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Sarat Dhal
Objective
Instruments
Targets
Objective
economic
assessment
Fiscal Policy
coordination
Instruments
Policy
Instrument
Repo / CRR
Output / employment
Inflation
Financial Market
Aggregate demand
Domestic demand
(consumption, investment)
External demand
(export/import
MP Objectives
Many advanced central banks focus
on
single objective: price or monetary
stability;
Some have legal mandate (Bank of
England has legislative mandate to
keep inflation low around 2 per cent)
Developing
and
economies (India):
emerging
effects
Clarity, Transparency
Comparative advantage of MP to
inflation than real growth
Indirect instruments
Interest rate
Exchange rate
Financial sector regulation
Prudential regulation / structural measures
Moral suasion
Assets
Capital (K)
Loans and
advances (L)
Bank Reserves
(R)
Total
Liabilities
Total Assets
+ =++
=
=
+ = + +
= 1 +
= 1 +
= 1 /(1 )
Higher the regulatory requirement
through , , lower is the loan supply
by banks. Regulatory requirements
directly interfere with banks balance
sheet management.
Since balance sheet affected, it can
shown that regulatory requirements
can affect banks deposits and loan
interest rates and profitability.
Because
of
temporary
funding, borrowing from
the central bank is not
major source of funds for
commercial banks. The cost
of borrowing may not
account for a major share of
total cost. Therefore, even if
central bank increases its
policy rate, banks do not
respond by way of deposit
and loan interest rate
revisions.
Medium-longer
segments affected
through
TERM
STRUCTURE
OF
FINANCIAL
MARKETS
MP Intermediate targets
Price stability:
Inflation rate around threshold level, core inflation
Intermediate Targeting
Targeting monetary aggregates and bank
credit through direct instruments (CRR)
Targeting money market interest rates through
indirect instruments, mainly, short-term policy
interest rate (repo/reverse repo)
What is money
Money is what money does
(Walker, Francis Amasa, 1879, Money
in its relations to trade and industry,
Henry Holt and Company, New York).
What is Money?
Coins
(Issued by Government of
India)
Paper money:
Money functions
Medium of exchange
Overcomes the inefficiency of barter
system; coincidence of wants
Store of value
Saving; stable value, purchasing
power
MUSS / SUMS
Precautionary demand
(contingent needs,
insurance against risk)
Speculative demand
(Store of value, wealth)
Stock of assets
Used for transactions
A type of wealth
As a medium of exchange,
money is used to buy goods and
services. The ease at which an
asset can be converted into a
medium of exchange and used
to buy other things is
sometimes called an assets
liquidity. Money is the
economys most liquid asset.
Monetary indicators
Base Money Reserve
Money / Fiat Money
Narrow Money:
1 = +
Transaction Purpose
Broad Money:
3 = + +
TD: interest earning
Transaction as well as
speculative
< 0,
<0
H: Reserve/Base Money
M: Broad Money Aggregate
C: Currency with the public
R: banks reserves (deposits of banks
held with the central bank due to
reserve requirement)
Aggregate Deposits (demand, saving
and time deposits) held with banks
:
: ()
CRR: fraction of net demand and
time liabilities of banks required to
be held with RBI
m: money multiplier; ratio of Broad
money supply to reserve money
Money Multiplier
1+
=
+
< 0,
<0
Higher
currency-deposit
ratio (c) for given reserve
requirement (r) will lead to
a lower money multiplier
and money supply.
Higher
reserve
requirement, for a given
currency-deposit
ratio,
leads to lower money
multiplier
and
money
supply.
Money Supply
=
= ln + ln()
Differentiating both sides and assuming constant/ stable money
multiplier:
=
Central bank can control money supply growth by controlling the
growth rate of its base money, provided the money multiplier is stable.
we know money multiplier is determined by currency-deposit ratio (c)
and cash reserve requirement or CRR (r); central bank has control over
the CRR but not currency-deposit ratio (c).
Money Multiplier
Money multiplier can be unstable due to currency
deposit ratio (CDR).
What determines CDR?
Preference for currency to deposits
Transaction motive
(income, inflation)
Interest on deposits
Technological changes
Payment and settlement system (credit, debit cards, ATM)
Social factors
Taxes and government policies
Seasonal demand
=
= +
Note here the difference
(Cambridge version = 1).
In India, RBI uses = 1.5
from
QTM
= +
Keynes: = ,
= (, , , )
( )
2
: /2
= ( )
2
M: average demand for money
N: cost minimising number of
tips
Y: total spending
F: cost of trip to banks
i: Interest rate
/2N
Time
Monetary Targeting
From quantity theory, we can
= +
For some central banks, inflation target has a legal mandate
(Bank of England: = 2%)
For many others, inflation target is informal set around a
tolerable rate (threshold/optimal level) based on some
research work.
Monetary Targeting
What about growth rate?
For full employment, it
could be set at potential
growth.
Monetary Targeting
Alternatively, we have seen that in a neoclassical
framework (Solow growth model), we can derive
potential growth on the basis of a production function
with constant return to scale.
= 1
= + + (1 )
Monetary Targeting
Business Cycle approach: we can estimate
potential growth using some univariate and
multivariate
trend-cycle
decomposition
techniques:
= + c
Note: in the case of univariate approach, we
do not require information about saving,
capital formation and technological progress.
Policy rate
(repo)
Market
short
interest
rates
Market
long
interest
rate
Consumption,
Saving,
investment
Output &
Inflation
Term structure
Option 2: Invest in a two year bond offering 2
2 = 1 + 2 1 + 2 = 1 + 2 2
No-arbitrage
1 = 2
1 + 1 1 + 1 = 1 + 2 2
Natural logarithm transformation
1 + 1 = 22
2 =
1
(1
2
+ 1 )
= +
: liquidity/term premium
=1; perfectly integrated markets
Market (private) interest rates : CAPM
, = + = + + = +
: risk premium (liquidity, credit etc)
=1, =1 , market fully integrated
: benchmark
(treasury bills; interest rate on risk free liquid shortterm instrument)
Transmission Channels
Evaluating MTM
Macro Variables:
Output (Y)
Money supply (M)
Price level (P)
Interest rate (r)
Asset prices
Exchange rate
Dynamic interaction
Long run and short-run
dynamics may be
different
Identification problem
enormous
Lags in transmission
mechanism
Long and variable lags
Evaluating MTM
Dynamic Interaction: increase in output can lead to increase in demand for
money, which in turn may increase aggregate demand and lead to
increase in prices and interest rates. All variables are endogenous.
The adjustment process involve lags: an increase money supply may lead
to increase in output with a time lag and the impact may percolate over a
period of time.
Long run: the interaction among monetary and macro variables may
follow an equilibrium path which can be interpreted in terms of
theoretical postulates in macroeconomics
Popular Rules:
Friedman: constant money growth rule;
Taylor rule for interest rate setting
McCallums rule for quantity of base money
setting
Policy Rules
Taylor Rule
= + + + ( )
McCallum Rule base money growth
= + ( )
: nominal interest; : observed inflation; : target
inflation; : actual output; : potential output; ,
parameters or weight assigned to growth inflation
objectives
: growth rate of base money; : real GDP growth; :
potential growth; : changes in income velocity of base
money; : weight to growth gap.
Rules vs Discretion
Rules
Clarity, transparency,
Stability,
Time consistency,
No political interference
Unbiased
Low expectation
Discretion
Judgments
Flexibility
Rise to the occasion
Market Imperfection
Practicality
Time inconsistency
(short-run vs. long-run)
RBI Objective
Price
stability
Sustained
Growth
RBI
Financial
stability
sound,
stable
external
sector
Banker to Government
Normal Transactions
Debt management
Banker to Banks
Lender of last resort
Institutional development
LIC, EXIM, NABARD, SIDBI,
NHB, UTI, IDBI, SBI
IGIDR, IDRBT, NIBM, IIBM
Development banking
Priority sector lending,
Cooperative banks
Financial inclusion
MP Instruments
Direct instruments
Cash reserve requirement
(CRR)
Open market operation
(Liquidity adjustment facilityLAF)
Marginal standing facility
(MSF)
Indirect instruments
Interest rate (repo / reverse
repo rates)
Others:
Statutory liquidity
requirement (SLR)
Priority sector lending (40%)
Benchmark loan interest rate
Moral suasion
Liquidity aggregates:
includes
institutions,
savings etc.
financial
post office
Banking aggregates
MP Intermediate targets
Price stability:
Inflation rate around threshold level, core inflation
Reform
Objective
Instruments
Emphasis on direct instruments
CRR, SLR, additional CRR; Bank
rate
Intermediate target:
Quantity of money and credit
channel of transmission;
targeting broad money growth,
bank credit growth
Instruments
Emphasis on indirect
Short-term
Interest
(repo/reverse repo rates)
OMO, LAF/MSF
rate
Multiple indicators
Intermediate targeting abolished
Emphasis on financial markets
stability / money market
Fiscal dominance
Automatic monetisation of
government deficit and debt
Reform
Deregulated banking
Banks free to determine deposit
and lending rates
Credit deployment (Priority
sector norm continues but list
expanded and flexible)
Half-yearly policy
Slack season
Macroeconomic assessment
Ambiguous,
Lacked rigour
Secrecy
Reform
Annual (Monetary and credit)
Policy
Macroeconomic Assessment
More in-depth analysis
(forecast, projections)
Fan charts
Public disclosure (released oneday before policy)
Reform
Pre-policy Consultation
Government
Banking sector; Academic experts;
Industry experts; Market experts
Internal experts
Internal Team
Policy Communication
Media release: press
statement
Policy Communication
LAF
Liquidity adjustment facility (LAF) is a monetary policy
tool which allows banks to borrow money through
repurchase agreements. LAF is used to aid banks in
adjusting the day to day mismatches in liquidity. LAF
consists of repo and reverse repo operations.
Liquidity adjustment facility has emerged as the
principal operating instrument for modulating short
term liquidity in the economy. Repo rate has become
the key policy rate which signals the monetary policy
stance of the economy.
Reverse repo
Reverse repo operation is
when RBI borrows money from
banks by lending securities.
The interest rate paid by RBI is
in this case is called the
reverse repo rate. Reverse
repo operation therefore
absorbs the liquidity in the
system. The collateral used for
repo and reverse repo
operations are Government of
India securities. Oil bonds have
been also suggested to be
included as collateral for
Liquidity adjustment facility.
MSF
The Marginal Standing Facility Scheme was
introduced on the lines of the existing
Liquidity Adjustment Facility Repo Scheme
(LAF Repo).
All Scheduled Commercial Banks having
Current Account and SGL Account with
Reserve Bank, Mumbai will be eligible to
participate in the MSF Scheme.
Reserve Money
domestic credit
foreign assets
2013
2010
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
1974
-20%
1971
0%
1.60
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
6.00
1.40
1.20
0.80
3.00
0.60
2.00
0.20
0.00
CRR
1951-52
1954-55
1957-58
1960-61
1963-64
1966-67
1969-70
1972-73
1975-76
1978-79
1981-82
1984-85
1987-88
1990-91
1993-94
1996-97
1999-00
2002-03
2005-06
2008-09
2011-12
1951-52
1954-55
1957-58
1960-61
1963-64
1966-67
1969-70
1972-73
1975-76
1978-79
1981-82
1984-85
1987-88
1990-91
1993-94
1996-97
1999-00
2002-03
2005-06
2008-09
2011-12
Indian Context
Money Multiplier
5.00
1.00
4.00
0.40
1.00
0.00
Domestic assessment
Threshold inflation, Core
inflation,
Inflation
projection,
Potential
growth, Growth projection,
Currency demand, Bank
aggregates
(deposits,
credit), Sectoral credit,
Trade deficit, capital flows,
BOP projections, Fiscal
indicators
Global developments
(global trade and growth,
oil price, commodity price
movements)
No DSGE model
Trend-cycle-seasonal
decomposition (HP trend)
Fan charts
probabilistic assessment of
growth and inflation
2009-10
7.5
8.5
16.5
8.6
3.8
16.9
2010-11
8.0
5.5
17.0
9.3
9.6
16.1
2011-12
7.4-8.5/8.0 6.0
16
6.2
8.9
13.2
2012-13
7.3
6.5
15
7.4
13.8
2013-14
5.7
5.5
13
Focus
Intermediate target
instrument
1935-50 (formative
years)
Financial intermediation
1951-70 (Development
phase)
Quantitative control
measures: selective
credit control, credit
authorisation scheme,
social banking (priority
sector)
1971-90 (Fiscal
dominance)
Monetary targeting
(reserve money growth
operating target, broad
money growth
intermediate target)
1990s: reform
Repo rate ,
MSF
Interest rate
Financial Markets
Long-end
Loan interest rate, Government bonds, capital
market
Affect investment, consumption of durables and
thus, growth
Short-end
Call money, treasury bills, certificates of deposits,
commercial paper, deposit interest rate
Consumption non-durables, some effect on
demand
04
05
06
CALL
07
08
REPO
09
10
RREPO
11
12
13
Assignment
Which graph could best describe the
relationship between money multiplier on the
one hand and currency deposit ratio and
reserve requirement ratio on the other hand.
Support your answer with a numerical
simulation for hypothetical values of currencydeposit ratio and reserve requirement ratio.
Assignment
(a)
(b)
Assignment
(c)
(d)
Assignment
(e)
(f)
Assignment 2
Another countrys multiplier just equals to the
inverse of central banks reserve requirement.
Analyse such an economy.
Numerical problems
For a developing economy, like India, the central bank has
the target for broad money supply growth at 13% in tune
with optimal inflation rate at 5% and potential real GDP
growth rate 8%. What is the implied income elasticity of
demand for money consistent with money supply target?
Discuss the theoretical insights underlying the money
demand function.
A central bank has inflation target of 4 % and its estimate of
income elasticity of money demand at 1.5 % and potential
growth at 6%. Its money supply growth is set at 15%.
Explain the central banks decision using quantity theory of
money.