GS Indian Economics Important Concepts of Economics

Lecture No.: 4Date: December 21, 2014

S. MaitraAssociate Professor of Economics

Monetary Policy and Role of Reserve Bank of India

Civil Services Study CentreAdministrative Training InstituteGovernment of West BengalSaltlake, Kolkata-700106CSE 20151Preparing for Prelims with focus on MainsPrices and Inflation21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in2The Reserve Bank of India had adopted the new Consumer Price Index (CPI) (combined) as the key measure of inflation.Earlier, RBI had given more weightage to Wholesale Price Index (WPI) than CPI as the key measure of inflation for all policy purposes.This has been done following recommendations of Urjit R. Patel Committee.ATI-CSSCCSE 2015Urjit Patel Committee Major Recommendations An Expert Committee under the Chairmanship of Urjit Patel, Deputy Governor of RBI to Revise and Strengthen the Monetary Policy Framework was appointed on September 12, 2013. The Choice of Nominal AnchorInflation should be the nominal anchor for the monetary policy framework. The Choice of Inflation MetricThe RBI should adopt the new CPI (combined) as the measure of the nominal anchor for policy communication. The nominal anchor should be defined in terms of headline CPI inflation, which closely reflects the cost of living and influences inflation expectations relative to other available metrics.3S. Maitra/ATI-CSSC iasstudymat.blogspot.in21/12/2014ATI-CSSCCSE 2015Urjit Patel Committee Major Recommendations Numerical Target and PrecisionThe nominal anchor or the target for inflation should be set at 4 per cent with a band of +/- 2 per cent around. Price stabilitySince food and fuel account for more than 57 per cent of the CPI on which the direct influence of monetary policy is limited, the commitment to the nominal anchor would need to be demonstrated by timely monetary policy

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4S. Maitra/ATI-CSSC iasstudymat.blogspot.in21/12/2014ATI-CSSCUrjit Patel Committee Major Recommendations Institutional RequirementsConsistent with the Fiscal Responsibility and Budget Management (Amendment) Rules, 2013, the Central Government needs to ensure that its fiscal deficit as a ratio to GDP is brought down to 3.0 per cent by 2016-17.Administered setting of prices, wages and interest rates are significant impediments to monetary policy transmission and achievement of the price stability objective, requiring a commitment from the Government towards their elimination.

5S. Maitra/ATI-CSSC iasstudymat.blogspot.in21/12/2014ATI-CSSCCSE 2015Prices and Inflation21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in6Measures to control inflation: Monetary measures Fiscal measures Other measuresATI-CSSCCSE 2015

Monetary Policy and its Objectives21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in7Monetary 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 of aggregate demand. Objectives of Monetary Policy:To 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. Promotion of a stable financial system which can avert crisis by absorbing shocks is thus an important goal of a Central Bank.Preventing sharp fluctuations in the value of the rupee so as to maintain orderly conditions in the foreign exchange market is rightly counted as a major goal of the RBI.

ATI-CSSCTraditional and New Tools of Monetary Policy21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in8Bank Rate Policy: Bank rate is the rate at which the central bank of a country provides loan to the commercial banks. If the bank rate is low, the banks are encouraged to borrow reserves against which they can advance loans. This facilitates credit creation. An upward revision of this rate discourages borrowing and exerts a contractionary effect on money stock. When central bank raises the bank rate, the commercial bank raises their lending rates, and it results in less borrowings and reduces money supply in the economy. Open Market Operations: Open market operation consists of purchase and sale of securities by the central bank of the country. The sale of security by the central bank leads to contraction of credit and purchase thereof leads to credit expansion. ATI-CSSCTraditional and New Tools of Monetary Policy21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in9Cash Reserve Ratio: Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep with RBI in the form of reserves or balances. When CRR is increased, the loanable funds at the disposable of commercial banks get reduced and the money supply contracts. The opposite effect occurs if the CRR is reduced. This increases the ability of the banks to create deposit money. Since it is rather a drastic way to change the money supply, the variation in CRR is not used very frequently.Selective Credit Control: Selective Credit Controls are aimed at regulating the distribution of credit amongst sectors or purposes. RBI uses this measure to prevent speculative hoarding of essential commodities and check undue rises in prices. Selective credit control measures include fixing the margin requirements for loans, fixing the maximum limit for advances and charging discriminatory interest rates on selective advances. RBI may also instruct banks not to provide loans for a specific purpose.ATI-CSSCTraditional and New Tools of Monetary Policy21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in10Repo Rate: Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks against securities. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can 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 rateReverse 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 invest anywhere 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 keep more and more surplus funds with RBI.Thus, we can conclude that 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 bank absorbs liquidity from the banks.ATI-CSSC

21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in11Expansionary or Easy Monetary Policy (undertaken during Recession and unemployment): Measures: (1) Central bank buys securities through open market operation. (2) It reduces cash reserves ratio. (3) It lowers the bank rateMechanism: Money supply increases Investment increasesAggregate demand increases Aggregate output increases by a multiple of the increase in investment Contractionary or Tight Monetary Policy (undertaken during 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 of goods Mechanism: Money supply decreases Interest rate raises Investment expenditure declinesAggregate demand declines Price level fallsTypes of Monetary PolicyATI-CSSCOperating Procedure of Monetary Policy21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in12Liquidity Adjustment Facility: Key element in the monetary policy operating framework of the RBI. On daily basis, the RBI stands ready to lend to or borrow money from the banking system, as per the latter's requirement, at fixed interest rates. The primary aim of such an operation is to assist banks to adjust to their day-to-day mismatches in liquidity, via repo and reverse repo operations.The interest rate on the LAF is fixed by the RBI from time to time.LAF operations help the RBI effectively transmit interest rate signals to the market.ATI-CSSCChanges in the Operating Procedure of Monetary Policy21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in13Effective 3 May 2011, based on the recommendations of the Working Group on Operating Procedure of Monetary Policy, the operating framework of monetary policy has been refined. The repo rate has been made the only independently varying policy rate. A new marginal standing facility (MSF) has been instituted, under which SCBs have been allowed to borrow overnight at their discretion, up to 1 per cent of their respective NDTL, at 100 bps above the repo rate. The revised MSF reverse repo corridor has been defined with a fixed width of 200 bps with the repo rate placed in the middle of the corridor. The reverse repo rate has been placed 100 bps below and the MSF rate 100 bps above the repo rate.ATI-CSSCReserve Bank of India21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in14The apex institution of our financial system, the Reserve Bank of India, was set up on 1 April 1935, under the Reserve Bank of India Act. It was nationalized on l January 1949. RBI has a central board of directors headed by the Governor. The head office is in Mumbai with four local boards at Delhi, Kolkata, Chennai, and Mumbai.

ATI-CSSCMajor functions of RBI21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in15Currency authority: RBI is the sole authority for the issue of currency other than one rupee notes and coins and other small coins (which are issued by the GOI). Controlling the supply of money and credit in the economy is the responsibility of the RBI.Banker to government: RBI is in charge of all banking business of the central as well as state governments. The governments maintain accounts at RBI which makes loans and advances to them. RBI is also the manager of the public debt, both internal and external, of the country. Currently, GOI bonds are auctioned through the public debt office (PDO) of RBI.ATI-CSSC21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in16Major functions of RBIBanker's bank and supervisor: The RBI holds part of the cash reserves of commercial banks, lends funds to them in times of need, provides them clearing facilities, and keeps a close watch on their activities. To banks, RBI is the lender of last resort. In India the demand for funds increases, steeply during the months of November to April to finance the marketing of major kharif crops. RBI lends to banks generously to help them meet this need. Custodian of foreign exchange: RBI is entrusted with managing the country's foreign exchange reserves and maintaining the external value of the rupee. In the days before economic reform, the exchange rate of the rupee was rigidly controlled. Now the RBI intervenes in the foreign exchange market only to keep the market-determined rate within reasonable bounds.

ATI-CSSCCHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in17In India, prior to 1991, interest rates and returns on all types of financial investments were strictly regulated. Banks had to operate under numerous restrictions imposed by the Government of India. There was virtually no competition in the banking sector and the nationalised banks were required to perform many social duties, like lending to priority sectors at subsidised rates of interest.Heavy regulation, lack of competition and accountability along with emphasis on social responsibility, at the cost of profitability, led to cumulative rise in inefficiency and non-performing assets (NPA) over the decades.

ATI-CSSCCHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in18RBI did not have desired autonomy during pre-reform period and monetary policy virtually played an accommodative role to fiscal policy. The central government could borrow without limit from the RBI through ad hoc treasury bills (which were basically overdrafts on the RBI). In addition to CRR, commercial banks were statutorily required to hold a specified per centage of their assets (statutory liquidity ratio, SLR) in the form of government bonds. These bonds had zero risk of default, but yielded very low returns. SLR was the mechanism by which the banks were forced to lend to the Government of India at interest rates that were kept artificially low. In the early 1990s more than 60 per cent of incremental bank deposits used to be allocated to meet the CRR and SLR requirements.ATI-CSSCCHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in19The GOI used to fix interest rates on government bonds at levels much lower than those on other assets with the obvious intention of minimising its cost of borrowing. As a result, general public did not show much interest in these bonds. These bonds were held, under compulsion, mostly by banks, provident funds, and nationalised insurance companies.In India, the process of economic reform began in 1991. Banking reform has been an important component of that process. On the recommendations of the Narasimham Committee on Financial System (1991), the GOI has adopted measures to restructure the banking system.

ATI-CSSCCHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in20The major steps include: lifting of regulations on interest rates on deposits and advances; allowing entry of private banker; liberalisation of branching regulations for both public and private sector banks; introduction of capital adequacy, income recognition, and provisioning norms; and reduction of the appropriation of loanable funds by the GOI through gradual decrease in CRR and SLR. Banks have now more funds at their disposal for lending on commercial terms. CSE 2015

ATI-CSSCCHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in21 The monetary reform undertaken in India was characterised by the move from direct instruments (such as administered interest rates, reserve requirements, selective credit control) to indirect instruments (such as open market operations, purchase and repurchase of government securities) for the conduct of monetary policy.

ATI-CSSCCHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in22The GOI no longer has the power to control interest rates on government bonds and the SLR has been progressively reduced.SLR was as high as 38.5 per cent in 1992, but gradually reduced to only 25 per cent in 2005. Banks continue to hold a larger portion of their portfolio in the form or such securities because of these are of low risk and high liquidity, but banks are no longer forced to do so.

ATI-CSSCCSE 2015CHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in23Earlier, through the use of ad hoc treasury bills the GOI used to enjoy unlimited access to the RBI credit. More than 90 per cent of the variations in reserve money, on an average, during 1980s, were due to the deficit financing or the RBI credit to the central government. This is known as automatic monetisation of deficit. Such automatic monetisation of deficit severely degraded the ability of the monetary authorities (RBI and Ministry of Finance) to pursue independent monetary policy. ATI-CSSCCHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in24As part of fiscal consolidation, issue of ad hoc treasury bills has been abolished and a system of Ways and Means Advances (WMA), with a mutually agreed prior limit, introduced to meet temporary mismatch between receipts and expenditures of the GOI.Significantly, greater autonomy of the RBI has been one of the major positive results of financial reform in India.ATI-CSSCCHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD21/12/2014S. Maitra/ATI-CSSC iasstudymat.blogspot.in25With budget deficits not being automatically monetised now, fiscal policy does not determine reserve money any more. On the contrary, it is increasingly reflecting the RBIs assessment of market liquidity and absorptive-capacity (RBI, Annual Report, 2000-01). The monetary authorities now have much more discretionary control over the stock of reserve money. In the pre-reform days, the yield on government bonds was kept at such a low level that there was not much demand for it. Since the market for government debt was very narrow and undeveloped earlier, OMOs as an instrument of credit control was ineffective. Situations are now changing.ATI-CSSC You may visit my blog for my earlier lectures and study materials iasstudymat.blogspot.in

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