Monetary Policy & Inflation

What is Money Supply?Money supply is one of the important indicator of

macroeconomic environment

This refers to the total volume of money circulating in the economy at a point in time.

Money supply in an economy determines liquidity conditions in the market, which in turn impacts interest rate structure and hence the cost of capital to the firms.

Contd..

Money supply is basically determined by the central bank of a country (e.g. Reserve Bank of India) and the commercial banking network.

RBI has adopted four measures of money supply viz.-Ml, M2, M3 and M4 .

M3 (broad money) is most popular from operational point of view. M3 includes time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1.

What cause increase in money supply?gulated? RBI has the power to print notes, they can hence release more

money into the economy.

However it is only partly true. Such a process cannot be sustained as more notes for the same quantity of physical goods in the economy will only bring down the value of the currency and hence will not benefit anyone.

After all increase in money supply should be done with an objective to benefit the economy as a whole by protecting the value of the currency. So, a government has to exercise restraint in printing notes.

Factors affecting Money supply

Bank credit

Deficit financing

Foreign exchange reserves

Government Expenditure

FII inflows

Why Is Money Supply Important?

An increase in the supply of money works both through interest rates, which spurs INVESTMENT, and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending.

Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods.

In a buoyant economy stock market prices rise and firms issue equity and debt. If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits

What is Inflation??A sustained increase in the general level of prices so that a

given amount of money buys less and less.

In the Keynesian sense True inflation begins when the elasticity of supply of output in response to increase in money supply has fallen to zero or when output is unresponsive to changes in money supply.

Opinion survey conducted in India, USA and many other countries reveal that inflation is the most important concern of the people as it badly affects their standard of living.

Important terms related to InflationDeflation: is the opposite of inflation when fall in prices

occurs.

Disinflation: is process of bringing down prices moderately from their high level.

Stagflation: is a term in macroeconomics used to describe a period of high inflation combined with low incomes, unemployment, or economic stagnation.

Types of InflationDemand pull inflation: This represents a situation where there is increase in

Aggregate Demand for resources either from the government or the entrepreneurs or the households. Result of this is that the pressure of Demand can’t be met by the Currently available Aggregate Supply which result in Aggregate Demand > Aggregate Supply which is bound to generate inflationary pressure in the economy.

Types of Inflation

Cost Push inflation: This is because of large increases in the cost of important goods or services where no suitable alternative is available. This may happen if the costs especially wage cost rise.

Hyperinflation: Hyperinflation is also known as runaway inflation or galloping inflation. This type of inflation occurs during or soon after a war

Causes of InflationInflation due to Monetary expansion (Monetary

inflation)

Inflation due to rise in real aggregate demand (Real inflation)

Inflation due to contraction in Aggregate Supply

Monetary inflation

It was Milton Friedman who famously quipped, “Inflation is always and everywhere a monetary phenomenon.” If the quantity of money grows at a pace greater than warranted by the growth of the economy, then the excess money supply drives up prices.

Remedies – Monetary Inflation

If the cause of inflation is instead monetary expansion, aggregate supply should still be stimulated, but the focus of effort should be constraining further monetary expansion.

Remedies - Real Demand Inflation

It involves inflation rising as the real gross domestic product rises and unemployment falls

If inflation is caused by strong real demand, the best response may be to support aggregate supply growth. Part of the solution may be to let prices rise.  Suppliers need incentives to invest in new capacity.

Stimulating aggregate supply include encouraging business investment; reducing input costs; and increasing competitive intensity.

Remedies - Real Demand InflationIf aggregate supply is sufficiently stimulated, inflation may be

converted into balanced economic growth:

If instead money supply is tightened in the face of strong real demand, the result will be a surge in interest rates, which may be counterproductive in this case, as it will be harder for aggregate supply to expand when borrowing costs are high.

Real v/s Money Inflation

To distinguish real demand inflation from monetary inflation is to look at interest rates.  When inflation is caused by strong real demand, interest rates will tend to be high.  When inflation is caused by excessive monetary growth, in contrast, interest rates will tend to be low.

Measurement of Inflation

Inflation is measured by the Wholesale Price Index (WPI)

Consumer Price Index (CPI)

A Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods.

Some countries use the changes in this index to measure inflation in their economies, in particular India – The Indian WPI figure is released weekly

WPI as a measure of inflation in India

WPI is preferred to CPIwider commodity coverage

available on weekly basis

computed at all-India basis

WPI Inflation is divided into three broad categoriesPrimary Articles

Fuel Products and

Manufacturing Items.

Headline inflationHeadline inflation is a measure of the total inflation

within an economy and is affected by certain components which may experience sudden inflationary spikes such as food or energy. As a result, headline inflation may not present an accurate picture of the current state of the economy.

WPI is the measure of headline inflation in India

Core inflation

Core inflation has emerged as an alternative for measuring inflation. In this, volatile items like food prices and fuel items are excluded.

The first two categories include food articles and fuel items which can be excluded. The third category – Manufacturing also includes food products which tends to be volatile as well and moves in line with prices of primary articles. So after excluding food products from manufacturing sector, we get non-food manufactured products inflation. This can also be called as core inflation for India

Consumer Price Index

CPI, also retail price index is a statistical measure of a weighted average of prices of a specified set of goods and services purchased by wage earners in urban areas. It is a price index which tracks the prices of a specified set of consumer goods and services, providing a measure of inflation.

CPI in India based on different economic groups.

CPI UNME (Urban Non-Manual Employee)

CPI AL (Agricultural Labourer)

CPI RL (Rural Labourer)

CPI IW (Industrial Worker).

While the CPI UNME series is published by the Central Statistical Organization, the others are published by the Department of Labor.

Effects of inflationWealth costs – inflation affects those on fixed incomes and

redirects wealth to other (physical) assetsPlanning costs – businesses uncertain about future price

changes may be reluctant to invest – hits economic growthCompetitiveness – inflation at a higher rate in the UK than

elsewhere hits domestic competitiveness and affects the balance of payments

Social stability - At very high rates, confidence in the currency is eroded and production and exchange can be stifled – can lead to food riots, looting and violence

Real & Nominal Interest rates

Real Interest Rate = Nominal Interest Rate – Inflation

Real interest rate, is one where the effects of inflation have been factored in. A nominal variable is one where the effects of inflation have not been accounted for.

Monetary Policy

What is Monetary Policy??

It is the process by which the central bank or monetary authority of a country regulates (i) the supply of money (ii) availability of money and (iii) cost of money or rate of interest in order to attain a set of objectives oriented towards the growth and stability of the economy

Monetary policy

Monetary policy is one of the tools used to control the supply and availability of money, to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank“.

What is Monetary Policy?? It is concerned with the changing the supply of money

stock and rate of interest for the purpose of stabilizing the economy by influencing the level of aggregate demand.

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 to stimulate aggregate demand in the economy.

At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money supply or raising the rate of return.

Monetary policy provides

a) an overview of economy

b) specifies measures that RBI intends to take to influence such

key factors like…money supply….interest rates….inflation

c) lays down norms for financial institutions like banks, financial companies etc. relating to CRR, capital adequacy

Monetary policy & Inflation

When inflationary pressures build up: raise the short-term interest rate (the policy rate)

which squeezes consumption and investment.

TYPES OF MONETARY POLICY

Cheap money policy : Followed in periods of slums & depression

Dear money policy: Followed in

periods of boom & inflation.

Monetary Policy Instruments

Open Market Operations

Bank rate

Cash Reserve Ratio

Statutory Liquidity Ratio

Repo rate

Reverse Repo rate

Open Market Operations

OMOs are the means of implementing monetary policy by which a central bank controls the nation’s money supply by buying and selling government securities, or other financial instruments

What is the outcome on account of OMO?

When the RBI buys bonds from the market and infuses liquidity, the consequences are:

It tends to soften the interest rates

It enables corporate to borrow at favorable interest rates

It may tend to increase inflation

Consequently… If the RBI were to sell bonds instead and suck in liquidity, the effect would exactly be the opposite!!

Bank rate

Rate at which Central Bank lends money to commercial Banks

The bank rate signals the central bank's long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa.

Any increase in Bank rate results in an increase in interest rate charged by Commercial banks which in turn leads to low level of investment and low inflation

Cash Reserve Ratio It refers to the cash which banks have to maintain with

RBI as certain percentage of their demand and time liabilities

An increase in CRR reduces the cash with commercial banks which results in low supply of currency in the market, higher interest rate and low inflation

Statutory Liquidity Ratio It is the percentage of total deposits commercial banks

have to invest in government bonds and other approved securities. RBI in November cut the SLR for banks by one percentage point and it now stands at 24% of their total demand and time deposit liabilities

Objectives of SLRTo restrict expansion of Bank creditTo augment bank’s investment in government securitiesTo ensure solvency of banks

Meaning of Repo The term Repo is used as an abbreviation for

Repurchase Agreement.

Repo rate is the interest rate at which the central bank lends funds to banks against pledging securities

It enables collateralized short term borrowing and lending through sale/purchase operations in debt instruments

Repo Rate In current review of monetary policy Repo rate 6.5% and

reverse repo is 5.5%

If the 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.

Reverse RepoThe rate at which RBI borrows money from the banks (or

banks lend money to the RBI) is termed the reverse repo rate.

If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk)

Reverse RepoConsequently, banks would have lesser funds to lend to their

customers. This helps stem the flow of excess money into the economy

Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected.

Importance of Repo & Reverse Repo

It helps borrower to raise funds at better ratesAn SLR surplus and CRR deficit bank can use the Repo deals as a convenient way of adjusting SLR/CRR positions simultaneously.

RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system

Reverse Repo is undertaken to earn additional income

on idle cash.

Major Players in Repo/Reverse Repo market

The major players in the repo and reverse repurchase market tend to be banks who have substantially huge portfolios of government securities as approved by RBI (Treasury Bills, Central/State Government securities).

Besides these players, primary dealers who often hold large inventories of tradable government securities are also active players in the repo and reverse repo market.

DFHI is very active in the Repo Market. It has been selling and purchasing on repo basis T-Bills and eligible dated Government Securities.

Discount and Finance House of India (DFHI)

The DFHI was set up in April 1988 by the Reserve Bank with the objective of deepening and activating the money market. It has commenced its operations from July 28, 1988.

DFHI is also an authorized institution to undertake repo transactions in treasury bills and all dated government securities to impart greater liquidity to these instruments.

Since November 13, 1995, DFHI is an accredited primary dealer. With this accreditation, its role has undergone a transformation. Now it acts as a market maker, giving two-way quotes and takes large positions on its account in government securities.

Call Rate – Short term Inter bank rate

Call rate is the interest rate paid by the banks for lending and borrowing for daily fund requirement. Since banks need funds on a daily basis, they lend to and borrow from other banks according to their daily or short-term requirements on a regular basis.

Liquidity Adjustment FacilityA tool used in monetary policy that allows banks to borrow money

through repurchase agreements. This arrangement allows banks to respond to liquidity pressures and is used by RBI to assure basic stability in the financial markets.

Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control.

banks use eligible securities as collateral through a repo agreement and use the funds to alleviate their short-term requirements, thus remaining stable.

Liquidity Adjustment Facility

Objective : The funds under LAF are used by the banks for their day-to-day mismatches in liquidity. Tenor :Under the scheme, Reverse Repo auctions (for absorption of liquidity) and Repo auctions (for injection of liquidity) are conducted on a daily basis (except Saturdays). Eligibility : All commercial banks (except RRBs) and PDs having current account and SGL account with RBI. Minimum bid Size : Rs. 5 cr and in multiple of Rs.5 cr Eligible securities: Repos and Reverse Repos in transferable Central Govt. dated securities and treasury bills.

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

Mid-Quarter Monetary Policy Review: December

2010 by RBI Monetary Measures: It has been decided to: retain the repo rate at 6.25 per cent and the reverse repo rate at 5.25 per

cent under the Reserve Bank’s liquidity adjustment facility (LAF); retain the cash reserve ratio (CRR) at 6.0 per cent of net demand and time

liabilities (NDTL) of scheduled banks.

Liquidity Measures: It has been decided to: reduce the statutory liquidity ratio (SLR) of scheduled commercial banks

(SCBs) from 25 per cent of their NDTL to 24 per cent with effect from December 18, 2010;

conduct open market operation (OMO) auctions for purchase of government securities for an aggregate amount of ` 48,000 crore in the next one month, the schedule for which is being issued separately.

The above two measures are expected to inject liquidity on an enduring basis of the order of ` 48,000 crore.

Contd.. Dec -10 Inflation Though inflation has moderated, inflationary pressures persist

both from domestic demand and higher global commodity prices. The pace of decline in food price inflation has been slower than expected due largely to structural factors.

There is a risk that rising international commodity prices will spill over into domestic inflation. Going forward, rising domestic input costs for the manufacturing sector combined with aggregate demand pressures could weigh on domestic inflation. The risk to the Reserve Bank’s projection of 5.5 per cent inflation by March 2011 is on the upside.

Contd.. Dec -10 Liquidity While the overall liquidity in the system has remained in deficit consistent

with the policy stance, the extent of tightness has been beyond the comfort level of the Reserve Bank. In addition, the liquidity deficit has been accentuated by structural factors such as relatively sluggish growth in bank deposits even as the credit growth accelerated in 2010-11. While the liquidity deficit improved transmission of monetary policy signals with several banks raising deposit and lending interest rates, excessive deficits induce unpredictability in both availability and cost of funds, making it difficult for the banking system to sustain credit delivery.

As the economy expands, it needs primary liquidity, which will have to be provided in a manner consistent with the monetary policy stance. Such provision of liquidity should not be construed as a change in the monetary policy stance since inflation continues to remain a major concern. The measures taken in this review need to be appreciated in that context.

Analyst comments for 25th Jan Review of credit policy

The vast majority of analysts surveyed expect the RBI to raise key

lending and borrowing rates by only 25 basis points (bps) on Jan. 25 despite persistent price pressures, as a slump in industrial production growth suggests some risks to economic momentum still exist.

The RBI raised its main lending rate or the repo rate Repo rate by 150 bps to 6.25 percent and its main borrowing rate by 200 bps to 5.25 percent through six rate increases in 2010.

This is the most widely expected policy action by the RBI to contain price pressures without sapping the economy's momentum. It would be in line with what it says is its "calibrated" or gradual approach to tightening, which is perceived as a 25 bps rate hike by the market.

With November industrial output data at an 18-month low, a 25-basis-point rate hike could be the least disruptive yet send an anti-inflationary signal.

Third Quarter Review of Monetary Policy 2010-11

Increase the repo and reverse repo rates by 25 basis points (bps) each. Accordingly, the repo rate stands at 6.5 per cent and the reverse repo rate at 5.5 per cent;

Retain the cash reserve ratio (CRR) at 6 per cent of net demand and time liabilities (NDTL) of banks.

Reserve Bank has cumulatively increased the repo rate by 175 bps and the reverse repo rate by 225 bps. Additionally, the CRR was increased by 100 bps. Banks have responded to this calibrated tightening by raising their deposit and lending rates, suggesting strong monetary policy transmission.

Considerations Behind the Policy Move

Inflation is clearly the dominant concern. Primary food articles inflation has risen again sharply. Non-food articles inflation and fuel inflation are already at elevated levels. Non-food manufacturing inflation has remained sticky. There are signs of food and fuel price increases spilling over into generalized inflation.

Second, there has been a sharp rise in global commodity prices which has heightened upside risks to domestic inflation.

Third, growth has moved close to its pre-crisis trajectory even in the face of an uncertain global recovery.

Fourth, the uncertainty with regard to global recovery has reduced.

Role of RBI

during

Recession

What is recession…? An economy which grows over a period of time tends to

slow down the growth as a part of the normal economiccycle.

An economy typically expands for 6-10 years andtends to go into a recession for about six months to 2 years.

A recession normally takes place When consumers lose confidence in the growth of the economy and spend

less. This leads to a decreased demand for goods and services,

which in turn leads to a decrease in production, lay-offsand a sharp rise in unemployment.Investors spend less as they fear stocks values will fall and thus stock markets fall on negative sentiment

Economic Cycle

RBI’s measures during III QUARTER OF 2008-09

Role of Monetary policy Problem: Recession and unemployment Expansionary monetary policy Measures: Central bank buys securities through open market operation

Reduces cash reserves ratio Lowers the bank rate Leads to

Money supply increases Investment increases

Aggregate demand increasesAggregate output increases by amultiple of the increase in investment

RBI Announces Further Monetary Stimulus Date : 02 Jan 2009

On a review of current global and domestic macroeconomic situation, the Reserve Bank has decided to take the following further measures:

Repo Rate To reduce the repo rate under the liquidity adjustment facility (LAF)  by 100 basis points

from 6.5 per cent to 5.5 per cent with immediate effect. Reverse  Repo Rate To reduce the reverse repo rate under the LAF by 100 basis points  from 5.0 per cent to 4.0

per cent with immediate effect. Cash Reserve Ratio To reduce the cash reserve ratio (CRR) of scheduled banks by 50 basis points from 5.5 per

cent to 5.0 per cent from the fortnight beginning January 17, 2009. The reduction in the CRR will inject additional liquidity of around Rs. 20,000 crore to the

financial system. It is expected  that the reduction in the policy interest rates and the CRR will further  enable banks to provide credit for productive purposes at appropriate interest rates. The Reserve Bank on its part would continue to maintain a comfortable liquidity position in the system.

The fundamentals of our economy continue to be strong. Once the crisis is behind us, and calm and confidence are restored in the global markets, economic activity in India would recover sharply. But a period of painful adjustment is inevitable.

Thank You