Group 7 Section B

Introduction to

Monetary Policy
73 - Shruti Patra
74 - Dhruv Devgun
79 - Reena Kumari
83 - Rupesh Jain
88 - Vaibhav Maheshwari
102 - Anshul Bansal
133 - Ravish Kapoor
Contents
1. Money
2. Creating Money
3. Monetary Policy
4. Instruments Of Monetary Policy
5. IS-LM Curve Model
6.Expansionary Monetary Policy
7.Contractionary Monetary Policy
8. RBI’s recent moves in monetary policy
 MONEY.
Money is often defined in terms of the
three functions or services that it provides.
 As a Medium of exchange,
 As a store of value, and
 As a unit of account.
 Creating Money.
 In a Fractional Reserve system a bank is required to hold a fraction of its
deposits in reserve, this reserve is known as Reserve Ratio.
 Example: Bank receives Rs,1000 in new reserves – can loan out Rs.800 with
RR of 20%...
 Rs.800 in loans deposited, Rs.640 in new loans..
 Rs.640 deposited, 0.8 x 640 = Rs.512 new loans..
 Potential Increase in Money supply is

 1/0.2 = Rs.5000 .
Thus, Money Multiplier = M/r
Fiscal Vs Monetary Policy.
 Fiscal Policy Related to budget, government
expenditure, taxation etc.
 Monetary Policy Related to money supply, exchange
rate control and bank rate control
Meaning of Monetary Policy.
 “Monetary policy are policy decisions made by the monetary

authorities, generally the central bank, to control and regulate the

supply of money with the public and the flow of credit with a view

to achieving predetermined macroeconomic goals”

 The objectives of monetary policy are the same as of

macroeconomic policies – price stability, currency stability,

financial stability, growth in employment and income.

 Instruments of Monetary Policy

Monetary & Credit Policy Instruments

Quantitative (General) Qualitative (Selective)

Direct Instruments Indirect Instruments

Bank Rate
Cash Reserve Ratio
(CRR) Open Market Operations

Outright

Repo/Reverse
Repo
Quantitative Measures .
Direct Instruments:
 Function according to regulation authorized to Central
Bank.
 Directly affect the volume or the price(interest rate)
of bank reserves, credit and money supply in the
country.
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
 MONEY.
Money is often defined in terms of the
three functions or services that it provides.
 As a Medium of exchange,
 As a store of value, and
 As a unit of account.
Statutory Liquidity Ratio.
 Every bank is required to maintain a minimum percentage
of their net demand and time liabilities as liquid assets in
the form of cash, gold and unencumbered approved
securities. This ratio of liquid assets to demand and time
liabilities is known as Statutory Liquidity Ratio (SLR) .
 Contd...
Objective of imposing SLR
 It augments the investment of the banks in govt.
securities.
 By making bank investment in safe & more liquid
assets it ensures solvency of banks.
Indirect Instruments.
 Rather than affecting the cost or volume of credit
directly influence these through the market
mechanism.
 Price channel ( market determined interest rates)
plays an important role in this.
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.
 Contd…
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!!
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.
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.
 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
 The current Bank rate is 9%.
 MONEY.
Money is often defined in terms of the
three functions or services that it provides.
 As a Medium of exchange,
 As a store of value, and
 As a unit of account.
 Repo Rate.
 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.
 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.
 The current Repo Rate is 8%.
 Reverse Repo Rate.
 The 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)
 Contd...
 Consequently, 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 Rates.
 It helps borrower to raise funds at better rates
An 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.

 Qualitative Measures.
 Qualitative or Selective Measures can be in the form of selective
credit control measures or in the form of moral suasion.
 Selective Credit Control Measures tries to fix the quantum of credit
flowing to the different areas of the economy and also the cost at
which the credit is available to different segments of the economy.
 Qualitative Tools.
 Credit ceiling
 In this operation RBI issues prior information or direction that loans to the
commercial banks will be given up to a certain limit. In this case commercial
bank will be tight in advancing loans to the public. They will allocate loans to
limited sectors. Few example of ceiling are agriculture sector advances, priority
sector lending.
 Moral Suasion
 A persuasion tactic used by an authority (i.e. Federal Reserve Board)
to influence and pressure, but not force, banks into adhering
to policy. Tactics used are closed-door meetings with bank directors,
increased severity of inspections, appeals to community spirit, or
vague threats. A good example of moral suasion is when the Fed
Chairman speaks on the markets - his opinion on the overall
economy can send financial markets falling or flying.
How Do Monetary
Policies Work.
 The IS- Curve.
The IS curve shows combinations of interest rates and levels of output such that planned
spending equals income
Derived in two steps:
1. Link between interest rates and investment
2. Link between investment demand and AD
Investment is no longer treated as exogenous, but dependent upon interest rates
(endogenous)
Investment demand is lower the higher are interest rates
Interest rates are the cost of borrowing money
Increased interest rates raise the price to firms of borrowing for capital equipment
 reduce the quantity of investment demand
Investment and the Interest Rate.
I  I  bi (1)
The position of the I schedule is
determined by:
The slope, b
If investment is highly
responsive to i, the
investment schedule is almost
flat
If investment responds little
to i, the investment schedule
is close to vertical
Level of autonomous spending
An increase in shifts the
investment schedule out
A decrease in shifts the
investment schedule in
The Interest Rate and AD: The IS Curve.
Need to modify the AD function we have learned to reflect the new
planned investment spending schedule

AD  C  I  G  NX
 C  cT R  c(1  t )Y   ( I  bi )  G  NX
 A  c(1  t )Y  bi (2)

An increase in i reduces AD for a given level of income

At any given level of i, can determine the equilibrium level of income
and output
A change in i will change the equilibrium
 Contd...
Derive the IS curve using the
figure:
Consider a lower interest rate,
i2
Shifts the AD curve upward to
AD’ with an intercept of
A  bi2
Given the increase in AD, the
equilibrium shifts to point E2,
with an associated income level
of Y2
Plot the pair (i2, Y2) in panel (b)
for another point on the IS curve
Money Curve and LM-Curve.
The LM curve shows combinations of interest rates and levels of output such
that money demand equals money supply  equilibrium in the money
market
The LM curve is derived in two steps:
1. Explain why money demand depends on interest rates and income
Theory of real money balances, rather than nominal
2. Equate money demand with money supply, and find combinations
of income and interest rates that maintain equilibrium in the
money market
(i, Y) pairs meeting this criteria are points on a given LM curve
Demand for Money.
The demand for money, is a demand for real money balances
People are concerned with how much their money can buy, rather than the
number of dollars in their pockets
The demand for real balances depends on:
Real income: people hold money to pay for their purchases, which, in turn,
depend on income
Interest rate: the cost of holding money
The higher the interest rate, the more expensive it is to hold money, and
the less cash will be held at each level of income
The demand for money is defined as: L  kY  hi (6)
 Contd...
 The parameters k and h reflect
the sensitivity of the demand for
real balances to the level of Y
and i
 The demand function for real
balances implies that for a given
level of income, the quantity
demanded is a decreasing
function of i
 The Figure illustrates the
inverse relationship
between money demand
and i  money demand
curve
 Money Supply.
Y M

 The nominal quantity of P

I
money supplied, M, is n
t
controlled by the e
r
central bank. e
 Real money supply is M , s
P t
X
where M and P are assumed 0
Real Balances
fixed
 Contd...
 Starting at Y1, the
corresponding demand
curve for real balances is
L1  shown in panel (a)
 Point E1 is the equilibrium point
in the money market
 Point E1 is recorded in
panel (b) as a point on the
money market equilibrium
schedule, or the LM curve
 (i1, Y1) pair is a point on LM
curve
 Contd…
 If income increases to Y2, real
money balances increase to
be higher at every level of i
 money demand shifts to L2
 The interest rate increases to
i2 to maintain equilibrium in
the money market
 The new equilibrium is at
point E2
 Record E2 in panel (b) as
another point on the LM
curve
 Pair (i2, Y2) is higher up the
given LM curve
Equilibrium and the Goods and
Money Market
• The IS and LM schedules summarize
the conditions that have to be
satisfied for the goods and money
markets to the in equilibrium
– How are they brought into
simultaneous equilibrium?
 Satisfied at point E in Figure
10-11, corresponding to the
pair (i0, Y0)
• Assumptions:
– Price level is constant
– Firms willing to supply whatever
amount of output is demanded
at that price level
Expansionary Monetary
Policy.
Expansionary monetary policy is when a central bank,
such as RBI, uses its tools to stimulate the economy. This
usually means lowering the CRR and SLR to increase
the money supply. This action increases liquidity, giving
banks more money to lend. As a result, mortgage and
other interest rates decline. With cheaper credit,
consumers can borrow and spend more, causing
businesses to expand to meet the increased demand.
Companies hire more workers, whose incomes rise,
allowing them to shop even more.
 M M
1 2
P P
LM1
LM2

Interest Rates
i1 e*1 i1 e1
Interest Rates

e*2
i2 e2
i2

IS L= KY- hi

Y1 Y2 Real Balances
Income = Output
Prices

e’1
P1
P2 e’2

AD

Y1 Y2
Income = Output
Contractionary Monetary
Policy.
Contractionary monetary policy is monetary policy that seeks
to reduce the size of the money supply. Contractionary policy can
be implemented by reducing the size of the monetary base.
This directly reduces the total amount of money circulating in the
economy by increasing CRR and SLR.
A central bank can also use open market operations to reduce the
monetary base. The central bank would typically sell bonds in
exchange for hard currency. When the central bank collects this
hard currency payment, it removes that amount of currency from
the economy, thus contracting the monetary base.
 M M
2 1
P P
LM2
LM1

Interest Rates
i2 e*2 i2 e2
Interest Rates

e*1
e1
i1 i1

IS L= KY- hi

Y2 Y1 Real Balances
Income = Output
Prices

e’2
P2
e’1
P1

AD

Y2 Y1
Income = Output
RBI Reports
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