Submitted by: Achal Jain(19) Bhawna Jain(20) Harsha Jain(21) Manisha Jain(22) Mishal Jain(23) Gaurav Jakhotia(24)
Topics to be covered
Introduction to Monetary Policy Money Measures Monetary Policy tools used Types and their effects Monetary policy and inflation, growth, currency and interest rates Limitations of monetary policy
Monetary Policy
Central Banks actions Expansionary (accommodative) Contractionary (restrictive)
Fiscal Policy
Governments use of spending & taxation * Balanced * Budget Surplus * Budget Deficit
Money Measures
Medium of Exchange
Means of payment Unit of account Store of value
SLR
It restricts the bank's leverage in pumping more money into the economy
CRR
It is the portion of deposits that the banks have to maintain with the RBI
Impact on Economy
Higher CRR + SLR Less loan Higher interest rate Expensive to start new business or buy house More Loan Lower interest rate More people can afford loan Boost in economy
Curb inflation
Lead to slowdown
Inflation
A fluctuation in bank rates impacts every sphere of a countrys economy. For instance, the prices in stock markets tend to react to interest rate changes. A change in bank rates affects customers as it influences prime interest rates for personal loans.
Under the Scheme, all scheduled commercial banks have to obtain prior authorization of the Reserve Bank before granting any fresh credit limit of Rs. 1 crores or more to any single borrower.
This limit was, however, raised to Rs. 2 crores in 1975.
A central bank uses them as the primary means of implementing monetary policy.
The usual aim of open market operations is to control the short term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.
Reverse Repo rate is the rate at which RBI borrows money from the commercial banks.
The increase in the Repo rate will increase the cost of borrowing and lending of the banks which will discourage the public to borrow money and will encourage them to deposit. As the rates are high the availability of credit and demand decreases resulting to decrease in inflation.
This increase in Repo Rate and Reverse Repo Rate is a symbol of tightening of the policy. As of December 2012, the repo rate is 8 % and reverse repo rate is 7%
Credit Ceiling
In this operation RBI issues prior information or direction that loans to the commercial banks will be given up to a certain limit. In this case commercial bank will be tight in advancing loans to the public. They will allocate loans to limited sectors.
Few example of ceiling are agriculture sector advances, priority sector lending.
Moral Suasion
A persuasion tactic used by an authority (i.e. RBI) to influence and pressure, but not force, banks into adhering to policy. Often termed simply 'suasion', it has been used to persuade banks and other financial institutions to keep to official guidelines. The 'moral' aspect comes from the pressure for 'moral responsibility' to operate in a way that is consistent with furthering the good of the economy. For example, RBI may request commercial banks not to give loans for unproductive purpose which does not add to economic growth but increases inflation.
Taylors Rule
Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions.
In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle.
First proposed by the U.S. economist John B. Taylor, the rule is intended to foster price stability and full employment by systematically reducing uncertainty and increasing the credibility of future actions by the central bank. It may also avoid the inefficiencies of time inconsistency from the exercise of discretionary policy.
As an equation
The nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:
In this equation, is the target short-term nominal interest rate, is the rate of inflation as measured by the GDP deflator, is the desired rate of inflation, is the assumed equilibrium real interest rate, is the logarithm of real GDP, and is the logarithm of potential output, as determined by a linear trend.
and
Monetary Policy and Economic Growth, Inflation, Interest and Exchange Rates
Central banks manipulation of short term rates affect inflation rate and economic growth It is known as TRANSMISSION MECHANISM The monetary transmission mechanism refers to the process through which changes in monetary policy instruments (such as monetary aggregates or short-term policy interest rates) affect the rest of the economy and, in particular, output and inflation.
Monetary Policy and Economic Growth, Inflation, Interest and Exchange Rates
Transmission Mechanism
Central Bank buys securities Bank Reserves Increase Interbank Lending Rate Decrease Other short term rate decrease
Business invest in Plant and Equipment due to low interest rates Currency depreciation increases foreign demand for domestic goods
Monetary Policy and Economic Growth, Inflation, Interest and Exchange Rates
Transmission Mechanism affects 4 things simultaneously : 1. Market Rate Decrease 2. Asset Price increase due to lower discount rates 3. Firms and individual expectations for economic growth rise, may expect central bank to reduce interest rates further 4. Domestic currency depreciates as real interest rate declines 4 things together leads to: I. Domestic Demand increase (Savings reduce) II. Net external demand increase (X-M) III. Increase in overall demand and import prices tends to increase Aggregate Demand and Domestic Inflation.
Expansionary policy is traditionally used to weaken unemployment in a recession by lowering interest rates.
Level of real income: when individuals have more income they tend to hold more money as a store of value and to carry out more transactions using money.
Unemployment
decreases
Inflation can be a result of expansionary monetary policy if the economy is too robust and creates too much money.
Increases Unemployment
Increased unemployment results from the slowing production and increasing interest rates
Inflation decreases
The main purpose of a contractionary monetary policy is to slow down the rampant inflation that accompanies a booming economy
Price Effect
Strengthen current account Lower exchange rate Less foreign investment Reduced Interest rates
Income Effect
Weaken current account Lower exchange rate More foreign investment
GDP rises
Limitations
Liquidity Trap
Elastic demand for money Hold more money even when there is a fall in short term rates
Credit Bubble
Increased Money supply Less lending by banks
Non-Monetized transactions
Developing countries Transactions in rural area