since 1996:

Reactivation of bank rate.

Repo rate system .



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Repo Rate System It is introduced through which RBI can add to

liquidity in the banking system. Through reposystem RBI buys securities from the bank and

there by provide funds to them. Repo refers to agreement for a transaction

between RBI and banks through which RBIsupplies funds immediately against government

securities and simultaneously agree torepurchase the same or similar securities after aspecified time which may be one day to 14 days.



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Liquidity Adjustment

Facility(LAF) It is the another instrument of monetary

policy from June 2000 to adjust on a daily

basis liquidity in the banking system.Through LAF, RBI regulates short-term

interest rates while its bank rate policy

serves as a signaling device for itsinterest rate policy in the intermediate

period.



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Movements in Key Policy Rates in India


Latest Rates


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Latest Rates

Bank Rate

9.50% (w.e.f. close of business of 13/02/2012) . Increased from 6.00% to 9.50% which was continuing

since 29/04/2003

Cash Reserve Ratio (CRR) 5.50% (wef 28/01/2012) - announced on 24/01/2012

Decreased from 6.00% to 5.50% which was

continuing since 24/04/2010

Statutory Liquidity Ratio (SLR)

24%(w.e.f. 18/12/2010)Decreased from 25% which

was continuing since 07/11/2009

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Latest Rates

Repo Rate under LAF 8.50% (w.e.f.25/10/2011)

Increased from 8.25% which was continuing since 16/09/2011

Reverse Repo Rate under LAF * 7.50% (w.e.f. 25/10/2011)

Increased from 7.25% which was continuing since 16/09/2011

*Reverse Report rate was an independent rate till

03/05/2011. However, in the monetary policy announced on03/05/2011, RBI has decided that now onwards the Reverse

Repo Rate will not be announced separately, but will be linked

to Repo rate and it will always be 100 bps below the Repo rate

(till RBI decides to delink the same)

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Neutral interest rate Neutral interest rate, as a concept, generally

refers to the level of interest rate at which

monetary policy stance is neither expansionary

nor contractionary. Policy stance can be deemed

neutral when the real interest rate reaches a

level that is consistent with full employment of

resources over the medium-term, and hence fullcapacity output and price stability.



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Neutral interest rate The concept of natural rate of interest was first

introduced into economics by the Swedish

economist Knut Wicksell in 1898. This rate,

theoretically, essentially relates to:

(i) the rate of interest that equates saving with

investment;

(ii) the marginal productivity of capital, and (iii) the rate of interest that is consistent with

aggregate price stability.



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Neutral interest rateAlthough natural and neutral rates of interest are

used interchangeably, there are major conceptual

differences between the two. Moreover, while the

former emerges in the market and is not directlyobservable, the latter essentially is an empirical

approximation used in practice for conduct of

monetary policy. Thus, the neutral rate of interest is

useful as an important benchmark for the actualconduct of monetary policy and also market analysis

of monetary policy stance.



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Liquidity Management Measures taken by the RBI

in 2010--11

Event:End-May 2010: Larger than

anticipated collection for 3G/ BWA

spectrum in addition to advance taxoutflow resulted in migration of

liquidity to central governments cash

balance account with the ReserveBank



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Liquidity Management Measures

taken by the RBI in 2010--11Measures:

For the period May 28, 2010-July 2, 2010, SCBs were:

(i) Allowed to avail additional liquidity support under the

LAF to the extent of up to 0.5 per cent of their NetDemand and Time Liabilities NDTL (for any shortfall inmaintenance of SLR arising out of availing of this facility,banks were allowed to seek waiver of penal interest).

(ii) Given access to second LAF (SLAF) on a daily basis.

With the persistence of deficit liquidity conditions,measure (i) was extended up to July 16, 2010 and

measure (ii) up to July 30, 2010.



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taken by the RBI in 2010--11Event:

End-October 2010: Frictional liquidity

pressure due to autonomous factorscompounded by banks high CRR

requirement (since the fortnight

ended October 22, 2010 had seen a

large increase in NDTL)



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taken by the RBI in 2010--11Measures: (i)The Reserve Bank conducted special SLAF on October 29

and November 1, 2010, a special two day repo auction underthe LAF on October 30, 2010, and allowed waiver of penal

interest on shortfall in maintenance of SLR (on October 30-31,2010) to the extent of 1.0 per cent of NDTL for availingadditional liquidity support under the LAF.

(ii) The Reserve Bank extended these liquidity easingmeasures further and conducted SLAF on all days duringNovember 1-4, 2010 and extended the period of waiver of

penal interest on shortfall in maintenance of SLR ( to the extent of 1.0 per cent of NDTL)

for availing additional liquidity support under the LAF tillNovember 7, 2010.



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taken by the RBI in 2010--11 (iii) The Reserve Bank re-started purchase of

government securities under its open market operations(OMO) from November 4, 2010.

(iv) On November 9, 2010, the Reserve Bankreintroduced daily SLAF and extended the period ofwaiver of penal interest on shortfall in maintenance ofSLR to the extent of 1.0 per cent of NDTLfor availingadditional liquidity support under the LAF till December16, 2010.

(v) On November 29, 2010, the Reserve Bank extendedthe daily SLAF and allowed additional liquidity support tothe SCBs under the LAF to the extent of up to 2.0 percent of their NDTL till January 28, 2011.



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taken by the RBI in 2010--11Event:

Mid-December 2010:Continued build up ingovernment balances onaccount of third quarterlyadvance tax collections



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taken by the RBI in 2010--11Measures:

In the mid-Quarter Review of December 2010, theReserve Bank:

(i) Reduced the SLR of SCBs from 25 per cent of NDTLto 24 per cent with effect from December 18, 2010. Giventhe permanent reduction in the SLR, additional liquiditysupport of 1.0 per cent of NDTL under the LAF would beavailable from December 18, 2010 till January 28, 2011.

(ii) Announced conduct of OMO auctions for purchase ofgovernment securities for an aggregate amount ofRs.48,000 crore in the next one month (staggered aspurchases of Rs.12,000 crore per week).

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