IMPACT OF MONETARY POLICY ON THE ECONOMY: A COMPARISON OF US AND INDIA

Mohit Bansal 07927852 Batch of 2009

Guidance Prof. Vinish Kathuria

INDEX

1. Objective 4 2. Introduction: Monetary Policy.5 3. Decoding Monetary Policy..6 Quantity theory of Money............................6

4. Need of Monetary Policy ..7 5. Tools for operating Monetary Policy by Central Banks....9 6. Lags in Monetary Policy...10 7. Analysis: India Macro parameters.....13 1. Inflation and monetary policy 13 Inflation and Monetary Tools......................................................................................13 Repo Rate and Inflation................14 CRR and Inflation.. ..17

2. GDP Growth Rate and Monetary Policy...19 Agriculture and Repo Rate......20 Manufacturing and Repo rate...21 Services and Repo Rate............22 Agriculture and CRR..............24 Manufacturing and CRR....25 Services and CRR..26

3. Index of Industrial Production (IIP)27 Impact of Repo Rate on IIP...28 Impact of CRR on IIP.....29

4. Money Supply .. 30 Impact of M3 on GDP.............................................................................................31

8. Analysis: US Macro parameters.....33 1. Discount Rate & Inflation.............34 2. Discount Rate and GDP Growth rate......35 3. Discount rate And IIP........................35 4. Open Market Operations: Fed Fund Rate....36 5. Money Supply M2 and GDP growth rate..38 9. Comparison between Macroeconomic Parameters: India and US...39 1. Inflation: India and US.39 2. Discount Rate (US) and Repo Rate (India).40 10. Conclusion ..41 11. References....................................43 12. Appendix..44

OBJECTIVE
The Objective of this project is to understand the various Policy Measures by the Central Banks of both US (Fed) and India (RBI). This comes under the light when the Central Banks in different countries are using the different or sometimes opposite Monetary Policies at the same time, clearly signifying their focus on various issues that are more relevant to their economies. There are instances when RBI (India) is following Contractionary Policy to tackle high Inflation whereas at the same time Fed (US) is following Expansionary monetary policy with a focus more on GDP growth rate. This project will focus on various Monetary Tools (like control of interest rate, Reserve ratio and control over Government Bonds in the system) with Central Banks and the way they try to take care of various Macroeconomic parameters of economy like Inflation, Unemployment etc in a given time frame. Also Monetary actions take some time to produce impact on various economic factors because of various lag effects, this project will look into the lags between various parameters and monetary actions, thus by looking at the output in the form of changes in macroeconomic parameters with their monetary tools, this project will highlight how effective the monetary policies of various Central Banks are?

INTRODUCTION: MONETARY POLICY

Monetary policy is the process of controlling the supply of money in the market by the controlling authority of the country to maintain various parameters. The controlling authority can be central bank or government of that country, usually it resides in the hands of Central Bank whereas Government uses Fiscal Policy as a tool to control and maintain certain set of objectives. Both Monetary and Fiscal Policy cannot be seen in isolation, each one is complementary to another and if one fails to provide solution, other comes in avail to support economy of the country. Central Banks uses various tools to control Monetary Policy in the country such as changing interest rates, increasing or decreasing reserve ratios and directly going in the markets to buy or sell rupees to alter money supply in the system. The certain objective of Monetary Policy is to attain Price Stability, high employment rate and GDP growth rate. Sometimes in order to control one of the macroeconomic parameter, certain actions are taken which can impact other parameters in a negative way, but this is required to take actions to control any parameter which is more sensitive to the economy of that country.

DECODING MONETARY POLICY: QUANTITY THEORY OF MONEY

Money Supply in the system can be understood by the Quantity theory of Money (given by Economist Henry Thornton in 1802 and updated by Economist Irving Fisher in 1911) which is related to the number of rupees exchanged in transactions. Quantity equation is the money supply (M) times the velocity of money (V) which equals price (P) times transaction (T) M x V= P x T Where M: Money supply V: Velocity (frequency) of money changing hands P: Price of Goods T: No. of Transactions Now T (Transaction) can be replaced by Y (Real GDP) as total transactions are equal to total GDP products produced over given period. M x V= P x Y Taking differential on both sides, the above equation will become d(M) + d(V) = d(P) + d(Y) Thus change in money supply (M) will directly impact the GDP (Y), inflation (Changes in P) and determine the state of economy on the velocity (V). Eg. With increase in Money supply (M) and keeping the velocity of money constant (V), both Price (P) will increase, thus leading to increase in Inflation and also GDP (Y) will increase. Example The equation of exchange can be explained mathematically to explain the direct relation between increase in Money Supply and Inflation.

If V and Q were constant, then:

Thus

Where (t) Is time. That is to say that, if V and Q were constant, then the inflation rate would exactly equal the growth rate of the money supply. Suppose there is Rs 100 (M) in the system and only economy is producing biscuits, the amount of Biscuits packets produced 40 units (Y) and the Price of 1 Biscuit packet is Rs 10 (P) , then the no. of times money changes hands is 40*10/100 = 4 times (V). Now in the above economy Say Central Bank increases the Money Supply to Rs.120 and keeping velocity 4 and Production same to 40 units , price will rise to 120*4/40 = Rs. 12/unit. Thus with increase in Money Supply keeping other things constant, Inflation increases. Thus Central Bank with its monetary policy determines the amount of money supply in the system, looking and controlling various other factors in the economy.

NEED OF MONETARY POLICY

The basic objectives of Monetary Policy to take care of are: Inflation Unemployment GDP Growth rate

As explained earlier by the Quantity of Money Theory, Inflation and GDP Growth can be altered by changing Money Supply in the system. Impact of Monetary Policy on Unemployment rate can be understood by that with increasing Money Supply in the system, GDP growth will increase which will come from production of more goods and services eventually creating more labor opportunities in the system. Hence with increase in monetary supply in the system, unemployment rate will come down. The two types of monetary policies adopted by various Central Banks time to time depending upon other economic factors are Contractionary Policy: When the central Bank takes action to reduce supply of money from the system, basically increasing the cost of excess money to reduce inflation. Expansionary policy: When the Central Banks takes action to increase the supply of money in the system to ensure easy availability of money at cheaper rates to support high GDP growth and to combat high unemployment.

Both these types of policies are opposite to each other and steps taken in each of them are exactly opposite to each other, but each works for the overall development of society and economy depending on requirement of external factors of Inflation , Unemployment , recession , Booming economy. Sr. No. 1 Policy Expansionary Monetary Policy: Increase Money Supply in the system Contractionary Monetary Policy: Decrease Money Supply in the system Impact on Macroeconomic Variables Inflation Unemployment Rate GDP Growth Rate Inflation Unemployment Rate GDP Growth Rate

As we have discussed the impact of both the monetary policies on the various macro policies, the next topic will bring out the various tools adopted by various Central Banks to take care of its Monetary Policy and their impact on Monetary Policy. The best thing is to see the impact of each tool on various macroeconomic parameters in togetherness rather than in isolation as all macro-variables is related to each other. For high inflation and GDP growth rate opposite monetary policies are required and thus impact of monetary policy needs to be seen together by analyzing various macroeconomic parameters together.

TOOLS FOR OPERATING MONETARY POLICY BY CENTRAL BANKS

1. Open Market Operations (OMO) Open market operations is the way of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other financial instruments. OMO has been used constantly to change the size of the monetary base, thereby impacting the total amount of money circulating in the economy. In OMO, The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base. 2. Interest rates The alteration with the Interest Rates has many fold effects on Monetary Policy. Under the normal economic environment both the expansionary and Contractionary policy can be controlled by altering the interest rates, but word of caution always remain as under extreme economic conditions monetary policy with the interest rates too fails to provide the results.. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In India ,RBI have different Interest rates by which they try to control the Monetary Policy, the increase in any of the Interest rates leads to Contractionary Monetary measures whereas with in decrease of these Interest rates , RBI pushed for Expansionary Monetary Policy. The various Interest rates RBI governs to control the Monetary Policy is: Repo rate/Discount rate: Repo rate is defined at the rate which RBI lends money to other banks in India, whenever any Bank needs money it borrows money from RBI at the current Repo Rate, so with lower Repo rate, banks can get the money at cheaper rates and hence leads to more money at cheaper rates leading to additional supply of money at cheaper rates. Discount rate is the term used in US for repo rate or base rate. Implication: With Lower Repo rates, cheaper money will be available hence enhanced money supply base. Reverse Repo rate: Reverse Repo rate is defined at the rate which RBI borrows money from other banks in India, whenever RBI wants to decrease the money from system , it increases Reverse Repo rate , so that Banks will park their excess Money with RBI and hence will reduce supply of money from the Market. So with higher reverse repo rate, banks will park the money at high rates and hence leads to reduction in money from the market.

Implication: With higher reverse repo rates, excess money with Banks will be parked with RBI hence reduced money supply base. 3. Reserve requirements This comes under regulatory controls over the bank. The reserve is the ratio bank has to maintain with itself of the excess money it holds with itself. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks often hold small portion of liquid assets in their balance sheets, rest all are invested in various forms of mortgages and

loans to increase their Net Profit Margins (NPM). By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Special care is taken of this reserve ratio, as this reserve Ratio has a multiplier effect on lending in the System, so to curb the volatility, this reserve ratio is reviewed on quarterly basis. Example: If the reserve requirement is 5%, for example, a bank that receives an Rs 100 deposit may lend out Rs 95 of that deposit. If the borrower then writes a check to someone who deposits the Rs 95, the bank receiving that deposit can lend out Rs 90.25. As the process continues, the banking system can expand the change in excess reserves of Rs 95 into a maximum of Rs 2000 of money (Rs 100+RS 95+90.25+85.73+...=2,000), e.g. Rs 100/0.05=2,000. In contrast, with a 10% reserve requirement, the banking system would be able to expand the initial Rs. 100 deposit into a maximum of (Rs. 100+90+81 +72.25+...=1000), e.g. Rs 100/0.10=1000. Thus, higher reserve requirements reduce artificial money creation and thereby reduce money supply in the system. Cash Reserve Ratio (CRR): CRR defines the ratio of deposit reserves banks has to keep with the RBI. This ratio is of the Net Time and deposit liabilities (NTDL) in India and RBI has the authority to alter this ratio to change the money left with the banks. With the increase of this CRR, banks have to deposit more money with RBI and hence they are left with less money, which can reduce the money in the system.

Implication: With high Reserve ratio, money supply base will contract and hence lead to contractory Monetary Policy. Statutory Liquid Ratio: This is again the regulatory measure, under which banks have to keep their assets in liquid form. The liquid form can be Cash, Gold or Government Securities. The primary objective of SLR is to (1) ensure that banks will remain solvent always (2) keep a check on expansionary credit policies of the bank. SLR limits has been defined as 40% to 25% (that is banks SLR can be less than 25% and it should not be more than 40%, defining the band of 2540%) With increasing SLR, banks are forced to invest in liquid assets and hence less money are available for credit expansion for banks, leading to lower money base in the system and hence contractionary monetary policy is achieved. RBI has kept the SLR constant for a period of 5 years (25% from April 2003 to November 2008, earlier it used to be above 31% before April 2003); moreover lower limit for SLR is relaxed to 24% in November 2008, due to liquidity crisis in market in later half of 2008. Implication: With low SLR Ratio, credit Expansionary policy by banks can be achieved and hence leads to expansionary Monetary Policy.

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LAGS IN MONETARY POLICY

There is lag between the Monetary Policy and its impact of economic parameters. Time lags that occur between the onset of an economic problem and the full impact of the policy intended to correct the problem. Policy lags come in two broad categories--inside lag (getting the policy activated) and outside lag (the subsequent impact of the policy). The three specific inside lags are recognition lag, decision lag, and implementation lag. The one specific outside lag is termed impact lag. Policy lags can reduce the effectiveness of business-cycle stabilization policies and can even destabilize the economy. Policy lags arise because government actions are not instantaneous. The use of any stabilization policy encounters time lags between the onset of an economic problem, such as a business-cycle contraction or the onset of inflation, and the full impact of the policy designed to correct the problem. For example, should a business-cycle contraction hit the economy on January 1st, stabilization policy cannot correct the problem by January 2nd. The use of any stabilization policy, especially fiscal policy and monetary policy, takes time to work through the system. Policy lags are commonly divided between inside lag and outside lag. Inside Lag Inside lag is the time it takes between the actual onset of a problem and the launching of the corrective actions by government. The wheels of government often spin slowly and deliberately. Three types of inside lag occur. Recognition Lag: Before any policy action can be pursued, the existence of the actual problem must be identified. It takes time to collect and analyze economic data. Unemployment and inflation data are usually available only a month or so after the fact. That is, the unemployment rate for January is usually available in February. Production and income data are reported quarterly and have an even longer lag. Gross production data for January, February, and March is seldom available until May. Once data are obtained, it must be analyzed and evaluated to ensure that it reflects the onset of an actual problem, such as a business-cycle contraction. This often requires several months of data to document an actual trend and determine that it is not just a temporary statistical aberration. Decision Lag: Once government policy makers have identified the problem, they need to decide on a suitable course of action, and then pass whatever legislation, laws, or administrative rules are necessary. Often this requires an act of Congress, signed into law by the President. Congress is bound to debate the appropriate policy, make amendments, and promote particular political interests along the way. For example, if a business-cycle contraction is identified, Congress is likely to debate over an expansionary fiscal policy use of increased government spending or decreased taxes. But will the spending go for purchases or transfer payments? If it goes for purchases, then what types of goods or services are purchased? If taxes are decreased, which taxes are cut and who receives the extra income? These decisions could take days, weeks, or months. Implementation Lag: After a particular policy has been selected, steps then need to be taken to implement the policy. For any change in spending, the appropriate government agencies need to

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be contacted. More often than not, this involves a change in budget appropriations. The affected agencies then need to actually make changes in their spending. The act of spending is not instantaneous. Most agencies require competitive bids to identify product suppliers before they can make the expenditures. Even the employment, then subsequent payment, of additional workers takes time. The implementation of fiscal and monetary policy is also likely to take weeks if not months. Inside lags are likely to take several months. A best case scenario involves at least two months. One month to recognize the problem and another month to select and implement the appropriation policy. A more likely scenario is three to six months of inside lags. Outside The outside lag is the time it takes after a policy is selected and implemented by appropriate government entities, before it works its magic on the economy. Such magic is not instantaneous. The principal outside lag is termed the impact lag.

Impact Lag: This lag is the time it takes any change initiated by a government policy to impact the producers and consumers in the economy. A key part of the impact lag is the multiplier. An initial change in government spending, taxes, the money supply, interest rates must work through the economy, triggering changes in production and income, which induces changes in consumption, which causes more changes in production and income, which induces further changes in consumption. Each "round" of changes (consumption expenditures on production that are induced income) is likely to take a month or two. Several rounds are needed (six to ten or more) before the bulk of this impact is realized. An impact lag of one to two years is not uncommon.

This project will focus on outside lag with impact lag; it means analysis is done to know how much lag it takes on macro-economic parameter once the monetary action is taken.

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ANALYSIS: INDIA
Inflation and monetary policy: They are closely related concepts wherein the latter can be used efficiently to reduce the effect of the Inflation. Inflation is thought of as the rise in prices and wages that reduces the purchasing power of money. As a consequence, the purchasing power of money will fall. Most of the countries in the world try to sustain a lower inflation rates. High inflation lowers the rate of savings and diminishes the purchasing power. Inflation takes place, when too much money is in circulation in comparison with the production of goods and services. Causes of Inflation The main cause behind inflation is the increase of money supply than the demand for money. Alternatively, it can be said that when the supply of money per unit of output increases, inflation occurs. The supply of money per unit of output increases, when "velocity" of money circulation increases. The demand for money depends on the overall economic activities of a country. Relationship between Monetary policy and Inflation The Fisher's equation depicts that proportional relation that exists between money supply and the price level. Monetary policy is a regulation of a central bank or any regulatory authority that ascertains the size and growth rate of the money supply. Monetary policy directly influences the interest rates which in turn has a negative relation with the price level. In the face of inflation the central bank of the country generally resorts to a rise in the cash reserve ratio, repo rate and reverse repo rate. So the basic idea is to reduce the money supply in the economy. To this end government securities are also issued so as to mop up the excess money supply from the mass. This would reduce aggregate demand. This reduction would again help reduce the price level.

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Inflation and Monetary Tools: Repo Rate and CRR Repo rate Repo rate is defined at the rate which RBI lends money to other banks in India. The way in which changes in the repo rate affect inflation and the rest of the economy is known as the transmission mechanism. The transmission mechanism is actually not one but several different mechanisms that interact. Some of these have a more or less direct impact on inflation while others take longer to have an effect. Banks lending rates and interest rates on securities are affected by both the actual and expected repo rate. If a raise in the repo rate is fully expected, market rates can begin to rise before the repo rate itself is raised. Then, when the repo rate is actually raised, it will not necessarily have any further effect on market rates if it merely confirms market expectations.

The following diagram shows the effect of change of Repo rate on Inflation.

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Monetary policy thus has an effect on the interest rates the general public face and thereby also on the total demand and total supply in the economy. The channels that mean that market interest rates affect supply and demand can be divided into the interest rate channel and the credit channel. Credit channel The credit channel describes the way in which monetary policy affects demand via banks and other financial institutions. If the interest rate rises, banks choose to decrease their lending and instead buy bonds. This means that households and companies find it more difficult to borrow money. Companies that are either unable or unwilling to borrow must cut back their activities, postpone investment and so on, and this dampens activity in the economy. Interest rate channel The interest rate channel affects the demand for goods and services. Higher interest rates normally lead to a reduction in household consumption. This happens for several reasons. Higher interest rates make it more attractive to save, in other words to postpone consumption, thus lowering present consumption. Consumption also falls because existing loans now cost more in terms of interest payments. Finally, higher interest rates mean that the price of both financial and real assets - shares, bonds, property, etc. - falls in that the present value of future returns drops when interest rates rise. When faced with dwindling wealth, households become less willing to consume. A rise in interest rates also makes it more expensive for firms to finance investment. As a result, higher interest rates normally curtail investment. If consumption and investment fall, so does aggregate demand. Lower aggregate demand results in lower resource utilization. When resource utilization is low, prices and wages usually rise at a more modest rate. However, it takes time before a decline in resource utilization leads to a fall in inflation. This is partly because wages do not change from month to month but more seldom than that. Result Table presents regression of various Time Leads Repo Rate and Inflation. Data taken in monthly from April 1998- March 2007 for repo rate and inflation Source: Inflation: RBI database and Repo Rate: Reuters Data base Variable Intercept 0 Months 1 Months 2 Months Coefficients 12.53194993 -0.96952424 0.67423314 0.020264496 Standard Error 1.391504307 0.872838383 1.201101166 1.206993744 t Stat 9.006044657 -1.110771775 0.561345838 0.016789231 P-value 1.50926E-12 0.27133032 0.576762217 0.986663392

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3 Months 6 Months 9 Months 12 Months 18 Months

-1.277943408 -0.015634256 0.734821901 0.245546366 -0.49859229

0.998026569 0.710999778 0.634121733 0.513404073 0.178234872

-1.280470328 -0.021989115 1.158802582 0.478271168 -2.797389113

0.205565965 0.982533435 0.251368513 0.634286557 0.007013635

Observations 1. This table indicates the lead of Repo rates on Inflation of various time frames. As repo rate and inflation are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that inflation depends on repo rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 18 months. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.518, which is good size of fit. No. of Observations: 66 Value of R2 = 0.518 The equation of Inflation with Repo rate Inflation = 12.53194993 - 0.49859229 (Repo rate 18 months lead)

All the above observation indicates that maximum effect of repo rates on inflation can be realized with a lag of 18 months (indicated by green color)

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CRR and Inflation Cash Reserve Ratio (CRR) is a % of total deposits of a scheduled bank that has to be mandatorily deposited by each bank with the Reserve Bank of India (RBI). If RBI increases the CRR, banks have to deposit an increased proportion of their total deposits to the RBI, which means banks effectively have reduced cash to lend or play around with. On the other hand if the RBI decreases the CRR, banks have more cash at their disposal. How does it affect inflation? As inflation shoots up with increased demand and reduced supply of goods, If RBI wants to reduce inflation; it has to either reduce demand or increase supply. If the RBI increases the CRR, banks have fewer funds to lend, which in effect means borrowing becomes costly, and that reduces demand. Thus when people go to buy a durable and non durable thing like car, home, automobile, the banks will not be as aggressive to lend the money to buy such goods. Moreover companies have to book high interests costs on their Profit & Loss statements and this reduces profits. Reduced profits depress sentiments and hence demand. A reduction in CRR causes the opposite effect. It increased demand. Result: CRR and Inflation Analysis is done with CRR and inflation with lag of different months, to find the maximum impact of CRR on inflation. CRR and inflation are inversely correlated and hence negative slope is expected between them. Data taken in monthly from April 1998- March 2007 for CRR and inflation Source: Inflation: RBI database and CRR: RBI database Variable Intercept Month 1 Months 2 Months 3 Months 6 Months 9 Months 12 Coefficients 3.443656 2.306883 0.010219 -0.045148 -0.653625 -1.150174 -0.072556 Standard Error 0.529287 0.604372 0.840071 0.669101 0.481471 0.461434 0.350991 t Stat 6.506217 3.816995 0.012165 -0.067476 -1.357556 -2.492609 -0.206718 P-value 0.000000 0.000259 0.990323 0.946365 0.178284 0.014669 0.836737

Observations

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1. This table indicates the lead of CRR on Inflation of various time frames. As repo rate and inflation are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that inflation depends on CRR, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 1 month and 9 months. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.455, which is good size of fit. No. of Observations: 90 Value of R2 = 0.455 The equation of Inflation with CRR Inflation = 3.4436 +2.3068 (CRR 1 month lead) 1.1501 (CRR 9 months lead) As there is discrepancy in the relation of CRR (1 m lead) with Inflation as slope being positive between the two, the relation cannot be established between CRR and Inflation. Hence from the above analysis, slope is both positive and negative for different lead time of CRR with Inflation, leads to conclude no relation between CRR and Inflation.

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GDP GROWTH RATE AND MONETARY POLICY Gross Domestic Product The gross domestic product (GDP) is one of the measures of national income and output for a given country's economy. It is the total value of all final goods and services produced in a particular economy; the dollar value of all goods and services produced within a countrys borders in a given year. GDP can be defined in three ways, all of which are conceptually identical. First, it is equal to the total expenditures for all final goods and services produced within the country in a stipulated period of time (usually a 365day year). Second, it is equal to the sum of the value added at every stage of production (the intermediate stages) by all the industries within a country, plus taxes less subsidies on products, in the period. Third, it is equal to the sum of the income generated by production in the country in the periodthat is, compensation of employees, taxes on production and imports less subsidies, and gross operating surplus (or profits) GDP is broadly categorized into 3 sectors 1) 2) 3) Agriculture Manufacturing Services

Agriculture: Agriculture Growth Rate in India GDP had been growing earlier but in the last few years it is constantly declining. Still, the Growth Rate of Agriculture in India GDP in the share of the country's GDP remains the biggest economic sector in the country. Agriculture growth rate in India GDP in spite of its decline in the share of the country's GDP plays a very important role in the all round economic and social development of the country. The growth rate of the agriculture sector in India GDP grew after independence for the government of India placed special emphasis on the sector in its five-year plans. Further the Green revolution took place in India and this gave a major boost to the agricultural sector for irrigation facilities, provision of agriculture subsidies and credits, and improved technology. This in turn helped to increase the agriculture growth rate in India GDP. The agricultural yield increased in India after independence but in the last few years it has decreased. This in its turn has declined the Growth Rate of the Agricultural Sector in India GDP. Agriculture Growth Rate in India GDP declined by 5.2% in 2002- 2003. The growth rate of the agriculture sector in India GDP grew at the rate of 1.7% each year between 2001- 2002 and 2003- 2004. This shows that agriculture growth rate in India GDP has grown very slowly in the last few years. Agriculture growth rate in India GDP has slowed down for the production in this sector has reduced over the years. The agricultural sector has had low production due to a number of factors such as illiteracy, insufficient finance, and inadequate marketing of agricultural products. The finance part has been majorly influenced by repo rate on macro level. Thus this analysis will do whether Repo rate will have any impact on Agriculture.

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Impact of Repo Rate on GDP Components Table presents impact of Repo rate on Agriculture growth rate. Data taken in quarterly from April 1998- March 2007 for repo rate and Agriculture component of GDP Source: Agriculture GDP: RBI database and Repo Rate: Reuters Data base Variable Intercept Lead 2 years Lead 2 years Coefficients 11.89435842 0.039972842 -1.276556025 Standard Error 6.416690383 0.606572285 0.612830171 t Stat 1.853659395 0.065899553 -2.083050224 P-value 0.075624902 0.947981965 0.047630113

Observation 1. This table indicates the lead of Repo rate on Agriculture (GDP) of various time frames. As repo rate and Agriculture growth are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that Agriculture depends on repo rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 2 lead. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.1479, which is not very good size of fit. No. of Observations: 28 Value of R2 = 0.1479 The equation of Agriculture with Repo rate Agriculture (GDP) = 11.894 1.27655 (Repo rate 2 years lead) There is considerable lag of 2 years of repo rate on Agriculture growth, primarily because of effects of repo rate to trickle down to agriculture production with passing of loans to farmers will take time , it takes time for increase in income of farmers. The low value of regression between 2 indicates other factors also dominently effects agriculture one could be Monsoons on agriculture.

Manufacutring: The growth rate of manufacturing sector in a country truly reflects its economic potentiality. Most of the developed countries are strong enough in their manufacturing sector. Though the services

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sector in India has brought faster economic success, still the manufacturing sector plays an important role on the ground of sustainability. In India, though the manufacturing sector is growing at a faster pace still it has failed to some extent with regards to its percentage share in the total GDP. The growth rate of manufacturing sector in the country has reached at a two-digit percentage growth in the year 2006-07 from April-August. India has signifant (39%) manufacturing production from Small and Medium size industries apart from few big ones. The capital required for Production in all these industries (even the bigger one) majorly depends upon cost of Capital. Thus theoratically Increase in Repo rate will increase Cost of Capital and thus reduces the growth rate of Manufacturing. Table presents impact of Repo rate on manufacturing growth rate Data taken in quarterly from April 1998- March 2007 for repo rate and Manufacturing component of GDP Source: Manufacturing GDP: RBI database and Repo Rate: Reuters Data base Variable Intercept Lead 1 year Lead 2 years Coefficients 16.36151897 -1.188718178 -0.000116676 Standard Error 2.001488257 0.189201478 0.191153432 t Stat 8.174676475 -6.282816544 -0.00061038 P-value 1.58132E-08 1.42049E-06 0.999517832

Observations 1. This table indicates the lead of Repo rate on Manufacturing (GDP) of various time frames. As repo rate and Manufacturing growth are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that Manufacturing depends on repo rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 1 lead. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.6123, which is good size of fit. No. of Observations: 28 Value of R2 = 0.6123 The equation of Manufacturing with Repo rate Manufacturing (GDP) = 16.3615 1.18871 (Repo rate 1 years lead)

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Repo rate has immediate impact on manufacturing, as Capital requirement/availibility at cheaper rate is the major factor for production in case of manufafturing. With lower Repo rate , easily capital is availaible and hence manufactuing production increases. Services The main thrust to industrial growth has come from the services sector. Services contribute more than 55 per cent of the GDP. Rapidly, the quality and complexity of the type of services being marketed is on the rise to match worldwide standards. Whether it is financial services, software services or accounting services, this sector is highly professional and provides a major impetus to the economy . Interestingly, this sector is populated with a range of players who cater to a niche market. India is fast becoming a major force in the Information Technology sector. The world's software giants such as Microsoft, Hughes and Computer Associates who have made substantial investments in India are increasingly tapping this potential. A number of multi-nationals have leveraged the relative cost advantage and highly skilled manpower base available in India, and have established shared services and call centers in India to cater to their worldwide needs. The software industry was one of the fastest growing sectors in the last decade with a compound annual growth rate exceeding 50 per cent. Software service exports increased from US$ 4.02 billion in 19992000 to US$ 6.3 billion in 2000-01, thereby registering a growth of 57 per cent. India's success in the software sector can be largely attributed to the industry's ability to cultivate superior knowledge through intensive R&D efforts and the expertise in applying the knowledge in commercially viable technologies. Services growth in India depends on various factors and primarily the boom in seen because of IT/ITES and Financial services , but again in all free capital plays a major role in the growth of Services . following is the analysis part to see whether RBI Monetary policy have any impact on Services sector of India. Table presents impact of Repo rate on services growth rate Data taken in quarterly from April 1998- March 2007 for repo rate and services component of GDP Source: Services GDP: RBI database and Repo Rate: Reuters Data base Variable Intercept Lead 1 year Lead 2 years Coefficients 11.65331194 -0.300298955 -0.127701568 Standard Error 2.106582989 0.199136125 0.201190573 t Stat 5.531855141 -1.508008428 -0.634729384 P-value 9.4765E-06 0.144086779 0.531371359

Observation

22

1. This table indicates the lead of Repo rate on Services (GDP) of various time frames. As repo rate and Services growth are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that Services depends on repo rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is not achieved in any of case. 3. The best value of coefficient of regression for this model is 0.0979, which is not good fit of size. No. of Observations: 28 Value of R2 = 0.0979 The equation of services with Repo rate Services (GDP) no relation with Repo rate is established. This analysis has shown that Repo rate dont have significant impact on Services (GDP). There could be many reasons for the same as Major growth un services in depends on IT/ITES which is not effected by Repo rate. Also because of lot of FIIs (in 2007 16 Billion $ compared to less than 2 Billion $ in 2000 ) have played a role of growth of finacial services in india.

23

Impact of CRR on GDP

CRR being a reserve ratio changes Money supply in the System Articifically. Increase in CRR will produce the same effects on major Macro economic parameters as Increae in Repo Rate as increase in either or both of them reduces the Money Supply from the market , where Increase in CRR indirectly increase the cost of Capital whereas Repo Rate directly increases the Cost of Capital.With the hike in CRR , Money Supply from the system reduces (with Multiplier Effect ) and thus reduces the Growth of GDP Rate . As decrease in CRR and decraese in Repo rate will move in same Monetary policy direction , the impact on CRR and repo rate on various GDP components is expected to be same, only possible variation could be difference in magnitude of impact on GDP components and the different time lag impact of CRR on various GDP components. Impact of CRR on GDP Components. Agriculture Table Presents impact of CRR on Agriculture production Data taken in quarterly from April 1998- March 2007 for CRR and Agriculture component of GDP Source: Agriculture GDP: RBI database and CRR: RBI database Variable Intercept Lead 1 year Lead 2 year Coefficients 5.347775754 2.225639715 -2.347632786 Standard Error 3.818963832 1.440857625 1.17438479 t Stat 1.400321132 1.544663176 -1.99903201 P-value 0.173706447 0.134993359 0.056587123

Observations 1. This table indicates the lead of CRR on Agriculture (GDP) of various time frames. As CRR and Agriculture growth are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that Agriculture depends on repo rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is not achieved in any of the case. 3. The best value of coefficient of regression for this model is 0.1514, which is not very good size of fit. No. of Observations: 28 Value of R2 = 0.1514

24

The equation of Agriculture with CRR Above analysis shows there is not much relation between Agriculture (GDP) and CRR. Changes in CRR doesnt seem to have impact on Agriculture growth rate. Manufaturing Table Presents impact of CRR on manufacturing production Data taken in quarterly from April 1998- March 2007 for repo rate and Manufacturing component of GDP Source: Manufacturing GDP: RBI database and CRR: RBI database Variable Intercept Lead 1 year Lead 2 year Coefficients 12.30130465 0.699426732 -1.282880944 Standard Error 1.429378046 0.539290328 0.43955374 t Stat 8.606054001 1.296939137 -2.918598631 P-value 6.05054E-09 0.206494796 0.007336024

Observations 1. This table indicates the lead of CRR on Manufacturing (GDP) of various time frames. As repo rate and Manufacturing growth are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that Manufacturing depends on CRR, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 2 lead. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.444, which is good size of fit. No. of Observations: 28 Value of R2 = 0.444 The equation of Manufacturing with CRR Manufacturing (GDP) = 12.301 1.2828 (CRR rate 2 years lead) Decrease in CRR increases the money with banks which they can easily lend, as Capital requirement/availibility at cheaper rate is the major factor for production in case of manufafturing. With lower CRR , easily capital is availaible and hence manufactuing production increases.

25

Services Table Presents impact of CRR on Services growth Data taken in quarterly from April 1998- March 2007 for repo rate and Services component of GDP Source: Services GDP: RBI database and CRR: RBI database Variable Intercept Lead 1 year Lead 2 years Observations 1. This table indicates the lead of CRR on Services (GDP) of various time frames. As CRR rate and Services growth are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that Services depends on repo rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved with the lag of 2 years. (Indicated by yellow) 3. The best value of coefficient of regression for this model is 0.6899, which is good fit of size. Coefficients 13.00604627 0.277801614 -0.884859994 Standard Error 0.736884004 0.278019113 0.226602137 t Stat 17.65005917 0.999217686 -3.904905773 P-value 1.26081E-15 0.327263205 0.000632253

No. of Observations: 28 Value of R2 = 0.6899 The equation of services with CRR Services (GDP) = 13.00604 0.88485 (CRR lead 2 years) This analysis has shown that CRR does have impact on Services (GDP).

26

INDEX OF INDUSTRIAL PRODUCTION (IIP)

Index of Industrial Production (IIP) in simplest terms is index which details out the growth of various sectors in an economy. E.g. Indian IIP will focus on sectors like mining, electricity, Manufacturing & General. In case of India the base year has been fixed at 1993-94 hence the same would be equivalent to 100 Points Index of Industrial Production (IIP) is an abstract number, the magnitude of which represents the status of production in the industrial sector for a given period of time as compared to a reference period of time. The first official attempt to compute and release the Index of Industrial Production was made by Office of Economic Advisor, Ministry of Commerce and Industry with the base year 1937 covering 15 important industries, which then accounted for more than 90 per cent of the total production of the selected industries. As per the United Nations Statistical Organizations recommendation, the general scope of IIP includes mining, manufacturing, construction, electricity and gas sectors. However, the present general index of industrial production compiled in India has mining, manufacturing, and electricity sectors only, due to constraints in data availability on construction and gas sector. This index indicates the production in industries across various sectors in India and determines the growth Month by Month on yearly basis. This IIP is directly related to the availability of Capital and thus lower Cost of Capital will result in higher Industrial Production and hence high growth in IIP. Cost of Capital is directly related to Repo Rate and CRR. Moreover Impact of Repo Rate and CRR will take some time to trickle down to produce impact on IIP numbers, so the impact of both Repo Rate and CRR will come with some lag on IIP numbers. Impact of Repo Rate on IIP Table presents impact of repo rate on IIP Data taken in monthly from April 1998- March 2007 for repo rate and IIP Source: IIP: RBI database and Repo rate: Reuters database Variable Intercept Lead1 months Lead 2 Months Lead 3 Months Lead 6 Months Lead 9 Months Coefficients 20.22394756 -0.578207226 0.04015633 0.037883498 -0.484026663 -0.374437219 Standard Error 1.948363251 0.292949744 0.366628596 0.323746127 0.241399651 0.24065169 t Stat 10.37996767 -1.973742042 0.109528637 0.117016066 -2.005084355 -1.555930149 P-value 3.71149E-16 0.052094585 0.913075745 0.907160113 0.048562778 0.123934673

27

Lead 12 Months Lead 18 Months Lead 24 months

-0.214696992 -0.253797169 0.033277798

0.209095798 0.169906675 0.155478346

-1.02678769 -1.493744544 0.214034935

0.3078207 0.139437754 0.831100643

Observations 1. This table indicates the lead of Repo rate on IIP of various time frames. As repo rate and IIP are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that IIP depends on repo rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 1 month and 6 months lead. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.5032, which is good size of fit. No. of Observations: 81 Value of R2 = 0. .5032 The equation of IIP with Repo rate IIP = 20.2239 -0.5782 (Repo lead 1 month) -0.484026663 (Repo lead 6 month)

Repo rate has immediate impact on IIP, as Capital requirement/availibility at cheaper rate is the major factor for production in case of industrial production. With lower Repo rate , easily capital is availaible and hence manufactuing production increases. Impact of CRR on IIP Table presents impact of CRR on IIP Data taken in monthly from April 1998- March 2007 for CRR and IIP Source: IIP: RBI database and CRR: RBI database Variable Intercept Lead1 months Lead 2 Months Coefficients 10.76578437 1.896265594 0.392896014 Standard Error 0.982897654 1.117593777 1.57616949 t Stat 10.95310822 1.696739578 0.249272693 P-value 1.00671E-17 0.093538975 0.803773192

28

Lead 3 Months Lead 6 Months Lead 9 Months Lead 12 Months Lead 18 Months

-1.161548601 -0.517118588 -0.85371199 1.035149786 -1.242731003

1.232628709 0.879751482 0.858216022 0.818464109 0.439439363

-0.942334535 -0.587800759 -0.994751867 1.264746707 -2.827991998

0.34878943 0.558281346 0.322783361 0.209544855 0.005885126

Observations 1. This table indicates the lead of CRR on IIP of various time frames. As CRR and IIP are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that IIP depends on CRR, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 18 months lead. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.4191, which is good size of fit No. of Observations: 90 Value of R2 = 0.4191 The equation of IIP with repo rate IIP = 10.7657 1.2427 (CRR rate 18 months lead) Decrease in CRR increases the money with banks which they can easily lend, as Capital requirement/availibility at cheaper rate is the major factor for production in case of industry. With lower CRR , easily capital is availaible and hence manufactuing production increases.

29

MONEY SUPPLY
There are various forms of Money defined depending on the functions of money used as it can be use as to give loans, keep money in form of Cheques, keeping money in banks, using money through Credit Cards or simply holding Money in Cash. Broadly two forms of Money are defined Narrow Money (M1) Broad Money (M3) Before that we also have basic form of Money (M0). M0: The most liquid form of money and also called Currency in the system both in circulation and in the Bank vaults. Also it accounts for the reserves RBI holds of other commercial Banks. M0 is the money from which other forms of Money M1 and M3 are created with the help of loans and money deposits. Narrow Money M1: This includes M0+ checkable deposits (sometimes called Demand Deposits); it is created when the system generates Assets to pay the debt, and thus when loan is sanctioned in the system, M1 increases in the System. Moreover various forms of Usage of debit cards, Travelers check form a part of M1. Broader Money M3: This Includes M1 and Time deposits where Time deposits are mainly saving accounts. Symbol C Assets included India Notes and coins in circulation + cash with public currency with banks C + demand deposits with banks and other deposits with RBI M1 + Post office savings + Bank deposits M2 + Time deposits Currency In USA

M1

C + demand deposits+ Travelers checks + other checkable deposits M1 + Retail Money market Mutual fund balances + Saving deposits + Small time deposits M2+ large time deposits+ repurchase agreements + Eurodollars + institutional- only money market mutual fund balances

M2

M3

30

Importance of various Money Supplies in India and US

Symbol C M1 M2 M3

India (Rs. Crores) 483,471 965,195 970,236 3,310,278

India (%) 14.5 28.9 29.1 99.2

USA (billion $) 539 1111 5100 7326

USA (%) 7.4 15.2 69.6 100

Thus in india major part of Money is in the form of M3 (99.2 %) whereas both M2 and M3 dominates in US. Impact of M3 on GDP According to the Quantity equation the money supply (M) times the velocity of money (V) which equals price (P) times GDP (Y) M x V= P x Y M: Money supply V: Velocity (frequency) of money changing hands P: Price of Goods Y: Real GDP Taking differential on both sides, the above equation will become d(M) + d(V) = d(P) + d(Y) Thus change in Money Supply (M) will directly impact the GDP (Y), keeping inflation and velocity constant. Tabular regression between Money supply (M3) and GDP growth rate. Data taken in annually from Jan 1975 to Jan 2007 for M3 and GDP growth rate Source: Money Supply M3: RBI database and GDP: RBI database Variable Intercept Lead 1 year Lead 2 year Coefficients 8.528202611 -0.084176349 -0.092236958 Standard Error 5.018549529 0.200381377 0.191610758 t Stat 1.699336145 -0.420080698 -0.481376719 P-value 0.10034146 0.677632711 0.633989587

31

Observations 1. This table indicates the lead of GDP rate with Money supply M3 of various time frames. As GDP rate and Money supply M3 are directly correlated, positive slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that GDP rate depends on Money supply M3, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is not achieved in any of the case. 3. The best value of coefficient of regression for this model is 0.01307, which is not very good size of fit. No. of Observations: 31 Value of R2 = 0.01307 The equation of GDP rate with Money supply M3 No relation is achieved between the two. The above analysis shows the deviation in quatity theory of money, according to which GDP rate should increase linearly with money supply.

32

ANALYSIS OF US MACROPARAMETERS
Discount Rate The discount rate is an interest rate a central bank charges depository institutions that borrow reserves from it. It serves the same function as Repo rate in India. Therefore the monetary policy actions taken by Fed to use the Discount rate could have significant impact on various macroeconomic parameters.

DISCOUNT RATE & INFLATION

Drawing parallel between the repo rate and discount rate, discount rate should have the same impact on macroecomomic parameters as the repo rate in case of India has. Table presents impact of Discount rate on Inflation Data taken in monthly from April 1998-March 2007 for discount rate and inflation Source: Inflation: Bureau of Labor Statistics and Discount Rate: Federal Reserve database Variable Intercept Lead1 months Lead 2 Months Lead 3 Months Lead 6 Months Lead 9 Months Lead 12 Months Lead 18 Months Observations 1. This table indicates the lead of Discount Rate with Inflation of various time frames. As discount rate and inflation are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that Inflation depends on Discount Rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is not achieved in any of the case. Coefficients 2.177950303 0.431290127 0.111763737 -0.430181043 0.292888537 -0.07813588 -0.041465204 -0.144168011 Standard Error 0.196253749 0.266209997 0.394193788 0.322684383 0.229330177 0.225576703 0.197899243 0.092027223 t Stat 11.09762392 1.620112439 0.283524857 -1.333132514 1.277147827 -0.346382757 -0.209526846 -1.566580044 P-value 3.27492E-18 0.108912465 0.777463955 0.186050409 0.205027745 0.729911061 0.83453835 0.120928389

33

3. The best value of coefficient of regression for this model is 0.01307, which is not very good size of fit. No. of Observations: 93 Value of R2 = 0.01307 The equation of Discount Rate with Inflation No relation is achieved between the two.

DISCOUNT RATE AND GDP GROWTH RATE

Table presents the impact of discount rate on GDP Data taken in quarterly from April 1998- March 2007 for repo rate and GDP growth rate Source: GDP rate: Bureau of Economic Analysis and Discount Rate: Federal Reserve database Variable Intercept Lead 1 year Lead 2 year Observations 1. This table indicates the lead of Discount Rate with GDP growth rate of various time frames. As discount rate and GDP growth rate are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that GDP growth rate depends on Discount Rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is not achieved in any of the case. 3. The best value of coefficient of regression for this model is 0.074, which is not very good size of fit. No. of Observations: 33 Value of R2 = 0.074 The equation of Discount Rate with GDP rate No relation is achieved between the two. 34 Coefficients 3.094944235 1.070468163 -1.108311745 Standard Error 0.863116842 0.718752288 0.715810657 t Stat 3.585776668 1.489342269 -1.548330882 P-value 0.001175057 0.146835991 0.132028496

DISCOUNT RATE AND IIP

Table presents impact of discount rate on IIP Data taken in monthly from April 1998- March 2007 for discount rate and IIP Source: IIP: Bureau of Economic Analysis and Discount Rate: Federal Reserve database Variable Intercept Lead1 months Lead 2 Months Lead 3 Months Lead 6 Months Lead 9 Months Lead 12 Months Coefficients 0.857671956 3.096285008 -0.515977169 -0.713700124 -0.819817163 -1.05711363 0.211253888 Standard Error 0.498566509 0.741018945 1.10768731 0.896775022 0.625093301 0.628526992 0.403835836 t Stat 1.720275912 4.17841545 -0.465814823 -0.79585192 -1.311511676 -1.681890584 0.52311823 P-value 0.088744329 6.67505E-05 0.642448977 0.428166821 0.192948573 0.095981594 0.602149652

Observations 1. This table indicates the lead of Discount rate on IIP of various time frames. As Discount rate and IIP are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that IIP depends on Discount rate, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 1 month lead. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.6198, which is good size of fit No. of Observations: 81 Value of R2 = 0.6198 The equation of IIP with Discount rate IIP = 3.09628(discount rate lead 1 month) This is the exactly opposite what was expected in relation between IIP and Discount rate , instead of negative slope there is positive slope between the two and with the increase in Discount rate , IIP increases in US.

35

OPEN MARKET OPERATIONS: FED FUND RATE

Open market operations are the means of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other financial instruments. Monetary targets, such as interest rates or exchange rates, are used to guide this implementation. Since most money is now in the form of electronic records, rather than paper records such as banknotes, open market operations are conducted simply by electronically increasing or decreasing ('crediting' or 'debiting') the amount of money that a bank has, e.g., in its reserve account at the central bank, in exchange for a bank selling or buying a financial instrument. Newly created money is used by the central bank to buy in the open market a financial asset, such as government bonds, foreign currency, or gold. If the central bank sells these assets in the open market, the amount of money that the purchasing bank holds decreases, effectively destroying money. The process does not literally require the immediate printing of new currency. A central bank account for a member bank can simply be increased electronically. However this will increase the central bank's requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance. Often, the percentage of the total money supply consisting of physical banknotes is very small. In the United States only around 10% of the "M2" money supply actually exists in the form of physical banknotes or coins. The rest exists as credits in computerized bank accounts. In practice, the Federal Reserve uses open market operations to influence short term interest rates, which is the primary tool of monetary policy. The federal funds rate, for which the Federal Open Markets Committee announces a target on a regular basis, reflects one of the key rates for interbank lending. Open market operations change the supply of reserve balances, and the federal funds rate is sensitive to these operations.[16] In theory, the Federal Reserve has unlimited capacity to influence this rate, and although the federal funds rate is set by banks borrowing and lending funds to each other, the federal funds rate generally stays within a limited range above and below the target (as participants are aware of the Fed's power to influence this rate). Table presents impact of Fed Fund rate on Inflation Data taken in monthly from April 1998- March 2007 for Fed Fund rate and Inflation Source: Inflation: Bureau of Labor Statistics and Fed Fund rate: Federal Reserve database Variable Intercept 1 month 2 Months 3 Months Coefficients 0.052325405 1.471378031 -0.394991394 0.009986966 Standard Error 0.03343033 0.107023547 0.188960934 0.138242228 t Stat 1.565207571 13.74817099 -2.090333619 0.07224251 P-value 0.121249811 2.5672E-23 0.039575138 0.942578634

36

6 Months 9 months 12 months 18 months Observations

-0.054355571 -0.123445287 0.089317275 -0.013459582

0.079069181 0.076065598 0.056724762 0.020526884

-0.687443196 -1.622879336 1.574572936 -0.655705085

0.493675006 0.108318503 0.119069977 0.513784808

1. This table indicates the lead of Fed funds on Inflation of various time frames. As Fed funds and inflation are inversely correlated, negative slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that inflation depends on Fed Fund, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is achieved in the lag of 1 month and 2 months lead. (indicated by yellow color) 3. The best value of coefficient of regression for this model is 0.99585 which is good size of fit No. of Observations: 93 Value of R2 = 0.99585 The equation of IIP with Discount rate Inflation = 1.471378031 (Fed Fund 1 m lead) -0.394991394 (Fed Fund 2 m lead) Slope is both positive and negative between the two variables , hence no conclusion can be drawn from it.

37

MONEY SUPPLY M2 AND GDP GROWTH RATE

In US prominent Money supply comes in the form of M2 , hence as we have seen earlier according to the Quantity equation the money supply GDP growth rate should increase with Money Supply M2. Table presents impact of Money Supply on GDP Growth rate Data taken in quarterly from Jan 1990- March2007 for money supply M2 and GDP growth rate Source: GDP: Bureau of Economic Analysis and Money Supply M2: Bureau of Economic Analysis
Variable Intercept Lead 1 year Lead 2 years Coefficients 3.833039428 -0.001742694 -0.136617509 Standard Error 0.591246925 0.138594785 0.138124865 t Stat 6.482975666 -0.01257402 -0.989087005 P-value 3.05895E-08 0.990014861 0.327114758

Observations 1. This table indicates the lead of GDP rate with Money supply M2 of various time frames. As GDP rate and Money supply M2 are directly correlated, positive slope is expected between these two variables. 2. To reject the null hypothesis and to actually say that GDP rate depends on Money supply M2, the t value should be greater than Critical t-value (which is 1.96 for 95% confidence interval), which is not achieved in any of the case. 3. The best value of coefficient of regression for this model is 0.0344, which is not very good size of fit. No. of Observations: 56 Value of R2 = 0.0344 The equation of GDP rate with Money supply M2 No relation is achieved between the two. The above analysis shows the deviation in quatity theory of money, according to which GDP rate should increase linearly with money supply.

38

COMPARISON BETWEEN MACROECONOMIC PARAMETERS : INDIA AND US

Various Macroeconomic parameters are taken together of India and US and see what is the relation between the two countries for the same economic paramter. After that if there exits significant relation between two countries on same parameter, then analysis is done whether the Macroeconomic policy actions are similar to keep control of that macro-economic factor. Eg . if there exits a similar relation between Inflation between US and India during the various time frame, then anaylsis is to be seen on the repo rate (India) and discount rate (US). Inflation: India and US Table presents relation between Inflaion of 2 countries Data taken in monthly from April 1998- March 2007 for Inflation (India and US) Source: Inflation US: Bureau of Labor Statistics and Inflation India: RBI database Variable Intercept Inflation India No of Observation : 110 Significant t- value is found after taking the regression between the inflation of 2 countries and the value of t is more than the critical t value (1.96 with 95% interval), thus there exists a relation between the two. Inflation (US) = 1.79751 + 0.1584 (Inflation India) F test : Inflation: India and US Variable Mean Variance Observations Degree of freedom F P(F<=f) F Critical India Inflation 5.023482933 2.878991811 108 107 3.971142112 3.41358E-12 1.37636448 Us Inflation 2.595462963 0.724978288 108 107 Coefficients 1.797514471 0.158481425 Standard Error 0.242580829 0.045674798 t Stat 7.409960965 3.469778341 P-value 2.97158E-11 0.00074958

39

Again the F-test value (3.9711) is greater than critical F value , indiacting Inflation at both the coutries are similar. Looking at the similar nature of inflation, now to analyse the monetary actions by 2 countries in the form of Repo rate and discount rate. Discount Rate (US) and Repo Rate (India) Source: Discount rate: Federal Reserve database and Repo Rate: Reuters database Variable Intercept Repo Rate (India) No. of observations: 108 Coeffficient of R2 : .00483 Significant t- value is not found after taking the regression between the inflation of 2 countries and the value of t is much less than the critical t value (1.96 with 95% interval), thus there exists no relation between the two. Also Coeffficient of regression is very low 0.00483. F-test : Discount Rate (US) and Repo Rate (India) Variable Mean Variance Observations Degree of freedom F P(F<=f) F Critical Discount Rate 3.800925926 3.306961751 108 107 1.210178703 0.162652578 1.37636448 Repo Rate 7.229166667 2.732622664 108 107 Coefficients 3.247976253 0.076488716 Standard Error 0.790269346 0.106590744 t Stat 4.109961081 0.717592476 P-value 7.82195E-05 0.47458706

The F value is less than F critical value, signifing Repo rate and Discount rate are not similar. Thus though inflation is two coutries are similar, monetary policy actions in the terms of repo rate is not similar in both of these countries.

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CONCLUSION
Monetary Policy adopted by RBI and Fed tried to take care of Inflation , GDP Growth rate and employment. Employment analysis is not done as unemployemnt rate changes in India has been very little as the variation is .3 in the last one decade , so no conclusion can be drawn on employment rate on the basis of Monetary policy. Regarding India Moneatry Policy actions are taken in the from of Repo rate (interest rate) and CRR (reserve ratio) , where in US reserve ratio doesnt play much role , so analysis is done in the form of Discount rate (interest rate) and Fed Fund rate (OMO). Analysis have shown that Monetary Policy of India is much stronger than US and Repo rate and CRR do impact various Macro-economic parameters. The impact of Monetary policy comes with lags of different time frames on various macro parameters thereby making the job much tougher for centeral banks for taking Monetary actions. Following Table concludes relation between various variable and Monetary tools. Independent Variable India Repo Rate Inflation Inverse Inverse 18 Months Inflation = 12.53194993 0.49859229 (Repo rate 18 months lead) Agriculture (GDP) = 11.894 1.27655 (Repo rate 2 years lead) Manufacturing (GDP) = 16.3615 1.18871 (Repo rate 1 years lead) Inflation = 3.4436 +2.3068 (CRR 1 month lead) 1.1501 (CRR 9 months lead) Dependent Variable Expected Relation Analyzed Relation Lag Equation

Repo Rate

Agriculture GDP

Inverse

Inverse

2 years

Repo Rate

Manufacturing GDP

Inverse

Inverse

1 year

Repo Rate CRR

Services GDP Inflation

Inverse Inverse

No relation Discrepancy : Improper relation

1 month and 9 months

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CRR CRR

Agriculture GDP Manufacturing GDP

Inverse Inverse

No relation Inverse

2 years

Manufacturing (GDP) = 12.301 1.2828 (CRR rate 2 years lead) Services (GDP) = 13.00604 0.88485 (CRR lead 2 years)

CRR

Services GDP

Inverse

Inverse

2 years

Repo Rate

IIP

Inverse

Inverse

1 month and 6 months

CRR

IIP

Inverse

Inverse

18 months

Money Supply M3 US Discount Rate Discount Rate Discount Rate Fed Fund Rate

GDP rate

Directly

No relation

IIP = 20.2239 -0.5782 (Repo lead 1 month) 0.484026663 (Repo lead 6 month) IIP = 10.7657 1.2427 (CRR rate 18 months lead) -

Inflation GDP rate IIP Inflation

Inverse Inverse Inverse Inverse

No relation No relation No relation Discrepancy : Improper relation

1 month and 2 months

Inflation = 1.471378031 (Fed Fund 1 m lead) 0.394991394 (Fed Fund 2 m lead) -

Money Supply M2

GDP Growth rate

Direct

No relation

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REFERENCES
www.rbi.org.in/ www.newyorkfed.org/ http://en.wikipedia.org/wiki/Monetary_policy http://www.federalreserve.gov/monetarypolicy/ http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html http://answers.yahoo.com/question/ www.data360.org/dsg.aspx http://business.mapsofindia.com/india-gdp/sectorwise/agriculture-growth-rate.html www.economywatch.com/inflation/economy/monetary-policy.html http://www.bea.gov/

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APPENDIX
India Inflation : April 1998- March 2009 Repo rate: April 1998- March 2009 CRR : April 1998- March 2009 IIP : April 1998- March 2009 Sector wise GDP Growth rate : April 2000- March 2008 Money Supply M3 : 1975-2008 US Inflation :April 1998- March 2009 Discount Rate :April 1998- March 2009 Fed Fund Rate : April 1998- March 2009 IIP : April 1998- March 2009 GDP Growth rate : Jan 1990- Dec 2008 Money Supply M2 : Jan 1990-Dec 2008

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