Monetary Policy and Money Market:

An Empirical Analysis of Indian

Economy

School of Economics, DAVV

A Synopsis Report is submitted to School of Economics, DAVV Indore

For Partial Fulfilment of the Degree ofMaster of Business Administration

In Financial Services

2017-2019

Submitted To: Submitted By:

Dr. M.Vasim Khan Rounak Chavhan

Sr.Lecturer, School of Economics DAVV, MBA (FS) IIIrd SEMESTER

2017-2019
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 Content

S.No Title Page No.

1. Introduction 3–4

2. Review of Literature 5–8

3. Rationale of the Study 9

4. Objective’s of the Study 9

5. Research Methodology 10 – 11

6. References 12 – 13

Introduction

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It refers to the policy of the central bank with regard to the use of monetary instruments under its
control to achieve the goals specified in the Act. The Reserve Bank of India (RBI) is vested with the
responsibility of conducting monetary policy. This responsibility is explicitly mandated under the
Reserve Bank of India Act, 1934.The primary objective of monetary policy is to maintain price
stability while keeping in mind the objective of growth. Price stability is a necessary precondition to
sustainable growth.In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to
provide a statutory basis for the implementation of the flexible inflation targeting framework.The
amended RBI Act also provides for the inflation target to be set by the Government of India, in
consultation with the Reserve Bank, once in every five years. Accordingly, the Central Government
has notified in the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for
the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and
the lower tolerance limit of 2 per cent.

The Central Government notified the following as factors that constitute failure to achieve the
inflation target: (a) the average inflation is more than the upper tolerance level of the inflation target
for any three consecutive quarters; or (b) the average inflation is less than the lower tolerance level
for any three consecutive quarters.Prior to the amendment in the RBI Act in May 2016, the flexible
inflation targeting framework was governed by an Agreement on Monetary Policy Framework
between the Government and the Reserve Bank of India of February 20, 2015.

Instruments of Monetary Policy:There are several direct and indirect instruments that are used for
implementing monetary policy. 1) Repo Rate: The (fixed) interest rate at which the Reserve Bank
provides overnight liquidity tobanks against the collateral of government and other approved
securities under the liquidity adjustment facility (LAF). 2)Reverse Repo Rate: The (fixed) interest
rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the
collateral of eligible government securities under the LAF.3)Liquidity Adjustment Facility (LAF):
The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has
increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of range
of tenors. The aim of term repo is to help develop the inter-bank term money market, which in turn
can set market based benchmarks for pricing of loans and deposits, and hence improve transmission
of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as
necessitated under the market conditions. 4) Marginal Standing Facility (MSF): A facility under
which scheduled commercial banks can borrow additional amount of overnight money from the
Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal
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rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking
system. 5) Corridor: The MSF rate and reverse repo rate determine the corridor for the daily
movement in the weighted average call money rate. 6) Bank Rate: It is the rate at which the Reserve
Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is
published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to
the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside
policy repo rate changes. 7) Cash Reserve Ratio (CRR): The average daily balance that a bank is
required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time
liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India. 8)
Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe and
liquid assets, such as, unencumbered government securities, cash and gold. Changes in SLR often
influence the availability of resources in the banking system for lending to the private sector.9)
Open Market Operations (OMOs): These include both, outright purchase and sale of government
securities, for injection and absorption of durable liquidity, respectively.10) Market Stabilisation
Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus
liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of
short-dated government securities and treasury bills. The cash so mobilised is held in a separate
government account with the Reserve Bank.

The money market is a market for short-term financial assets that are close substitutes of money.
The most important feature of a money market instrument is that it is liquid and can be turned into
money quickly at low cost and provides an avenue for equilibrating the short-term surplus funds of
lenders and the requirements of borrowers. The call/notice money market forms an important
segment of the Indian Money Market. Under call money market, funds are transacted on an
overnight basis and under notice money market; funds are transacted for a period between 2 days
and 14 days. There is no physical market as such, the money market is intangible. Most transactions
happen online or via the telephone. The main aim is to provide short-term finance at reasonable rates to
the institutes in need. Let us take a look at some of the main instruments of the money market.

Review of Literature
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Prabu (2015), in his research articleDo Monetary Policy Announcements in India have any impact
on the domestic Stock Market?, tried to examine the impact of monetary policy announcements on
stock indices in the Indian context; and they find no statistically significant impact ofmonetary
policy announcements on stock indices, although there is some evidence that policysurprises matter.
The results, although somewhat non-confirmative, are not unprecedented in the literature. Their
findings may be attributed to several factors viz, (i) dominance of the bank lending channel in
monetary transmission; (ii) few policy surprises in a relatively stable macro environment;(iii)
limited influence of domestic monetary policy on FPIs; (iv) absence ofcommonality among players
in stock and other financial market segments; and (v) the relative ineffectiveness of the asset-price
channel of monetary transmission. Moreover, while it is entirely feasible that the impact of policy
announcements on daily data isnot evident, it could have some impact on a smaller window of
about 15-20 minutes immediatelyafter the announcement. Pending the availability of such intensive
high-frequency data, anyassessment of the impact of monetary policy on financial market behavior
wouldremainimperfectand, at best, partial.

Leith (2009), analyzed the effects monetary policy has on interest rates in the private money market
using market micro structure variables.He also examines the impact of policy announcements on
these rates. According to his study “The Effect of Monetary Policy on Private Money Market Rates
in Jamaica: AnEmpirical Microstructure Study”,the nature of therelationship between monetary
policy and/or policy announcements on money marketinterest rates is investigated by examining the
volatility of interest rates. The results show that generally volatility is highest in the thirty-day
segment of the private money market and lowest in the inter-bank segment. The BOJ open market
operations have no impact on the overnight money market rates. However, OMOs increase
volatility in the inter-bank and thirty-day segments of the money market. There appears to be
volatility spill-over’s from the thirty-day market to the inter-bank but none to the overnight market.
Interestingly, this spill-over is positive for the inter-bank. In other words, an increase in the
volatility in the thirty-day market (possibly from monetary policy action) causes an increase in the
volatility of interest rates in the inter-bank money market.

Akiwatkar (2014),through his article “Effect of Monetary Policy on Indian Stock Market shows
the analysis performed in the research and the impulse response graphs drawn, it can be interpreted

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that money growth in addition to market growth is the major determinant of stock market
performance since it is the major variable that determines stock market performance in the long run.
This is followed by FII growth and inflation rate which were secondary determinant affecting the
stock market of India. The short run, medium run and long run equilibrium relationships between
the four variables has been examined and these would be useful in giving appropriate policy
recommendations to central bankers for better formulation of monetary policy for stock market
stability and growth.

Sensarma (2015), documented “Measuring monetary policy and its impact on the bond market of
an emerging economy”according to his study, In view of multiple instruments used by many central
banks in emerging market economies, we derive a composite measure of monetary policy for India
and assess its impact on the yieldcurve. Our results show that while monetary policy has the
dominant impact amongmacroeconomic variables on the entire term structure, it is particularly
strong at the shorter endand on credit spreads. Shifts in the level of the government yield curve and
credit spreads alsolead to changes in monetary policy. In terms of robustness, our measure performs
better than anarrative based measure of monetary policy available in the literature.

Hojat (2015), addressed the significance of the monetary policy instruments M2, FFR, and FFF on
the expected rate of returns of publicly traded companies. The research design was ex post facto. To
answer the research questions, annual data were collected for the period of January 2005 through
January 2015 for the rate of return on the overall equity market, rate of return on stocks of 90
publicly traded companies, size of the sample companies, M2, FFR, and FFF. A multiple regression
showed a positive effect of market rate of return and company size, a positive moderation effect of
M2, and a negative moderation and mediation effect of FFR and FFF on the expected rate of returns
of publicly traded companies (p < .05). These findings could have positive social change
implications in that they may help individual and institutional investors in their investment decision
making, leading to better allocation of economic resources. The findings may also assist monetary
policy authorities in assessing the impact of monetary policy on the equity market and thus pre-
empting stock market crashes.

Brockie (1954),was one of the earliest studies to investigate the relationship between debt
andmonetary policy. The study argues that debt management must be coordinated with credit
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andmonetary policy. Looking at the three traditional tools used by central banks, open
marketoperations, regulated discount rates and regulated reserves; Brockie notes that each one
canimpact on some aspect of debt management. Open market operations for example
indirectlyinfluence the interest rates and can impact on the cost of government’s debt
obligations.Moreover as changes in interest rates, through the monetary policy transmission
mechanismimpacts on the demand for credit, there could be further effects on the yields from
governmentdebt auctions.

Beard and McMillin (1986), analyse the effects of government budgets and the conduct
ofmonetary policy. The analysis is based upon the theoretical premise that debt monetising occursto
finance the deficit only if fiscal and monetary authorities are coordinated. A reaction functionfor the
Federal Reserve was formulated where the monetary aggregate which is assumed to becontrolled by
the Federal Reserve, was expressed as a function of last period’s stock of money;unemployment or
the gap between real output and real potential output, inflation, interest rates,the fiscal deficit, and
other controlled variables such as the balance of payments or otherinternational variables. Beard
and McMillin do find some relationship between deficits andmoney but how the monetary
authorities react to deficits is indeterminate because no specificmodel can be formulated to include
variables such as political factors and the self-interest ofbureaucrats. For example, The Fed makes
decision based on several concerns that they maydeem important at the time, such as interest rates,
deficits, macroeconomic stability and politicalfactors. There is no definite pattern of monetary
authorities’ behaviour to deficits.

Scott et al (2008), focused on the execution of monetary policy through the instrument of
openmarket operation: the correlation between that instrument and government debt. The
FederalReserve’s open market operations directly affect the yields on government securities,
andinadvertently affect the federal funds rate by its effects on the commercial bank
reservepositions. Outstanding debt constrains monetary policy conduct through open market
operations:if outstanding debt is smaller than the private and public demands monetary policy is
lesseffective.

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Norton (1969), in his analysis of the United Kingdom, seeks to determine ifgovernment securities
have a significant impact on the interest rate. Norton argues that themonetary authorities have to
predict the public’s reaction to changes in interest rates and theselling of government bonds and
securities in order to affect debt management. Models werecreated for the expected interest rates
based on Keynesian normal-rate hypothesis1 and theDuesenberry’s2 critical reaction to the
Keynesian theory. Equations were specified for thepublic’s demand and banks’ demand for
government securities. These equations were used totest the hypothesis that government securities
impact on the interest rate. The results suggest thatthe authorities should use government securities
as a policy instrument to impact upon theinterest rate. It was also found that open market operations
are not as effective as the use ofspecial deposits in restricting the level of advances in the banking
industry to achieve debttargets. The authorities managing government securities must focus on the
impact their policieshave on the interest rate in order to manage debt efficiently.

Chen (2007), the newly used instrument for analyzing the effect of equity markets' expectations and
the future course of monetary policy, the Federal Funds Futures, came from a study conducted by
Bernanke and Kuttner. Their research showed that the elements of monetary policy changes that are
unexpected by the public have a significant effect on equity prices by changing the equity premium.
Bernanke and Kuttner (2003) derived a model for monetary policy changes and used Federal Funds
Futures contracts as a proxy for market expectations. The authors showed that expectations were
significantly more effective concerning the equity market than the real rate of interest (Chen, 2007).
The model that I developed was similar to those of Bernanke and Kuttner and Bernanke (2010),
with the addition of three independent variables.

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Rationale of the Study

In India Monetary Policy plays an important role to maintain price stability in every sector of the
economy by making changes in the instruments of Policy, it will directly impact on the possibility
of more investments coming in and consumers spending more by putting liquidity in the liquidity in
the market.Money marketis a market for short-term financial assets that are close substitutes of
money and the liquidity in the market is very. By this study we will find out the impact of monetary
policy on the investment trends in the money market instruments, changes of the rates offered in the
money market instruments. This study will help investor in making prediction on the basis of news
of monetary policy linking with changes in interest rates offered in the money market instruments.
Also, this will help me in increasing the analytical skills, knowledge and understanding the present
scenario.

Objective’s of the Study

 To study the major changes in Indian Monetary Policy after Economic Reforms in India.

 To know the growth of selected money market instruments.

 To determine the impact of monetary policy on chosen money market instruments.

 To analyse the trend of investment due to changes in the monetary policy.

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Research Methodology

Nature of the Study: The study “Monetary Policy and Money Market: An Empirical Analysis of
Indian Economy” it is exploratory in nature.

Time Period: Last 10 years data is taken for the study.

Tools for Data Collection:

This study is based on secondary data. The data is collected from various sources like RBI, CCIL,
FIMMDA, and other various sources as required in the research.

Tools for Data Analysis:

Arithmetic Mean: The arithmetic mean is the most commonly used and readily understood
measure of central tendency in a data set. In statistics, the term average refers to any of the
measures of central tendency. The arithmetic mean of a set of observed data is defined as being
equal to the sum of the numerical values of each and every observation divided by the total number
of observations.

Standard Deviation:The standard deviation of a random variable, statistical population, data set, or
probability distribution is the square root of its variance. It is algebraically simpler, though in
practice less robust, than the average absolute deviation. A useful property of the standard deviation
is that, unlike the variance, it is expressed in the same units as the data

Coefficient of Variance: The coefficient of variation (CV) is defined as the ratio of the standard
deviation σ to the mean μ. c v = σ μ . It shows the extent of variability in relation to the mean of
the population. The coefficient of variation should be computed only for data measured on a ratio
scale, as these are the measurements that allow the division operation. The coefficient of variation
may not have any meaning for data on an interval scale.

Moreover, for assessing the impact of instruments of Indian monetary policy that of money market,
regression model will be applied.

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Regression Analysis:In statistical modelling, regression analysis is a set of statistical processes for
estimating the relationships among variables. It includes many techniques for modelling and
analyzing several variables, when the focus is on the relationship between a dependent variable and
one or more independent variables (or 'predictors'). More specifically, regression analysis helps one
understand how the typical value of the dependent variable (or 'criterion variable') changes when
any one of the independent variables is varied, while the other independent variables are held fixed.

Appropriate tools will be for accomplishment of the above noted objectives of the study. For
achieving the second objective basic statistical tool will be used.

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References

Norton,(1969). "Debt management and Monetary Policy in the United Kingdom."Economic Journal
79, no. 315: 475-494.

Chen, (2007). Does monetary policy have asymmetric effects on stock returns?Journal of Money,
Credit and Banking, 39(2), 667-688…. Retrieved fromhttps://jmcb.osu.edu

Sensarma (2015). “Measuring monetary policy and itsimpact on the bond market of anemerging
economy” MPRA Paper No. 81067, posted 31 August 2017.

Retrieved from https://mpra.ub.uni-muenchen.de/81067/

Pray. (2015). Do Monetary Policy Announcements in India have any impact on the domestic Stock
Market?.... Retrieved from https://www.iimcal.ac.in/users/pray

Hojat, S. (2015). Unpublished paper submitted to Walden University….Retrieved

fromhttps://catalog.waldenu.edu/content.php?catoid=129&navoid=38482

Leith, D. (2010). The Effect of Monetary Policy on Private Money Market ... Retrieved from
http://www.boj.org.jm/uploads/pdf/papers_pamphlets/papers_pamphlets_The_Effect_of_Monetary_
Policy_on_Private_Money_Market_Rates_in_Jamaica__An_Empirical_Microstructure_Study.pdf

Akiwatkar, R. (2014). Effect of monetary policy on stock market. Retrieved from

http://www.academia.edu/5617253/Effect_of_monetary_policy_on_stock_market

Beard and McMillin. (1986). the effects of government budgets and the conduct of monetary
policy…. Retrieved from

https://www.researchgate.net/publication/271665896_Government_Budgets_and_Money_How_Are
_They_Related

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Retrieved from https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2752

https://investinganswers.com/financial-dictionary/stock-market/call-market-2837

https://economictimes.indiatimes.com/definition/monetary-policy

https://www.nipfp.org.in/event/57/

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