ECONOMICS PROJECT

Monetary Policy And Its Impact On Indian Economy

Project Submitted To:

Ms. ERITRIYA ROY

(FACULTY OF ECONOMICS)

Submitted By:
Varsha Gurde

B.A. LLB (HONOURS)

Semester I
Section - B
Roll No: 189

HIDAYATULLAH NATIONAL LAW UNIVERSITY

RAIPUR, CHHATTISGARH
 ACKNOWLEDGMENTS

I, Varsha Gurde, would like to humbly present this project to Ms. Eritriya Roy. I would first of
all like to express my most sincere gratitude to Ms. Eritriya Roy for her encouragement and
guidance regarding several aspects of this project. I am thankful for being given the
opportunity of doing a project on Monetary Policy and its impact on Indian Economy.

I am thankful to the library staff as well as the IT lab staff for all the conveniences they
have provided me with, which have played a major role in the completion of this paper.

I would like to thank God for keeping me in good health and senses to complete this
project.

Last but definitely not the least, I am thankful to my seniors for all their support, tips and
valuable advice whenever needed. I present this project with a humble heart.

Varsha Gurde

SEMESTER I, B , 189

BA LLB (HONS.)
 CONTENTS

1) ACKOWLEDGMENTS..

2) OBJECTIVES...

3) RESEARCH METHODOLOGY

4) INTRODUCTION1

5) OBJECTIVES OF MONETARY POLICY...............................2-3

6) INSTRUMENTS OF MONETARY POLICY IN INDIA..4-8

7) ROLE OF MONETARY POLICY..............................9-10

8) CONCLUSION.11
REFERENCES
 OBJECTIVES

I. To give a brief background of the origin of Monetary policy, and highlight its basic
functions.

II. To study in detail the relationships between Monetary Policy and Indian Economy..

BI. To access the relationship with adequate data and details.

RESEARCH METHODOLOGY
NATURE OF RESEARCH

This research work is descriptive and Analytical in nature. It describes the Monetary Policy & its
impact on Indian economy.

SOURCES OF DATA

This study is done with the help of secondary data. This secondary information has been
obtained from published sources such as books, journals, newspapers, official websites,
government publications etc.

MODE OF CITATION

A uniform mode of citation has been adopted and followed consistently throughout this paper.

INTRODUCTION

Monetary policy is the process by which monetary authority of a country, generally a central
bank controls the supply of money in the economy by its control over interest rates in order to
maintain price stability and achieve high economic growth. In India, the central monetary
authority is the Reserve Bank of India (RBI). is so designed as to maintain the price stability in
the economy.

In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of
money in order to meet the requirements of different sectors of the economy and to increase the
pace of economic growth.The RBI implements the monetary policy through open market
operations, bank rate policy, reserve system, credit control policy, moral persuasion and through
many other instruments. Using any of these instruments will lead to changes in the interest rate,
or the money supply in the economy. Monetary policy can be expansionary and contractionary in
nature. Increasing money supply and reducing interest rates indicate an expansionary policy. The
reverse of this is a contractionary monetary policy.1

For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the RBI
is dependent on the monetary policy. By purchasing bonds through open market operations, the
RBI introduces money in the system and reduces the interest rate.

The recent time has seen a dynamic change in Indias macroeconomic health. The inflationary
tendency either caused by supply side elements or the food commodities has impacted on Indias
rising as economic superpower. The economic survey of 2010-11 attributes a 9% growth of
Indian economy. In the era of globalisation no economy can be isolated or completely shielded
from the global trends of the market. But the severity of effect can be controlled through the
tools of monetary policy.

OBJECTIVES OF MONETARY POLICY

1 https://en.wikipedia.org/wiki/Monetary policy of_India

 Price Stability

Price Stability implies promoting economic development with considerable emphasis on

price stability. The centre of focus is to facilitate the environment which is favourable to
the architecture that enables the developmental projects to run swiftly while also
maintaining reasonable price stability.

Controlled Expansion Of Bank Credit

One of the important functions of RBI is the controlled expansion of bank credit and
money supply with special attention to seasonal requirement for credit without affecting
the output.

Promotion of Fixed Investment

The aim here is to increase the productivity of investment by restraining non essential
fixed investment.

Restriction of Inventories and stocks

Overfilling of stocks and products becoming outdated due to excess of stock often results
in sickness of the unit. To avoid this problem the central monetary authority carries out
this essential function of restricting the ors of the economy and all social and economic
class of people
2

To Promote Efficiency
It is another essential aspect where the central banks pay a lot of attention. It tries to increase the
efficiency in the financial system and tries to incorporate structural changes such as deregulating
interest rates, ease operational constraints in the credit delivery system, to introduce new money
market instruments etc.2

Reducing the Rigidity

RBI tries to bring about the flexibilities in the operations which provide a considerable
autonomy. It encourages more competitive environment and diversification. It maintains
its control over financial system whenever and wherever necessary to maintain the
discipline and prudence in operations of the financial system.

INSTRUMENTS OF MONETARY POLICY IN INDIA

2 http://theviewspaper.net/policies-in-india
 Cash Reserve Ratio

Cash reserve ratio as the ratio which banks maintain between their holdings of cash and
their deposit liabilities, and sometimes referred to as the Cash Ratio.

Banks have to keep a certain proportion of their total assets in the form of cash, partly to meet
the statutory reserve requirement and partly to meet their own day-to-day needs for making cash
payments. Cash is held partly in the form of cash on hand and partly in the form of balances
with the RBI.

Statutory Liquidity Ratio

Every bank is required to maintain a minimum percentage of their net demand and time
liabilities as liquid assets in the form of cash, gold and unencumbered approved securities. This
ratio of liquid assets to demand and time liabilities is known as statutory Liquidity Ratio (SLR).

The difference between CRR and SLR is that cash Reserves are to be kept with the Central Bank
whereas statutory ratio is maintained by the commercial banks concerned. The SLR operates as
an instrument of monetary control in two distinct ways. One is by affecting the borrowings of the
government from the RBI and the other is by affecting the freedom of banks to sell government

Bank rate

The dictionary meaning of Bank Rate is the discount rate of a central bank. Now it is known as
the base rate and it is also called as the Minimum Lending Rate (MLR). It is the rate at which the
central bank lent to the other banks.

Generally, Bank rate policy aims at influencing the level of economic activity, the cost and
availability of credit to the commercial banks, and the interest rates and money supply in the
economy. There is a direct relationship between the bank rate and the market interest rates.
Changes in the bank rate influence the entire interest rate structure, i.e. short-term as well as long
term interest rates. A rise in the bank rate leads to a rise in the other market interest rates, which
implies a clear money policy increasing the cost of borrowing. Similarly, a fall in the bank rate
results in a fall in the other market rates, which implies a cheap money policy reducing the cost
of borrowing.3

Repo rate

Repo is a money market instrument, which enables collateralized short-term borrowing and
lending through sale or purchase operations in debt instruments. Under a repo transaction, a
holder of securities sells them to an investor with an agreement to repurchase at a pre-determined
date and rate.

In short, Repo rate is the rate at which the RBI lends short term money to banks. When the repo
rate increases, borrowing from RBI becomes more expensive.

Reverse Repo rate

Reverse repo rate is the rate at which banks park their short-term excess liquidity with the RBI.
The RBI uses this tool when it feels that there is too much money floating in the banking system.
An increase in the reverse repo rate means that the RBI will borrow money from the banks at a
higher rate of interest. As a result, banks would prefer to keep their money with the RBI. Thus
Reverse repo rate is the rate at which RBI borrows money from banks. Banks are always happy
to lend money to RBI, since their money is in safe hands with a good interest. An increase in
reverse repo rate can cause the banks to transfer more funds to RBI due to these attractive
interest rates.

Relation between two variables

Interest rates & investments

3 http://Investopedia.com5
Interest rates & the bond prices are inversely related to each other. When interest rates move up,
it causes the bond prices to fall & vice versa. Say for example, you have a bond, which is
yielding 10% now. Suddenly, the interest rates in the economy move up to 11%. Now your bond
is giving fewer yields than the market return. Obviously it price is going to fall in such a case.
Reverse is the case when interest rates fall, the bond price will move up because it is giving more
returns than the market return. So movements in interest rates have serious implications for
individual investments.

Money supply and the economy

Money supply also effects the economy on three sides. One, money supply is used to control
the inflation in an economy. On the demand side, whenever money supply in the economy
increases, consumer-spending increases immediately in the economy because of increased
money in the system. But supply cant vary in the short term. This argument assumes that
demand drives supply, which is generally the case. On the supply side, due to an increase in
demand, supply can only be increased by capacity additions. This causes the cost of production
to rise & that is reflected in inflation.

Cash Reserve Ratio (CRR) & statutory liquidity ratio (SLR) and an economy

CRR is the percentage of its total deposits a bank has to keep with RBI in cash or near cash
assets & SLR is the percentage of its total deposits a bank has to keep in approved securities. The
purpose of CRR & SLR is to keep a bank liquid at any point of time. When banks have to keep
low CRR or SLR, it increases the money available for credit in the system. This eases the
pressure on interest rates & interest rates move down. Also when money is available & that too at
lower interest rates, it is given on credit to the industrial sector which pushes the economic
growth.

Monetary policy and economy

It refers to a regulatory policy whereby the monetary authority of a country maintains its control
over the money supply for the realization of general economic objectives. It involves
manipulation of money supply, the level & structure of interest rates & other conditions effecting
the level of credit. The central bank signals the market about the availability of credit & interest
rates through this policy. The RBI fixes the bank rate in this policy which forms the basis of the
structure of interest rates & the CRR & SLR, which determines the availability of credit & the
level of money supply in the economy. So it plays a very important role in the development of a
economy.4

Inflation and economy

Inflation effects the economy on three sides. One, it is directly linked to interest rates. The
interest rates prevailing in an economy at any point of time are nominal interest rates, i.e., real
interest rates plus a premium for expected inflation. Due to inflation, there is a decrease in
purchasing power of every rupee earned on account of interest in the future, therefore the interest
rates must include a premium for expected inflation. In the long run, other things being equal,
interest rates rise one for one with rise in inflation.

In economics, inflation is a sustained increase in the general price level of goods and services in
an economy over a period of time. When the price level rises, each unit of currency buys fewer

goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit
of money a loss of real value in the medium of exchange and unit of account within the
economy. A chief measure of price inflation is the inflation rate, the annualized percentage

4 http://federal reserve.com
change in a general price index (normally the consumer price index) over time.[4] The opposite of
inflation is deflation.

Inflation affects an economy in various ways, both positive and negative. Negative effects of
inflation include an increase in the opportunity cost of holding money, uncertainty over future
inflation which may discourage investment and savings, and if inflation were rapid enough,
shortages of goods as consumers begin hoarding out of concern that prices will increase in the
future..

Economists generally believe that high rates of inflation and hyperinflation

are caused by an excessive growth of the money supply. However, money
supply growth does not necessarily cause inflation. Some economists
maintain that under the conditions of a liquidity trap, large monetary
injections are like "pushing on a string". Views on which factors determine
low to moderate rates of inflation are more varied. Low or moderate inflation
may be attributed to fluctuations in real demand for goods and services, or
changes in available supplies such as during scarcities.5

Role of Monetary Policy in Controlling Inflation

Governments and central banks primarily use monetary policy to control inflation. Central banks
such as the U.S. Federal Reserve increase the interest rate, slow or stop the growth of the money
supply, and reduce the money supply. Some banks have a symmetrical inflation target while
others only control inflation when it rises above a target, whether express or implied.

5 http://Investopedia.com
Most central banks are tasked with keeping their inter-bank lending rates at low levels, normally
to a target annual rate of about 2% to 3%, and within a targeted annual inflation range of about
2% to 6%. Central bankers target a low inflation rate because they believe deflation endangers
the economy.

Higher interest rates reduce the amount of money because fewer people seek loans, and loans are
usually made with new money. When banks make loans, they usually first create new money,
then lend it. A central bank usually creates money lent to a national government. Therefore, when
a person pays back a loan, the bank destroys the money and the quantity of money falls. In the
early 1980s, when the federal funds rate exceeded 15 percent, the quantity of Federal Reserve
dollars fell 8.1 percent, from $8.6 trillion down to $7.9 trillion.

Monetarists emphasize a steady growth rate of money and use monetary policy to control
inflation by increasing interest rates and slowing the rise in the money supply. Keynesians
emphasize reducing aggregate demand during economic expansions and increasing demand
during recessions to keep inflation stable. Control of aggregate demand can be achieved using
both monetary policy and fiscal policy (increased taxation or reduced government spending to
reduce demand).caused by money supply growing faster than the rate of economic growth.

Role of Monetary Policy in controlling Deflation

In economics, deflation is a decrease in the general price level of goods and services. Deflation
occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be
confused with disinflation, a slow-down in the inflation rate (i.e., when inflation declines to
lower levels). Inflation reduces the real value of money over time; conversely, deflation increases
the real value of money - the currency of a national or regional economy. This allows one to
buy more goods with the same amount of money over time.

Although the values of capital assets are often casually said to "deflate" when they decline, this
should not be confused with deflation as a defined term; a more accurate description for a
decrease in the value of a capital asset is economic depreciation (which should not be confused
with the accounting convention of depreciation, which are standards to determine a decrease in
values of capital assets when market values are not readily available or practical).

10

CONCLUSION

RBI increase or decrease the rates i.e. repo rate, reverse repo rate, Cash reserve ratio, statutory
liquidity ratio to control the money supply in the economy.
As this small change in these ratios affect a lot on the whole economy and its various component
like on investment index, cost of production, inflation, interest rate, exchange rate, prime lending
rate of bank, home loan and car loan rate, deposit rate of bank and etc.

Today, most economists favor a low and steady rate of inflation. Low (as opposed to zero or
negative) inflation reduces the severity of economic recessions by enabling the labor market to
adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary
policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is
usually given to monetary authorities. Generally, these monetary authorities are the central banks
that control monetary policy through the setting of interest rates, through open market
operations, and through the setting of banking reserve requirements.

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 REFERENCES

1. www. Google..com
2. www.yahoo.com
3. www. Investopedia.com
4. www.federal reserve.com