Art and Science of Central

Banking and Monetary Policy

Sarat Dhal

Monetary Policy Transmission

Mechanism

Objective

Instruments

Targets

Monetary Policy Transmission Mechanism

Objective
economic
assessment

Fiscal Policy
coordination
Instruments

Policy
Instrument
Repo / CRR

Output / employment
Inflation

Financial Market

Market interest rates

Credit
Asset prices
Exchange rate
Confidence / expectation

Aggregate demand
Domestic demand
(consumption, investment)
External demand
(export/import

Central Bank Objective- generalised

perspectives
Monetary stability or Price
stability
low, moderate inflation
Economic stability:
rapid and sustained economic
growth/progress

potential growth / full

capacity output
Full employment
low unemployment

Stable exchange rate

sustainable and stable
external sector
CAD must be financed by
non-debt, non-volatile capital
flows
Financial stability (latest entry)
Nobody knows what it is?
Operationally, sound, stable
and efficient banks and
financial institutions, and
markets
Debate: trade-off between
financial stability, growth and
inflation

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)

United States: Fed has dual

mandate: price stability and low
unemployment; no legal mandate
for price stability or growth.

Developing
and
economies (India):

emerging

multiple objectives and instruments

Single Objective: Monetary (Price) stability

Inflation is a monetary phenomenon;

Monetary instruments can have control

over nominal indicators;

Neutrality of money and policy: no real

effects

No long-run relationship between inflation

and unemployment or growth
Short-run trade-off: uncertainty and
dangerous

Clarity, Transparency

Single objective and single instrumenteffective operational framework;

Boost Credibility, accountability and avoid

time inconsistency problem

Feasible and Realistic for MP to target

Price stability.

Independence from political authorities

Financial stability : Inflation risk premium

low, interest rate volatility low

Economic stability : promote investment

and ensure economic stability

Comparative advantage of MP to
inflation than real growth

Rule bound policy and Predictable

outcome

Single Objective: demerits

Inflation nutter
Very Low inflation-MP instrument may not
work
Inflexibility of MP
Ignore unforeseen events

Central bank objective

Focusing on a single objectivelow and stable inflationis
ultimately the best way that monetary policy can promote
macroeconomic and financial stability. This does not mean
sacrificing or ignoring growth. Indeed, well-anchored
inflationary expectations may well be the best tonic that
monetary policy can provide for growth. Contrary to what
some commentators seem to believe, there is no long-run
trade-off between growth and inflation, and for monetary
policy to try and engineer a short-run trade-off can be
dangerous. In short, the inflation objective would in fact make
monetary policy more effective and strengthen RBIs hands
rather than pinning them down.
(Raghuram Rajan, Mint, Aug 07 2013)

Monetary Policy Instruments

Direct instrument
Cash reserve requirement,
SLR

Indirect instruments
Interest rate
Exchange rate
Financial sector regulation
Prudential regulation / structural measures
Moral suasion

Direct instrument: CRR

Liabilities

Assets

Capital (K)

Loans and
advances (L)

Deposits (D) Investment (G)

Others (O)

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.

Indirect instrument: Interest rate

Policy rate (repo rate):
central banks do not fund
private sector. They provide
short-term liquidity to
banks in case of their
balance sheet mismatch. It
is only when banks borrow
from the central bank that
their balance sheet is
affected
by
cost
of
borrowing.

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.

Indirect Instrument: Role of Financial

Markets Integration
Policy rate short-end of
the financial markets
(money market
including interbank and
treasury bills,
commercial paper,
certificates of deposits)

Medium-longer
segments affected
through

TERM
STRUCTURE
OF
FINANCIAL
MARKETS

Monetary Policy Operating Framework

Monetary policy instruments cannot have
direct connect with ultimate objectives
(inflation, growth, unemployment)

Connect through intermediate targets:

Monetary indicators
Money supply, bank credit, interest rates,
exchange rate, asset prices

MP Intermediate targets
Price stability:
Inflation rate around threshold level, core inflation

Stability in money and gilt market

Interbank money market bound by repo rate

Adequate flow of credit to producing sectors for

stimulating investment
Growth rate of monetary aggregate, Bank credit growth

Appropriate deposit and loan interest rates

Stability in financial markets (money, credit, treasury
bonds, foreign exchange)

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)

Both money, credit and interests rates

Intermediate Targeting of Money and

Credit Aggregates
Money Supply = Money Demand
Money Market Equilibrium
All genuine demand for money and credit
requirements for productive purpose are
fulfilled without consequences for inflation

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).

Anything that is generally

acceptable as a means of
exchange and which at the
same time acts as a measure
and store of value
(G Crowther, 1940, An Outline of
Money, Thomas Nelson and Sons Ltd,
London)

What is Money?
Coins
(Issued by Government of
India)

Paper money:

Bank notes Reserve Bank of

India(5, 10, 20, 50, 100, 500,
1000)

Government of India issues 1

Rs notes (signature of
finance secretary).

Bank deposits (chequable)

Post office savings

Money functions
Medium of exchange
Overcomes the inefficiency of barter
system; coincidence of wants

Unit of account (common measure of

value)
Divisible, fungible, countable
(verifiable)

Standard of value (deferred payment)

Settle debt

Store of value
Saving; stable value, purchasing
power

MUSS / SUMS

Motives for Holding Money

Transaction demand
(unit of account,
medium of exchange)

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

Money Supply Process

For all countries money supply is managed by
central banks. In India, it is Reserve Bank of
India.

Why do not they print enough money so that

people can be rich?
How does RBI decides money supply?

Money Supply process

Imagine you are placed in an isolated Island
with a truck load of money. What good
money will do to you since you cannot buy
goods not available in the Island.
Too much money chasing too few goods.
Increasing money supply without a matching
increase in production can lead to inflation.

Money Supply Process:

Base Money Hypothesis
Base Money Hypothesis:
= +
= +
Money multiplier:
+
= =
+
Let us have:
=
=
+
1+
=
=
+
+

< 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

Notation: c and r not for

consumption propensity
and interest rate

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

Money demand function

Classical Quantity Theory of Money

=
Cambridge Version
=
Keynesian
/ = (, )

Money demand function: QTM

Fisher QTM

Cambridge Version: if T=Y, k =1/v

=

As long as v is a constant, k also constant. From the

Cambridge version, we can derive
= +
Thus, central bank can set money supply growth equal
to money demand growth as a sum of inflation rate
and real GDP growth .

Money demand function

=

=
= +
Note here the difference
(Cambridge version = 1).
In India, RBI uses = 1.5

from

QTM

Money demand: Keynes

= +
Keynes: = ,

Classical: b=0, Interest rate inelastic demand for money (vertical

LM Curve)

Friedmans Money Demand

= (, , , )

Income, return on bonds, return on equities and

return on consumer durables
The role of , , small and transitory effect; it
is primarily the income, which will determine the
demand for real money balance largely for
transaction purpose in the long-run.

Baumol-Tobin Transaction demand

Even if money is demand for
transaction purposes, it can
also be influenced by interest
rate.
=

( )
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.

In India: = % % (Vasudevan, Bhoi and Dhal,

1997 and others later)

Monetary Targeting
What about growth rate?
For full employment, it
could be set at potential
growth.

How do we know the

potential growth which is
unobserved?
Useful here are theoretical
and empirical insights.

Recall the Harrod-Domar

model.
Potential growth can be
determined at warranted
growth rate: = /
If we know saving rate s and
capital output ratio v in the
medium-longer
horizons,
we can set growth target
and accordingly, money
supply growth target.

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 )

In the Indian context, we do not have appropriate

employment and work hours data.

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.

Instability in Demand for Money

Like money-multiplier, money demand can be unstable
process.
Instability due to changes in velocity and income and
interest rate elasticity parameters.
Structural shifts / regime changes

Thus, monetary targeting can fail. A large empirical

literature pointed to the failure of monetary targeting.
Some countries have abandoned monetary aggregates.
Move on to indirect instruments of monetary policy
through market mode: interest rate

Interest rate Instrument:

role of term structure

Policy rate
(repo)

Market
short
interest
rates

Market
long
interest
rate

Consumption,
Saving,
investment

Output &
Inflation

Effectiveness of Interest Rate Policy

Benchmark risk free instrument

Existence of term structure
Integration of Financial market segments
Liquidity and depth of various segments
Operating and allocation efficiency of banks
and financial institutions in terms pricing and
quantity decisions
Efficient market hypothesis

Term structure of interest

Term structure hypothesis:
Long rate is a combination of current and future short
rates.
Suppose you have 1 rupee to invest for two years. You have
two options.
Option 1:
Invest for 1-year and earn interest 1 and then reinvest in
the second year.
But for the second year, you do not know what will be the
interest rate. You have some expected rate: 1
Total income from investment
1 = (1 + 1 )(1 + 1 )

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 )

Term structure and CAPM

= +
: 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)

Reserve Bank of India

Established in 1935 (RBI Act
1934); Nationalised in 1949
(Government Share capital of
Rs 5 crore)
Preamble:
Regulate the issue of
banknotes,
Maintain reserves with a view
to securing monetary stability
and
Operate the credit and currency
system of the country to its
advantage.

Transmission Channels

Money & Credit (Quantity Channel)

Interest rate (Price Chanel)
Exchange rate
Asset prices
Confidence / Animal Spirit
Financial stability

Mishkin, F: Monetary Transmision mechanism, JEP, 1994

Bernanke, B and Gertler, M. (1994), Credit Channel: Inside the Black Box

MTM: Money and Credit

1 Bank lending
& & &

2 Balance sheet of firms

&


&

MTM Channels: Interest rate

( ) & &
Fall in policy rate (repo), fall in market interest
rate, increase in consumption and investment,
increase in output and price
2. Effectiveness of interest rate channels will
depend term structure of interest rates and the
linkages among various financial market
segments.

MTM Channels: Exchange rate

( ) &
Fall in policy rate (repo), fall in market interest
rate,
depreciation
of
exchange
rate,
improvement in trade balance (net exports goes
up), increase in output and price

MTM Channels: Asset Prices

: Two theories

3.1 Tobins q theory investment

&

3.2 Wealth effect on Consumption

&

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

Mishkin, F: Monetary Transmision mechanism, JEP, 1994

Bernanke, B and Gertler, M. (1994), Credit Channel: Inside the Black Box

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

Long-run: we have seen that theoretical postulates in macroeconomics are

not unique.
Short-run: variation in all variables may adjust to the deviation from the
common long-run path. The speed of adjustment to equilibrium is
important for policy analysis.

Monetary Policy Debate:

Rules or Discretion
How to set instruments?
Rules: passive / automatic pilot
Discretion: active / judgments

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)

Reserve Bank of India

Multi-purpose central
bank
Multiple objectives,
instruments
Conflicting objectives
and stakeholders
Balance of risk
perspective

RBI Objective
Price
stability

Sustained
Growth

RBI

Financial
stability

sound,
stable
external
sector

Reserve Bank of India: Functions

Monetary Authority
Monetary policy
Issue of Bank Notes
Public interest (depositor
protection)

Banker to Government
Normal Transactions
Debt management

Banker to Banks
Lender of last resort

Banking regulator and

supervisor (BR Act)
Banks and NBFCs
Financial sector stability

Payment and settlement

system
Clearing service

Institutional development
LIC, EXIM, NABARD, SIDBI,
NHB, UTI, IDBI, SBI
IGIDR, IDRBT, NIBM, IIBM

Development banking
Priority sector lending,
Cooperative banks
Financial inclusion

Manage Foreign exchange

External sector stability

RBI : an arms house of monetary

instruments

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

Systemic risk and stability

Prudential regulation of banks
and NBFCs
CAMELS (capital adequacy,
asset quality, managerial
efficiency, earnings, liquidity,
and systems)

Monetary Aggregates Indicators

Base/Reserve/High
powered/ Fiat money
(created by central banks)
M0 = Currency + bank
reserves
Currency: bank notes and
coins held by the public
Bank reserves: commercial
banks hold a fraction of net
demand and time liabilities
such as deposits with the
central bank: cash reserve
requirement (CRR)

Narrow money (M1):

Currency (C) plus demand
deposits (DD)- Transaction
purpose

Broad money (M3):

M1+Time deposits (TD)

Liquidity aggregates:
includes
institutions,
savings etc.

financial
post office

Banking aggregates

MP Intermediate targets
Price stability:
Inflation rate around threshold level, core inflation

Stability in money and gilt market

Interbank money market bound by repo rate

Adequate flow of credit to producing sectors for

stimulating investment
Growth rate of monetary aggregate, Bank credit growth

Appropriate deposit and loan interest rates

Stability in financial markets (money, credit, treasury
bonds, foreign exchange)

RBI Operating Framework for Policy:

Paradigm Shift
Pre-reform

Reform

Objective

Objective (same as before)

Price stability, adequate flow of

credit
Ambiguity in price stability,
growth

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

Less ambiguity in Price stability,

and growth objectives; Threshold
inflation,
potential
growth,
forecasts and projections

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

RBI Policy: Paradigm Shift

Pre-reform
Heavily Regulated banking
sector
Regulation of Interest rates
on deposits and loans,
Credit deployment across
sectors (Priority sector
lending)

Fiscal dominance
Automatic monetisation of
government deficit and debt

Banking regulation (annual

onsite inspection)

Reform
Deregulated banking
Banks free to determine deposit
and lending rates
Credit deployment (Priority
sector norm continues but list
expanded and flexible)

Fiscal dominance abolished

Banking regulation
Prudential regulation; Basel
Norm; onsite and off-site
surveillance

RBI Policy: Paradigm Shift

Pre-reform
Annual Credit Policy
Busy season (Kharif)

Half-yearly policy
Slack season

Credit policy cell

Macroeconomic assessment
Ambiguous,
Lacked rigour
Secrecy

Reform
Annual (Monetary and credit)
Policy

Quarterly, bi-monthly policy

review
Monetary policy department

Macroeconomic Assessment
More in-depth analysis
(forecast, projections)
Fan charts
Public disclosure (released oneday before policy)

RBI Policy: Paradigm Shift

Pre-reform
Pre-policy Consultation
Government
Banking sector,

Reform

Pre-policy Consultation
Government
Banking sector; Academic experts;
Industry experts; Market experts

Internal experts

Internal Team

Policy Communication
Media release: press
statement

Technical Advisory Group (minutes

disclosed)

Policy Communication

Real time Media coverage of policy

announcement
Enhanced Communication (town hall, media
briefing, video conferencing
Seminars, lectures, speeches across the country

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.

Repo vs. reverse repo

Repo
Repo or repurchase option is a
collaterised lending i.e. banks
borrow money from Reserve
bank of India to meet short
term
needs
by
selling
securities to RBI with an
agreement to repurchase the
same at predetermined rate
and date. The rate charged by
RBI for this transaction is
called the repo rate. Repo
operations therefore inject
liquidity into the system.

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.

LAF & MSF

Under LAF - Repo rate, Banks can borrow from
RBI at the Repo -rate by pledging government
securities over and above the statutory liquidity
requirements.
However, in case of borrowing from the
marginal standing facility, banks can borrow
funds up to two percentage of their net demand
and time liabilities, at the rates announced by
RBI and this can be within the statutory liquidity
ratio of 23%.

RBI Balance sheet: Base Money Supply

Liabilities
Assets
(Components)
(Sources)
1. Currency in circulation 1. Domestic Assets
2. Bankers reserves
Credit to Government
(Reserve requirement) Credit to Commercial sector
3. Other deposits
2. Foreign Assets
Foreign currency
Gold
3. Less Non-monetary liabilities
Total: Reserve Money

Reserve Money

Composition of Reserve Money

100%
80%
60%
40%
20%

domestic credit

foreign assets

2013

2010

2007

2004

2001

1998

1995

1992

1989

1986

1983

1980

1977

1974

-20%

1971

0%

1.60

Currency Deposit Ratio

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

RBI: Monetary analysis

Money demand
: 3 =
3, = + 1.5,
Interest rate = F(inflation
gap, output gap, other
indicators)
No rule followed
Judgment plays a critical
role

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)

RBI Forecasting / Projections

Univariate time series
econometric models

There is no structural macro

model!

Multivariate time series

models (VAR, VECM)

No DSGE model

Suits of VAR models with 3-four

variables

Trend-cycle-seasonal
decomposition (HP trend)
Fan charts
probabilistic assessment of
growth and inflation

Monetary Targeting Regime

Multiple Indicators Regime

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

Evolution of RBI Operating Procedure

Period

Focus

Intermediate target

instrument

1935-50 (formative
years)

Financial intermediation

Regulate supply of and

demand for credit

Bank rate, OMO

1951-70 (Development
phase)

Support five year Plan

financing, accommodate
government deficit,
Contain inflationary
pressures

Quantitative control
measures: selective
credit control, credit
authorisation scheme,
social banking (priority
sector)

Bank rate frequently

used

1971-90 (Fiscal
dominance)

Credit planning, Fiscal

dominance, Statutory
pre-emption of funds for
supporting government
budget

Monetary targeting
(reserve money growth
operating target, broad
money growth
intermediate target)

High SLR, high CRR

SLR: 25 to 38.5
CRR: 3 to 15
Money market
instruments (IBPCs, CDs,
CPs)

1990s: reform

Reduce fiscal dominance, market determined

Market based policy;
interest rate and
exchange rate

CRR and SLR reduced;

Bank rate, repo rate, LAF

2011 (new OP)

Single policy rate,

financial market stability

Repo rate ,
MSF

Overnight call money

rate stability within a

Interest rate

Monetary Policy Effectiveness:

Role of Financial Markets

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

Financial Market Integration

For successful conduct of monetary policy
through interest rate channel, financial market
integration is critically important.

Integrated markets: policy shocks can have

wide-spread effect across market

Managing Liquidity & Money Market

16
14
12
10
8
6
4
2
0
03

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.