Macro Economics

Government in the Business

Money, banking and monetary policy
 Money- The Basics
• What is money: A medium of exchange, a
store of value and unit of account.
• Distinction between income and money:
What we earn in income, money is used to
pay income.
• Money supply: currency, chequeable
deposits with banks, fixed or time deposits
with banks.
 Why do we demand for money
• Real demand for money: Md/ Price level,
higher the Price level higher the Md.
• Nominal demand for money
• Transactional demand for money =
f( Income, rate of interest and frequency of
payment, financial sophistication), positive
relationship with GDP
• Precautionaly demand for money =
f(Income,rate of interest)
 Contd...
- Speculative demand for money = f(interest
rate capital gains).
- Inverse relationship between bond prices
and rate of interest. Rs. 100 bond with a
fixed coupon rate of Rs. 10 every year,
traded at Rs. 105 he gets Rs. 10 on Rs.105
rather than Rs. 100 which works out 9.52%
return. If it is traded at Rs. 95 then the yield
is 10.52%.
 How does Money supply affect
GDP
• GDP is the total production of Gs and Ss
• MS refers to a stock of liquid assests which can be
exchanged for Gs and Ss.
• GDP depends on the stock of money multiplied by
the speed with which the money changes hands.
• Demand for money and Supply of money decide
interest rate.
• Real interest rate and nominal interest rate. With
inflation lender looses and borrower gains.
 Banking
• A bank is a financial institution and a
financial intermediary that accepts deposits
and channels those deposits into lending
activities, either directly or through capital
markets. A bank connects customers that
have capital deficits to customers with
capital surplus.
 Creation of credit
• Every advance made by a bank creates a
corrosponding deposit. Both happen
simultanenously.
• Bank receive primary deposits from public from
household savings, payments received from RBI
for sale of govt. Bond, payments received from
abroad and deposited in the banks and money
deposited for convenience in transaction.
• With these deposits banks keep Statutory Credit
Ratio as prescribed by RBI and excess reserves
and loan out the balalance to borrowers.
 A Rs. 100 crs primary deposit by setting
aside Rs. 20 crs (20% SCR) can create total
credit of Rs. 500 crs by repeateldly lending
and depositing by banks and keeping aside
20% SCR every time.
- Deposit multiplier = Total deposit creation/
primary deposit (500/100=5)
- Credit multiplier= additional credit creation/
total cash reserves (400/100=4)
 Contd..
• It is appropriate to say that economic
development in India is primarily policy led.
• What are the various policies which
significantly influence the management and
growth of the economy?
• Monetary policy, fiscal policy, exim policy
and industrial policy.
 Contd...
• In this session we are going to discuss the
monetary policy.
• Before we discuss monetary policy per se, let
us understand why policy are formulated and
what are the general objectives of a policy
and how do we judge the efficacy of a policy.
Define Policy

• Economic Theory helps us understand how the

world works (positive economics)
• Economic Policy goes a step ahead and examines
issues such as :
- What do we want to change? Why?
- What is good and what is bad about
the way system is operating - Can we make it
better?
- Normative considerations at the
centre stage.
 Criteria for Judging Economic Outcomes

1. Efficiency
In economics it refers to allocative efficiency.
An efficient economy is one that produces what
people want at the least possible cost.
2. Equity
• Fairness – Subjective
• Social Welfare always at centre stage
• Programs are driven by equity concerns
 Contd..
.3.Growth
• An increase in the total output (GNP/GDP) of an
economy.
• Build economic and social overhead capital.
• Enhance resource potential of both men and material.
4. Stability
It refers to the following conditions:
• Steady growth of national output
• Low Inflation
• Full employment
 What is Monetary Policy

Monetary Policy is:


Essentially a program of actions undertaken
by the monetary authorities generally the
central bank.

It aims at to control and regulate the supply
of and demand for money with the public and
the flow of credit with a view to achieving
predetermined macro economic goals.
 Scope of Monetary Policy
• It refers to all those economic activities involving
money which can be influenced by monetary policy.
Interest rates, asset prices, exchange rate, consumption,
investment, GDP and prices.
• The effectiveness of monetary policy depends on the
monetisation of economy and development of financial
markets.
• Financial market comprises capital market, commercial
banks, credit organisations, financial institutions,
commodity market, currency market, foreign exchange
market etc.
 Objectives of MP
Taditional:
Price stability (5-6% Inflation)
• Adequate availability of credit to productive sectors
 Recent Objectives
• Foreign exchange stability
• Stimulating growth by maintaining price
stability through money supply targeting
thorough changing monetary base (currency
with public and banks' reserves with RBI
• Money supply targets (14%) based on
expected increase in output (8%)and
tolerable level of inflation (6%)
 Contd...
- Achieving Money supply targets depends upon the
velocity of circulation of money is stalble and the
credit multiplier and the deposit multiplier are
predictable and the GDP growth is materialised.
- If anything goes wrong in these three aspectes, RBI
resorts to changes in interest rate (bank rate or
OMO).
- M3 targeting and interest rate targeting cannot
place together.
Components of Money Supply

M1 = Currency with public +

Demand Deposits with banks + Other
deposits with RBI
M2 = M1 + Post Office saving Deposits
M3 = M1 + Time Deposits with Banks
M4= M3+ all post office deposits
M1 Narrow money and M3 is known as broad
money and from the monetary policy point
of view M3 is considered.
 Instruments of Monetary Policy:general credit
controls

CRR or SRR
• A requirement that banks must hold a proportion of
their total deposits in the form of cash reserves with
RBI. It was 15% in 1991 and 4% as of now.
• CRR is quick and direct instrument to effect money
supply. But it does not fetch any interest for banks
and impacts the growth directly and hence less in
use.
• It is an instrument to prevent banks to lend
excessively and land into financial crisis.
• It directly effects the money supply and creation of
money through money multiplier.
 Statutory Liquidity Ratio(SLR)

-Banks are required to maintain 23% of their daily

demand and time deposits in the form of liquid assets
such as excess reserves, govt securities, current
account balance.
- Bank tend to invest more in G-Sec, govt. bonds as
these are risk free.(lazy banking-Rakesh mohan).
-As against the stipulated SLR of 23% it was 29.47% in
April 5 '13 and 29.88% Nov 15, '13.
- Safe banking rather than productive banking.
 Open market operations
-Open Market operations refer to sale and purchases of Govt.
Securities and T-Bills, Foreign Exchange, Gold, Short-term
commercial bills and other approved securities by RBI.
-G-sec are predominantly held by Banks and Insurance agencies.
-Conduct repo (repurchase) transactions whereby RBI purchases
G-Sec from the banks with an agreement that the G-Sec will be
bought back by the banks at a later date at a specified rate and
conduct reverse repo purchase.
- Purchases of foreign exchange from the banks with an agreement
that the banks will buy back the foreign exchange at a later date
at a specified exchange rate and selling to banks.
 OMO
-RBI sets the quantity targets and invites bid/auction through
commercial banks at market rate of interest. For example on
19thNov in the morning auction RBI received accepted 64 bids
for Rs. 407.70 billion for 1 day repo at 7.75% interest.
- The buyers of govt. bonds are commercial banks, financial
corporations, corporates, HNIs etc.
- Effectiveness of OMO depends upon the liquidity position of
banks, rate of interest on bonds, state of economy etc.
 RBI operations as on 18.11.13
-C. Liquidity Adjustment Facility
(i) Repo(1 day) amt.41,076crs @7.7%int.
(ii) Term Repo $ (11 days) amt.39,005.00 @8.51%*
(iii) Reverse Repo (1 day) amt.4.00 @ 6.75%
-D. Marginal Standing Facility(1 day) Rs.28,975.00 crs.
@8.75% interest.
Overnight segment:
I: call money Rs. 17071 crs @ 7 to 8.85% interest
II:CBLO Rs. 70001 crs @ 8.5-8.85int(collateral borrowing
and lending operations)
III:Mkt repo Rs.23593crs @7.95 to 8.85int
 Bank rate
-The rate at which RBI lends or discouns their bills of
exchange, comercial papers(GSec) to commercial
banks through its discount window to meet their
depositors' demands and reserve reqirements.
- By lowering the bank rate, RBI can increase money
supply and vice-versa The rate at which RBI lends or
discouns their bills of exchange, comercial
papers(GSec) to commercial banks through its
discount window to meet their depositors' demands
and reserve reqirements.
 Bank rate
- By lowering the bank rate, RBI can increase money
supply and creation of money and vice-versa.
- Discount window is not always open, in such case bank
borrow from banks having extra reserves at call
money market rate.
- Bank Rate down from 12% in 1997 to 8.75 as of now.
- Effectiveness of bank rate depends upon the
development of financial mkts. The dependence of
banks on RBI has gone down considerably as many
avenues of mobilisation of capital are available.
 Direct controls: Selective credit control

-General credit controls, expansionary or contrationary impact on

all the sectors of the economy.
- Some time priorities of development require different kind of
treatment of credit to different sectors.
- Credit rationing, change in leding margins, moral suation, direct
controls.
-Directed interest rates on small savings, PF.
-Mandatory requirements of banks to keep 23% their deposits in
the form of G-sec commonly know as SLR ( interest bearing).
- Lending to priority sector (40%)
- Social function Vs efficienty and monetary transmission
mechanism.
 How does MP works
• We know that money supply is one of the
determinants of agg. Demand.
• It influences the income and price level as
there is organic link bet the product mkt and
money mkt through invt and rate of intt.
• According to Keynes during recession and
unemployment it works in the following
way.
 Transmission mechanism
Expansionary MP
• Central bank buys securities through OMO.
• It reduces CRR
• It lowers Bank rate
• Money supply increases,it works through interest
rate channel, asset prices channel and exchange rate
channel.
• These three channels have special bearing on the
aggregate consumption and aggregate investment
which ultimate impact on GDP and general prices.
 Transmission Mechanism
Tight MP
• This is used to arrest Inflation
• RBI sells securities through OMOs
• It raises CRR and SLR and Bank rate
• It raises maxm margin against holding of
stocks of goods
• MS decreases, intt rate rises, invt exp
declines, AD declines and price level falls.
• Inter relationship among money, interest rate,
output and prices.
• Demand for money is dependent upon level of
output, price level and interest rate.
• Supply of money is based on expected increase in
income, expected level of price increase and
income elasticity of demand for money.
• All these issues involve the use of proper
transmission mechanism.
• Transmission Mechanism Refers to :
- Origin and Transmission of different types
of shocks in the financial system.
- The nature and extent of feedback in
policy.
- Effectiveness of different policy
instruments.
• Transmission channels are used in monetary
policy.
 Contd..
• Main are : Quantum channel, Interest rate
channel, Exchange rate channel.
- Quantum channel through reserve money,
credit aggregates affect the real output and
price level directly of course with a time
lag.
- Remaining channels are indirect channels
and effect real activities through changes in
interest rate or exchange rate.
 Evolution of Monetary Policy

Imperatives
Onset of Reforms has brought about :
Changed institutional framework brought about by
financial sector reforms.
Domain of operations of Financial institutions and
Banks.
Intensification of the competition for resources for
both FIs and Banks.
 Contd...
 Competition due to entry of new banks in
private sector.

Prudential Regulations in terms of capital
adequacy, exposure norms in respect of
investment in equity etc.

Board for financial supervision constituted
with a focus on :
- Restructuring system of inspection
- Setting up of off-site surveillance
- External auditors
- Internal controls and audit procedures.

Development of Financial Markets.

Opening up of economy.

Increase in foreign exchange reserves and
capital inflows vis-à-vis exchange rate
stability.
 Gains From Reforms

• New Transmission channels have opened

up.
• Indirect monetary control have assumed
importance.
CRR, a primary instrument of monetary
policy, has been brought down from 15% in
1991 4% now, Bank Rate 8.75 %, Statutory
Liquidity Ratio :- 23 %
MSF: 8.75,Repo Rate :- 7.75 %,Reverse
Repo :- 6.75 %
 contd..

• SLR down from 38.5% to 23%

• Deregulation and rationalisation of interest rate
• Operational flexibility to banks
• PLR down from 16.5% in 1991 to 10%
• Dormant Bank Rate activated from 1997.
• Bank Rate down from 12% in 1997 to 8.75
• Multiple indicator approach comprising
interest rates in money, capital and Gilt
market along with data on Currency, Credit,
Fiscal Position, Trade, Capital Flows ,
Inflation rate, Exchange rate and Juxtaposed
with output data need for drawing policy
perspective.
• Repo and reverse repo (1997), Liquidity
adjustment facility introduced in June 2000
to modulate short term liquidity and signal
short term interest rates.
 contd..
• It operates through repo and reverse repo
auctions of govt. securities since 1997 for
NBFIs, primary dealers, FIIs, banks from 1-
14 days and through call money market (for
banks) for overnight to 14 days.
• Strengthening of regulatory framework to
improve the functioning of MM, Credit
Market, Capital Market, Govt. Security
Market and Foreign Exchange Market.
• Abolition of system of automatic
monetisation.
• Borrowing by Govt. at market interest rate
through auction system.
• Call and Term money market purely inter
bank market for banks.
• Accommodation of Large Capital Inflows
and Control of its impact through OMO –
including repos and reverse repos.
 Question bank

- Whats money, what are its functions and how do the banks create money.
- How do money multipliers ( deposit multiplier and credit multiplier )
work.During slowdown why do the size of the money multipliers goes down?
- What is monetary policy and what are its instruments and how do they effect the
money supply?
- What are the components of money supply. Assume money supply is Rs. 1000
crs and bank deposits are Rs. 750 crs and RBI purchases 20 crs govt securities
from the mkt, what will be the new money supply.
-Asssume the RBI reducesa money supply. How will it affect the financial
variables and thereby consumer and investment spending in the economy?