THE MONETARY POLICY OF INDIA

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INTRODUCTION
Monetary policy is the process by which the monetary authority controls

 the money supply  availability of money  cost of money or rate of interest

to ensure growth and stability of the economy.

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Monetary policy is referred to as either being an

expansionary , or a contractionary policy,

where an expansionary policy increases the total supply of money in the economy, and a contractionary decreases the money supply. Expansionary policy is used to combat unemployment in recession by lowering the interest rates, while contractionary policy involves raising interest rates in order to combat inflation.

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Objectives of Monetary Policy

Price stability Ensure adequate flow of credit to the productive sectors of the economy Stability for the national currency Growth in employment and income

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Instruments to Regulate Monetary Policy

QUANTITATIVE METHODS
Discount Rate (Bank Rate): The discount rate is the interest charged by Central Banks to member banks, other depository institutions, and the government for loans.

Higher interest rates

Less borrowing

Lower aggregate demand Higher aggregate demand

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Lower interest rates

More borrowing
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 Open Market Operations: Open market operations is the buying and selling of government securities by the government (Central Bank).
Sells govt. securities Withdraws money from the economy Buys govt. securities Pumps money into the economy

Reserve Requirement: The reserve requirement is the amount of money that banks must hold as vault cash or keep on deposit with their Central Banks.
Increase reserve requirement Decrease reserve requirement Less loanable funds to offer Less borrowing

More loanable funds to offer

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More borrowing
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Reserve Requirements are of 2 types: 1. Cash Reserve Ratio (CRR) refers to that portion of total deposits of commercial banks that it has to keep with the reserve bank of india as cash reserves. 2. Statutory Liquidity Requirements (SLR) refers to that portion of the total deposits of a commercial bank which it has to keep with itself in the form of liquid assets.

Reverse Repo Rate: The rate at which the Central Bank borrows money from the banks (or banks lend money to the CB) is termed the reverse repo rate. The CB uses this tool when it feels there is too much money floating in the banking system.
RRR increased Member Banks lend money to CB
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Less money with member banks to lend to consumers

 Prime Lending Rate (PLR): The rate at which the commercial banks lend money to their regular clients with high credit worthiness. This particular class borrows huge amounts of money and hence, there is lot of fluctuation in the monetary supply even with small changes in the PLR. It is one of the only rates controlled by the commercial banks. The below shows the lending rates given by the commercial banks in the last 10 years.

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QUALITATIVE METHODS
Regulation of Consumer Credit: It is an important instrument of selective credit control which aims at regulating the consumer instalment credit on higher purchase. Finance is the method of using bank credit by consumers to buy expensive durable goods like motor cars, houses, computer, etc. A certain percentage of the price of the durable goods paid by the consumers as the cash down payment in the remaining portion is financed by the bank.
Reduce downpayment Maximise period of payment

Higher bank credit

Lower bank credit

Increase downpayment

Minimize period of payment

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 Marginal Requirement: Its one of the most important instruments. The commercial banks give loans to their customers against some securities, however, they do not give loans equivalent to the full amount of the security, but of an amount which is less than its value. This difference between the value of the security and the amount of loan granted is known as marginal requirements.
If marginal requirements is 10%

Higher the rate less is the money supply and vice versa. Thus, money supply can be regulated by increasing or decreasing the marginal requirement.

Bank would give a loan of Rs.9000 against a security of Rs.10000

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 Credit Rationing: It aims at limiting the maximum or ceiling of total amount of bank loans and advances by fixing the maximum limit of loans for specific purposes. It may take place in two forms: i. The central bank may fix maximum amount of loans and advances for every member bank, ii. The central bank may also fix the maximum ratio of loans of a commercial bank towards total assets. Direct Action: It refers to various directives issued by the central bank from time to time so as to regulate their lending and investment activities. This policy may not be used against all banks but against erring banks. These direct actions may take the form of refusal of discounting facilities, refusal of loans, charging of penal rate of interest, etc.
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 Moral Suasion: It is the method of persuasion, request, informal suggestions and advice towards member banks by the central bank. The central bank relies upon this instrument to influence its member banks as the head and leader of the financial institutions. Publicity: It is the method selective credit control. The central bank expresses its views about various monetary and banking policies. The central bank uses this method for influencing credit policies as well as the public opinion in the country.

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Contractionary Monetary Policy

Introduction
Contractionary monetary policy seeks to reduce the size of the money supply. They are fiscal policies, like lower spending and higher taxes, that reduce economic growth. In India, monetary policy is controlled by the RBI.

Tools for Implementation

Monetary Base: The contractionary policy can be implemented by reducing
the size of the monetary base. A central bank uses open market operations by typically selling bonds in exchange for hard currency. When the central bank collects this hard currency payment, it removes that amount of currency from the economy, thus reducing the total amount of money circulating in the economy.
CB sells bonds Collects payment in hard currency Reduces the money circulation Contracts the monetary base

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Reserve Requirements: It can be implemented by requiring banks to hold a higher portion of their total assets in reserve. By doing so, the central bank reduces the availability of loanable funds. This acts as a reduction in the money supply. Interest Rates: In this method, the nominal interest rates are increased. By raising the interest rate, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage lending.

How can monetary policy be used to control inflation?

Inflation is defined as continuing increase in price levels. Since price level is a monetary variable, contractionary policy reduces inflation by reducing upward pressure on price levels.
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Effects of Contractionary Policy

Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates. Higher interest rates lead to lower levels of capital investment. The higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls. The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. (The value of the domestic currency is now higher relative to foreign currencies) A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.
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Expansionary Monetary Policy

Introduction
Expansionary monetary policy seeks to increase the size of the money supply.

Tools for Implementation

Monetary Base: Expansionary policy can be implemented by increasing the size of the monetary base. This directly increases the total amount of money circulating in the economy. The RBI would buy bonds in exchange for hard currency. When the RBI disburses this hard currency payment, it adds that amount of currency to the money supply, thus increasing the monetary base.
Disburses payment in hard currency Increases money circulation Expands the monetary base

RBI buys bonds

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Reserve Requirements: It can be implemented by requiring banks to hold a lower portion of their total assets in reserve. By doing so, the central bank increases the availability of loanable funds. This acts as a increase in the money supply. Interest Rates: In this method, the nominal interest rates are decreased. By lowering the interest rate, a monetary authority can expand the money supply, because lower interest rates discourage savings and encourage lending. How does monetary policy affect the real economy? Expansionary monetary policy should not be confused with an increase in economic output in the real economy. Any change to the real economy resulting from an expansionary monetary policy is subject to time lags and effects from other economic variables; in addition, there are possible side effects of expansion, including inflation.
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Effects of Expansionary Policy

Expansionary monetary policy causes an increase in bond prices and a reduction in interest rates. Lower interest rates lead to higher levels of capital investment. The lower interest rates make domestic bonds less attractive, so the demand for domestic bonds falls and the demand for foreign bonds rises. The demand for domestic currency falls and the demand for foreign currency rises, causing a decrease in the exchange rate. (The value of the domestic currency is now lower relative to foreign currencies) A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase.
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Monetary Policy s Impact on the Economy

The monetary policy not only impacts financing conditions in the economy but also influences the expectations about economic activity and inflation. Monetary policy can affect the prices of goods, asset prices, exchange rates as well as consumption and investment in the following ways:
 Interest rate cuts lead to lower cost of borrowing, which results in higher investment activity and the purchase of consumer durables.  The expectation that economic activity will strengthen may also prompt banks to ease lending policy, which in turn enables businesses and households to boost spending.
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 In a low interest-rate environment, shares become a more attractive buy, raising households financial assets.  This may also contribute to higher consumer spending, and makes companies investment projects more attractive.  Lower interest rates also tend to cause currencies to depreciate: Demand for domestic goods rises when imported goods become more expensive.  All of these factors raise output and employment as well as investment and consumer spending.

However, this stepped-up demand may cause prices and wages to rise if goods and labor markets are fully utilized.
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The Monetary Policy Transmission Mechanism

The process through which monetary policy decisions impact on an economy in general and the price level in particular is known as the monetary policy transmission mechanism. The main channels of monetary policy transmission are set out in a simplified, schematic form in the chart on the next page.
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Interest rate channel: An expansion of the money supply by the central bank feeds through to a reduction of short-term market rates through this channel. As a result, the real interest rate and capital costs decline, raising investment. Additionally, consumers save less and opt for current consumption over future consumption. This, in turn, causes demand to strengthen. However, this stepped-up demand may cause prices and wages to rise if goods and labor markets are fully utilized.

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 Credit channel: Central banks monetary policy decisions influence commercial banks refinancing costs; banks are inclined to pass the changes on to their customers. If financing costs diminish, investment and consumer spending rise, contributing to an acceleration of growth and inflation.

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 Exchange rate channel: Expansionary monetary policy affects exchange rates because deposits denominated in domestic currency become less attractive than deposits denominated in foreign currencies when interest rates are cut. As a consequence, the value of deposits denominated in domestic currency declines relative to that of foreign currency-denominated deposits and the currency depreciates. This depreciation makes domestic goods cheaper than imported goods, causing demand for domestic goods to expand and aggregate output to augment. Wealth channel: Monetary policy impulses are also transmitted through the price of assets such as stocks and real estate. The expansionary monetary policy effects of lower interest rates make bonds less attractive than stocks and result in increased demand for stocks, which bids up stock prices. Conversely, interest rate reductions make it cheaper to finance housing, causing real estate prices to go up.
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