Monetary Policy

- Dr Vighneswara Swamy

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Coverage
1.Objectives of Monetary Policy
2. Instruments of Monetary Policy:
1. Open market operation
2. Bank rate
3. Cash reserve ratio
4. Statutory liquidity ratio
5. Repo rate
6. Reverse repo rate

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Coverage..
9. Marginal standing facility
10.Liquidity Adjustment Facility
11.Market Stabilization Scheme
12.Easing Vs. Tightening of Monetary Policy
13.Expansionary and Contractionary Monetary Policy
14.The Impact of Monetary Policy
15.Impact of demonetization on Indian economy.

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Monetary Policy
Monetary policy is the macroeconomic policy laid down by the
central bank.
Monetary policy is the management of money supply and interest
rates by central banks to control prices and employment.
It involves management of money supply and interest rate and is the
demand side economic policy used by the government of a country
to achieve macroeconomic objectives like inflation, consumption,
growth and liquidity.

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Monetary Policy: Characteristics
Goals

Intermediate Monetary Instruments

Targets Policy

Objectives
Objectives of Monetary Policy
The following points highlight the six main objectives of
monetary policy in India:
1.High employment
2.Economic growth
3.Price stability
4.Interest-rate stability
5.Stability of financial markets
6.Stability in foreign exchange markets

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What is Monetary Policy in India?
According to RBI:
Monetary policy refers to the use of monetary instruments
under the control of the central bank to regulate magnitudes
such as interest rates, money supply and availability of credit
with a view to achieving the ultimate objective of economic
policy.
In India, monetary policy of the Reserve Bank of India is
aimed at managing the quantity of money in order to meet
the requirements of different sectors of the economy and to
increase the pace of economic growth.
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Monetary Framework in India
Monetary policy 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.
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The Goal(s) of Monetary Policy in India
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.
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.
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.

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The Monetary Policy Framework
1. The amended RBI Act provides the legislative mandate to the Reserve Bank to operate the
monetary policy framework.
2. The framework aims at setting the policy (repo) rate based on an assessment of the current and
evolving macroeconomic situation; and modulation of liquidity conditions to anchor money
market rates at or around the repo rate.
3. Repo rate changes transmit through the money market to the entire the financial system, which,
in turn, influences aggregate demand – a key determinant of inflation and growth.
4. Once the repo rate is announced, the operating framework designed by the Reserve Bank
envisages liquidity management on a day-to-day basis through appropriate actions, which aim at
anchoring the operating target – the weighted average call rate (WACR) – around the repo rate.
5. The operating framework is fine-tuned and revised depending on the evolving financial market
and monetary conditions, while ensuring consistency with the monetary policy stance.

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Monetary Policy Committee (MPC)
Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-
member monetary policy committee (MPC) to be constituted by the Central
Government .
The MPC determines the policy interest rate required to achieve the inflation target.
The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating
the monetary policy. Views of key stakeholders in the economy, and analytical work of
the Reserve Bank contribute to the process for arriving at the decision on the policy
repo rate.
The Financial Markets Operations Department (FMOD) operationalises the monetary
policy, mainly through day-to-day liquidity management operations. The Financial
Markets Committee (FMC) meets daily to review the liquidity conditions so as to
ensure that the operating target of the weighted average call money rate (WACR).
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Monetary Policy Committee (MPC)
The MPC is required to meet at least four times in a year.
The quorum for the meeting of the MPC is four members.
Each member of the MPC has one vote, and in the event of an
equality of votes, the Governor has a second or casting vote.
Once in every six months, the Reserve Bank is required to
publish a document called the Monetary Policy Report to
explain:
a) the sources of inflation; and
b) the forecast of inflation for 6-18 months ahead.
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Instruments of Monetary Policy
1. Repo Rate 6. Bank Rate
2. Reverse Repo Rate 7. Cash Reserve Ratio (CRR)
3. Liquidity Adjustment Facility 8. Statutory Liquidity Ratio (SLR)
(LAF)
4. Marginal Standing Facility 9. Open Market Operations
(MSF) (OMOs)
5. Corridor 10. Market Stabilisation Scheme
(MSS)
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#1. Repo Rate
Repo Rate: The (fixed) interest rate at which the Reserve
Bank provides overnight liquidity to banks against the
collateral of government and other approved securities
under the liquidity adjustment facility (LAF).

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#2. Reverse Repo Rate
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.

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#3. Liquidity Adjustment Facility (LAF)
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.
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#4. Marginal Standing Facility (MSF)
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 rate of interest.
 This provides a safety valve against unanticipated liquidity shocks to
the banking system.

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#5. Corridor
Corridor: The MSF rate and reverse repo rate determine the corridor for the daily
movement in the weighted average call money rate.
An interest rate corridor or a policy corridor refers to the range within which the
operating target of the monetary policy - a short term interest rate, say the
weighted average call money market rate - moves around the policy rate
announced by the central bank.
The policy rate is set within a corridor charted by
◦ A standing collateralised marginal lending facility available throughout the
day at a rate higher than the Policy rate that provides the upper bound; and
◦ A standing uncollateralised deposit facility at a rate lower than the Policy rate
that provides the lower bound to the corridor.
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#6. Bank Rate
Bank Rate: It is the rate at which the Reserve Bank is ready to buy or
rediscount bills of exchange or other commercial papers.
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.
Bank rate is also called discount rate because
bank provide finance to the commercial bank
by rediscounting the bills of exchange.
When central bank raises the bank rate, the
commercial bank raises their lending rates, it
results in less borrowings and reduces money
supply in the economy.
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#7. Cash Reserve Ratio (CRR)
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.
Increase in the CRR leads to the contraction of credit
Decrease in the CRR leads to the expansion of credit and banks
tends to make more money available to borrowers.

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#8. Statutory Liquidity Ratio (SLR)
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.
Increase in the SLR leads to the contraction of credit
Decrease in the SLR leads to the expansion of credit and banks tends
to make more money available to borrowers.

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#9. Open Market Operations (OMOs)
Open Market Operations (OMOs): These include both, outright purchase and sale of
government securities, for injection and absorption of durable liquidity, respectively by
central bank of the country.
The sale of security by the central bank leads to contraction of credit and purchase there
of to credit expansion.
OMO is used to wipe out shortage/excess of Money in Money Market, to influence the
term and structure of interest rate and to stabilize the market for government securities.
When RBI sells securities in open market, commercial banks and public buy it. This reduces
the existing money supply as money gets transferred from the Commercial Banks to RBI.
When RBI buys securities from commercial banks in open market, commercial banks sell it
and get back the money they had invested in them, thereby increasing the existing money
supply.
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#10. Market Stabilisation Scheme (MSS)
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.

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The Monetary Policy Process
1. The Monetary Policy Committee (MPC) constituted by the Central
Government under Section 45ZB determines the policy interest rate
required to achieve the inflation target.
2. The Reserve Bank’s Monetary Policy Department (MPD) assists the
MPC in formulating the monetary policy. Views of key stakeholders
in the economy, and analytical work of the Reserve Bank contribute
to the process for arriving at the decision on the policy repo rate.
3. The Financial Market Committee (FMC) meets daily to review the
liquidity conditions so as to ensure that the operating target of
monetary policy (weighted average lending rate) is kept close to the
policy repo rate.
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Selective Credit Control
1. Rationing of credit
2. Margin Requirement
3. Variable interest rates
4. Regulation of consumer credit
5. Moral Suasion

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Expansionary Monetary
Policy in a Recessionary Gap
1. If the central bank is combatting a
recessionary gap, it can increase the
money supply, which leads to a
change in aggregate demand from
AD1 to AD2.
2. The result is greater RGDP of a
higher price level.
3. The expansionary monetary policy
has moved the economy to the
natural rate (where RGDP 5
potential GDP).
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Contractionary
Monetary Policy
in an Inflationary Gap
1. If the central bank is
combatting an inflationary
gap at E1, it can decrease
the money supply, which
would lead to a change
from AD1 to AD2.
2. The result is a lower RGDP
and a lower price level at
E2, and the economy moves
to the natural rate (where
RGDP 5 potential GDP).
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 Expansionary vs. Contractionary
monetary policy
Expansionary monetary policy is monetary policy that increases aggregate demand.
Contractionary monetary policy is monetary policy that reduces aggregate demand.

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 Expansionary Monetary Policy
At times of Recession and unemployment
Expansionary monetary
policy is monetary policy 1. OMO – buys
that increases aggregate securities Money supply Investment
demand. 2. CRR - reduced increases increases
Expansionary monetary
policy reduces the 3. Bank Rate -
interest rate by reduced
increasing the money
supply. This increases
investment spending Aggregate output
and consumer spending,
increases by a Aggregate
which in turn increases demand
aggregate demand and multiple of the
real GDP in the short increase in investment increases
run.

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Expansionary
Monetary
Policy to Fight
a
Recessionary
Gap

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 Contractionary Monetary Policy
At times of Inflation
Contractionary
monetary policy is 1. OMO – sells
monetary policy that
Interest
securities Money supply
reduces aggregate
decreases
rate
demand. 2. CRR & SLR - raised
increases
Contractionary 3. Bank Rate -
monetary policy raises reduced
the interest rate by
reducing the money
supply.
This reduces
Aggregate Investment
investment spending Price level
and consumer demand declines expenditure
spending, which in turn
falls declines
reduces aggregate
demand and real GDP
in the short run. 31
Contraction
ary
Monetary
Policy to
Fight an
Inflationary
Gap

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Monetary Policy and the Multiplier

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Monetary Targeting
Flexible, transparent, accountable
Advantages
◦ Almost immediate signals help fix inflation expectations and produce less
inflation
◦ Almost immediate accountability
Disadvantages
◦ Must be a strong and reliable relationship between the goal variable and the
targeted monetary aggregate
◦ Relies on stable money – inflation relationship

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Inflation Targeting
1. Inflation targeting occurs when the central bank sets an explicit target for
the inflation rate and sets monetary policy in order to hit that target.
2. Public announcement of medium-term numerical target for inflation
3. Institutional commitment to price stability as the primary, long-run goal of
monetary policy and a commitment to achieve the inflation goal
4. Information-inclusive approach in which many variables are used in
making decisions
5. Increased transparency of the strategy
6. Increased accountability of the central bank
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Inflation Targeting
Advantages
◦ Does not rely on one variable to achieve target
◦ Easily understood
◦ Reduces potential of falling in time-inconsistency trap
◦ Stresses transparency and accountability
Disadvantages
◦ Delayed signaling
◦ Too much rigidity
◦ Potential for increased output fluctuations
◦ Low economic growth during disinflation
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Implicit Nominal Anchor
Forward looking and preemptive
Advantages
◦ Uses many sources of information
◦ Avoids time-inconsistency problem
◦ Demonstrated success
Disadvantages
◦ Lack of transparency and accountability
◦ Strong dependence on the preferences, skills, and trustworthiness of
individuals in charge
◦ Inconsistent with democratic principles

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Money,
Output,
and
Prices in
the Long
Run

Potential output
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Monetary Neutrality
Why economists believe in monetary neutrality — that monetary
policy affects only the price level, not aggregate output, in the long
run
In the long run, changes in the money supply affect the aggregate
price level but not real GDP or the interest rate.
In fact, there is monetary neutrality: changes in the money supply
have no real effect on the economy. So monetary policy is ineffectual
in the long run.

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 The Long-Run Relationship Between Money and
Inflation
 The horizontal axis measures the
annual percent increase in a
country’s money supply between
1970 and 2007.
 The vertical axis measures the
annual percent increase in a
country’s aggregate price level
over the same period.
 Each point represents a specific
country.
 The scatter of points lies close to a
45-degree line, demonstrating
that in the long run increases in
the money supply lead to roughly
equal percent increases in the
aggregate price level.
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Source: OECD.
Key words
1. Monetary policy
2. Open market operation
3. Bank rate
4. Cash reserve ratio
5. Statutory liquidity ratio
6. Repo rate
7. Reverse repo rate
8. Marginal standing facility
9. Liquidity Adjustment Facility
10.Market Stabilization Scheme

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