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NAME OF STUDENTS ROLL NO.
AFSHA RATANSI 19
RITIKA SHETTY 23
TOPIC Pg. No
1 Introduction 52 Monetary Policy And The
3 Implementation Of Monetary Policy
4 Types Of Monetary Policy 125 Monetary Policy Tools 186 Objectives Of Monetary Policy 237 Goals Of Monetary Policy 258 Limitations Of Monetary
9 Monetary Aggregates 3010 Monetary Policy Of India 3211 The Australian Monetary
12 Monetary Policy Of China 3913 Monetary Policy Of Singapore 4414 Monetary Policy Of Japan 4615 The United States Monetary
16 Conclusion 51
INTRODUCTIONMonetary policy is the process by which the central
bank or monetary authority of a country controls the supply of money, often targeting a rate of interest. Monetary policy is usually used to attain a set of objectives oriented towards the growth and stability of the economy. These goals usually include stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy rapidly, and a contractionary policy decreases the total money supply or increases it only slowly. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation.
Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation . An attempt to achieve broad economic goals by the regulation of the supply of money.
MONETARY POLICY AND THE ECONOMY
Being one of the most influential government policies, monetary policy aims at affecting the economy through the Fed's management of money and interest rates. As generally accepted concepts, the narrowest definition of money is M1, which includes currency, checking account deposits, and traveler's checks. Time deposits, savings deposits, money market deposits, and other financial assets can be added to M1 to define other monetary measures such as M2 and M3. Interest rates are simply the costs of borrowing. The Fed conducts monetary policy through reserves, which are the portion of the deposits that banks and other depository institutions are required to hold either as cash in their vaults, called vault cash, or as deposits with their home FRBs. Excess reserves are the reserves in excess of the amount required. These additional funds can be transacted in the reserves market (the federal funds market) to allow overnight borrowing between depository institutions to meet short-term needs in reserves. The rate at which such private borrowings are charged is the federal funds rate.
Monetary policy is closely linked with the reserves market. With its policy tools, the Fed can control the reserves available in the market, affect the federal funds rate, and subsequently trigger a chain of reactions that influence other short-term interests rates, foreign-exchange rates, long-term interest rates, and the amount of money and credit in the economy. These changes will then bring about adjustments in consumption, affect saving and investment decisions, and eventually influence employment, output, and prices.
How Monetary Policy Affects The Economy
The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. Depository institutions have accounts at their Reserve Banks, and they actively trade balances held in these accounts in the federal funds market at an interest rate known as the federal funds rate. The Federal Reserve exercises considerable control over the federal funds rate through its influence over the supply of and demand for balances at the Reserve Banks. The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments.
A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households’ and businesses’ spending decisions, thereby affecting growth in aggregate demand and the economy.
IMPLEMENTATION OF MONETARY POLICY
Since the early 1980s, the Fed has been relying on the overnight federal funds rate as the guide to its position in monetary policy. The Fed has at its disposal three major monetary policy tools:
Under the Monetary Control Act of 1980, all depository institutions, including commercial banks, savings and loans, and others, are subject to the same reserve requirements, regardless of their Fed member status. As of March 1999, the basic structure of reserve requirements is 3 percent for all checkable deposits up to $46.5 million and 10 percent for the amount above $46.5 million. No reserves are required for time deposits (data from Federal Reserve Bank of Minneapolis, 1999).
Reserve requirement affects the so-called multiple money creation. Suppose, for example, the reserve requirement ratio is 10 percent. A bank that receives a $100 deposit (bank 1) can lend out $90. Bank 1 can then issue a $90 check to a borrower, who deposits it in bank 2, which can then lend out $81. As it continues, the process will eventually involve a total of $1,000 ($100 + $90 + $81 + $72.9 … $1,000) in deposits. The initial deposit of $100 is thus multiplied 10 times. With a lower (higher) ratio, the multiple involved is larger (smaller), and more (less) reserves can be created.
Reserve requirements are not used as often as the other policy tools. Since funds grow in multiples, it is difficult to administer small adjustments in reserves with this tool. Also, banks always have the option of entering the federal funds market for reserves, further limiting the role of reserve requirements.
The Discount Rate
Banks may acquire loans through the "discount window" at their home FRB. The most important credit available through the window is the adjustment credit, which helps depository institutions meet their short-term needs against, for example, unexpected large withdrawals of deposits. The interest rate charged on such loans is the basic discount rate and is the focus of discount policy. A lower-rate encourages more borrowing. Through money creation, bank deposits increase and reserves increase. A rate hike works in the opposite direction. However, since it is more efficient to adjust reserves through open-market operations (discussed below), the amount of discount window lending has been unimportant, accounting for only a small fraction of total reserves. Perhaps a more meaningful function served by the discount rate is to signal the Fed's stance on monetary policy, similar to the role of the federal funds rate.
By law, each FRB sets its discount rate every two weeks, subject to the approval of the Board of Governors. However, the gradual nationalization of the credit market over the years has resulted in a uniform discount rate. Its adjustments have been dictated by the cyclical conditions in the economy, and the frequency of adjustments has varied. In the 1990s, for example, the Fed cut the rate seven times—from 7 percent to 3 percent— during the recession from December 1990 to July 1992. Later, from May 1994 to February 1995, the rate was raised four times—from 3 percent to5.25 percent—to counter possible economic overheating and inflation. In January 1996, the rate was lowered to 5 percent and it stayed there for the next thirty-two months, during which the U.S. economy experienced a solid and consistent growth with only minor inflation. From October to November 1998, the Fed cut the rate twice, first to 4.75 percent and then to 4.5 percent, anticipating the threat from the global financial crisis that had began in Asia
in mid-1997 (data from "United States Monetary Policy," 1999).
The most important and flexible tool of monetary policy is open-market operations (i.e., trading U.S. government securities in the open market). In 1997, the Fed made $3.62 trillion of purchases and $3.58 trillion of sales of Treasury securities (mostly short-term Treasury bills). As of September 1998, the Fed held $458.13 billion of Treasury securities, roughly 8.25 percent of the total Federal debt outstanding
The FOMC directs open-market operations (and also advises about reserve requirements and discount-rate policies). The day-to-day operations are determined and executed by the Domestic Trading Desk (the Desk) at the FRB of New York. Since 1980, the FOMC has met regularly eight times a year in Washington, D.C. At each of these meetings, it votes on an intermeeting target federal funds rate, based on the current and prospective conditions of the economy. Until the next meeting, the Desk will manage reserve conditions through open-market operations to maintain the federal funds rate around the given target level. When buying securities from a bank, the Fed makes the payment by increasing the bank's reserves at the Fed. More reserves will then be available in the federal funds market and the federal funds rate falls. By selling securities to a bank, the Fed receives payment in reserves from the bank. Supply of reserves falls and the funds rate rises.
The Fed has two basic approaches in running open-market operations. When a shortage or surplus in reserves is likely to persist, the Fed may undertake outright purchases or sales, creating a long-term impact on the supply of reserves. However, many reserve movements are temporary. The Fed can then take a defensive position and
engage in transactions that only impose temporary effects on the level of reserves. A repurchase agreement (a repo) allows the Fed to purchase securities with the agreement that the seller will buy back them within a short time period, sometimes overnight and mostly within seven days.
The repo creates a temporary increase in reserves, which vanishes when the term expires. If the Fed wishes to drain reserves temporarily from the banking system, it can adopt a matched sale-purchase transaction (a reverse repo), under which the buyer agrees to sell the securities back to the Fed, usually in less than seven days.
TYPES OF MONETARY POLICYIn practice, all types of monetary policy involve
modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations. Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.
The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.
Monetary Policy:Target Market
Variable:Long Term Objective:
Inflation TargetingInterest rate on overnight debt
A given rate of change in the CPI
Price Level Targeting
Interest rate on overnight debt
A specific CPI number
The growth in money supply
A given rate of change in the CPI
Fixed Exchange Rate
The spot price of the currency
The spot price of the currency
Gold Standard The spot price of goldLow inflation as measured by the gold price
Mixed Policy Usually interest ratesUsually unemployment + CPI change
The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the
currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price index).
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Eurozone,
New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.
Price Level Targeting:
Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called monetarism.
While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.
Fixed Exchange Rate:
This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of
fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).
These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.
The gold standard is a system in which the price of the national currency is measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. (i.e. open market operations, cf. above). The selling of gold is very important for economic growth and stability.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".
Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world between the mid-1800s through 1971. Its major advantages were simplicity and transparency.
The major disadvantage of a gold standard is that it induces deflation, which occurs whenever economies grow faster than the gold supply. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to
make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value.
Deflation can cause economic problems, for instance, it tends to increase the ratio of debts to assets over time. As an example, the monthly cost of a fixed-rate home mortgage stays the same, but the dollar value of the house goes down, and the value of the dollars required to pay the mortgage goes up. William Jennings Bryan rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.
Policy Of Various Nations:
Australia - Inflation targeting Brazil - Inflation targeting Canada - Inflation targeting Chile - Inflation targeting China - Monetary targeting and targets a currency
basket Eurozone - Inflation targeting Hong Kong - Currency board (fixed to US dollar) India - Multiple indicator approach New Zealand - Inflation targeting Norway - Inflation targeting Singapore - Exchange rate targeting South Africa - Inflation targeting Switzerland - Inflation targeting Turkey - Inflation targeting United Kingdom - Inflation targeting, alongside
secondary targets on 'output and employment'. United States - Mixed policy (and since the 1980s it is
well described by the "Taylor rule," which maintains
that the Fed funds rate responds to shocks in inflation and output)
MONETARY POLICY TOOLS
Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base.
The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the
rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.
Discount Window Lending:
Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.
The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates.
In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool — open market operations; one must choose which one to control.
In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its
control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.
A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are three-fold:
1. To import monetary credibility of the anchor nation; 2. To maintain a fixed exchange rate with the anchor
nation; 3. To establish credibility with the exchange rate (the
currency board arrangement is the hardest form of fixed exchange rates outside of dollarization).
In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board). A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.
The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of
foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners.
Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession.
This emphasized the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced by the Euro).
Currency boards have advantages for small, open economies that would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.
Unconventional Monetary Policy At The Zero Bound:
Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include credit easing, quantitative easing, and signaling.
In credit easing, a central bank purchases private sector assets, in order to improve liquidity and improve access to credit. Signaling can be used to lower market expectations for future interest rates. For example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an “extended period”, and the Bank of Canada made a “conditional commitment” to keep rates at the lower bound of 25 basis points (0.25%) until the end of the second quarter of 2010.
Monetary policy can't rein in food inflation: RBIBS Reporter | 2010-06-30 01:30:00
Rising food prices have been a concern for the last few months, but the response to food inflation is beyond the monetary policy, according to RBI Deputy Governor Subir Gokarn.
FM hints at rate review in July
"The dynamics of food prices is not the result of one or two failed monsoons," Gokarn said on the sidelines of the statistical day seminar organized by RBI.
He said the rise in food prices was due to a combination of shifting consumption patterns, which was pushing up the demand for primary articles like pulses, even as productivity of the agriculture sector reached stagnation.
"As affluence spreads, there is diversification in food consumption patterns. There is a greater emphasis on protein-rich items, resulting in higher demand for pulses and milk. The significant part of the rise in food prices was structural in nature," he added.
India’s food inflation rose to 17.60 per cent in the week ended June 12 from 16.86 per cent in the previous week. This rise was mainly due to a hike in the prices of fruits, vegetables, and spices.
'Rising fuel prices will spur inflation'
Gokarn also pointed out that capacity constraints as well as deficient rainfall have affected productivity in the farming sector.
OBJECTIVES OF MONETARY POLICY
To maintain price stability is the primary objective of the Euro system and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1).
"Without prejudice to the objective of price stability", the Euro system will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community". These
include a "high level of employment" and "sustainable and non-inflationary growth".
The Treaty establishes a clear hierarchy of objectives for the Euro system. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favorable economic environment and a high level of employment.
These Treaty provisions reflect the broad consensus that
The benefits of price stability are substantial (see benefits of price stability). Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy.
The natural role of monetary policy in the economy is to maintain price stability (see scope of monetary policy). Monetary policy can affect real activity only in the shorter term (see the transmission mechanism). But ultimately it can only influence the price level in the economy.
The Treaty provisions also imply that, in the actual implementation of monetary policy decisions aimed at maintaining price stability, the Euro system should also take into account the broader economic goals of the Community.
In particular, given that monetary policy can affect real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective.
The Federal Reserve sets the nation’s monetary policy to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates. The challenge for policy makers is that tensions among the goals can arise in the short run and that information about the economy becomes available only with a lag and may be imperfect.
GOALS OF MONETARY POLICY
The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Stable prices in the long run are a precondition for maximum sustainable output growth and employment as well as moderate long-term interest rates. When prices are
stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living. Moreover, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation—and the need to guard against such losses—are minimized, households are encouraged to save more and businesses are encouraged to invest more.
Although price stability can help achieve maximum sustainable output growth and employment over the longer run, in the short run some tension can exist between the two goals. Often, a slowing of employment is accompanied by lessened pressures on prices, and moving to counter the weakening of the labor market by easing policy does not have adverse inflationary effects. Sometimes, however, upward pressures on prices are developing as output and employment are softening—especially when an adverse supply shock, such as a spike in energy prices, has occurred.
Then, an attempt to restrain inflation pressures would compound the weakness in the economy, or an attempt to reverse employment losses would aggravate inflation. In such circumstances, those responsible for monetary policy face a dilemma and must decide whether to focus on defusing price pressures or on cushioning the loss of employment and output. Adding to the difficulty is the possibility that an expectation of increasing inflation might get built into decisions about prices and wages, thereby adding to inflation inertia and making it more difficult to achieve price stability.
Beyond influencing the level of prices and the level of output in the near term, the Federal Reserve
can contribute to financial stability and better economic performance by acting to contain financial disruptions and preventing their spread outside the financial sector. Modern financial systems are highly complex and interdependent and may be vulnerable to wide-scale systemic disruptions, such as those that can occur during a plunge in stock prices.
The Federal Reserve can enhance the financial system’s resilience to such shocks through its regulatory policies toward banking institutions and payment systems. If a threatening disturbance develops, the Federal Reserve can also cushion the impact on financial markets and the economy by aggressively and visibly providing liquidity through open market operations or discount window lending.
LIMITATIONS OF MONETARY POLICY
Monetary policy is not the only force acting on output, employment, and prices. Many other factors affect aggregate demand and aggregate supply and, consequently, the economic position of households and businesses. Some of these factors can be anticipated and built into spending and other economic decisions, and some come as a surprise. On the demand side, the government influences the economy through changes in taxes and spending programs,
which typically receive a lot of public attention and are therefore anticipated. For example, the effect of a tax cut may precede its actual implementation as businesses and households alter their spending in anticipation of the lower taxes. Also, forward-looking financial markets may build such fiscal events into the level and structure of interest rates, so that a simulative measure, such as a tax cut, would tend to raise the level of interest rates even before the tax cut becomes effective, which will have a restraining effect on demand and the economy before the fiscal stimulus is actually applied.
Other changes in aggregate demand and supply can be totally unpredictable and influence the economy in unforeseen ways. Examples of such shocks on the demand side are shifts in consumer and business confidence, and changes in the lending posture of commercial banks and other creditors. Lessened confidence regarding the outlook for the economy and labor market or more restrictive lending conditions tend to curb business and household spending. On the supply side, natural disasters, disruptions in the oil market that reduce supply, agricultural losses, and slowdowns inproductivity growth are examples of adverse supply shocks. Such shocks tend to raise prices and reduce output. Monetary policy can attempt to counter the loss of output or the higher prices but cannot fully offset both.
In practice, as previously noted, monetary policy makers do not have up-to-the-minute information on the state of the economy and prices. Useful information is limited not only by lags in the construction and availability of key data but also by later revisions, which can alter the picture considerably.
Therefore, although monetary policy makers will eventually be able to offset the effects that adverse demand shocks have on the economy, it will be some time before the shock is fully recognized and—given the lag between a policy action and the effect of the action on aggregate
demand—an even longer time before it is countered. Add to this the uncertainty about how the economy will respond to an easing or tightening of policy of a given magnitude, and it is not hard to see how the economy and prices can depart from a desired path for a period of time.
The statutory goals of maximum employment and stable prices are easier to achieve if the public understands those goals and believes that the Federal Reserve will take effective measures to achieve them. For example, if the Federal Reserve responds to a negative demand shock to the economy with an aggressive and transparent easing of policy, businesses and consumers may believe that these actions will restore the economy to full employment; consequently, they may be less inclined to pull back on spending because of concern that demand may not be strong enough to warrant new business investment or that their job prospects may not warrant the purchase of big-ticket household goods.
Similarly, a credible anti-inflation policy will lead businesses and households to expect less wage and price inflation; workers then will not feel the same need to protect themselves by demanding large wage increases, and businesses will be less aggressive in raising their prices, for fear of losing sales and profits. As a result, inflation will come down more rapidly, in keeping with the policy-related slowing in growth of aggregate demand, and will give rise to less slack in product and resource markets than if workers
and businesses continued to act as if inflation were not going to slow.
Guides To Monetary Policy
Although the goals of monetary policy are clearly spelled out in law, the means to achieve those goals are not. Changes in the FOMC’s target federal funds rate take some time to affect the economy and prices, and it is often far from obvious whether a selected level of the federal funds rate will achieve those goals. For this reason, some have suggested that the Federal Reserve pay close attention to guides that are intermediate between its operational target—the federal funds rate—and the economy.
Monetary aggregates have at times been advocated as guides to monetary policy on the grounds that they may have a fairly stable relationship with the economy and can be controlled to a reasonable extent by the central bank,
either through control over the supply of balances at the Federal Reserve or the federal funds rate. An increase in the federal funds rate (and other short-term interest rates), for example, will reduce the attractiveness of holding money balances relative to now higher-yielding money market instruments and thereby reduce the amount of money demanded and slow growth of the money stock. There are a few measures of the money stock—ranging from the transactions-dominated M1 to the broader M2 and M3 measures, which include other liquid balances—and these aggregates have different behaviors.
Ordinarily, the rate of money growth sought over time would be equal to the rate of nominal GDP growth implied by the objective for inflation and the objective for growth in real GDP. For example, if the objective for inflation is 1 percent in a given year and the rate of growth in real GDP associated with achieving maximum employment is 3 percent, then the guideline for growth in the money stock would be 4 percent. However, the relation between the growth in money and the growth in nominal GDP, known as “velocity,” can vary, often unpredictably, and this uncertainty can add to difficulties in using monetary aggregates as a guide to policy. Indeed, in the United States and many other countries with advanced financial systems over recent decades, considerable slippage and greater complexity in the relationship between money and GDP have made it more difficult to use monetary aggregates as guides to policy. In addition, the narrow and broader aggregates often give very different signals about the need to adjust policy. Accordingly, monetary aggregates have taken on less importance in policy making over time.
The Components Of The Monetary Aggregates:
The Federal Reserve publishes data on three monetary aggregates. The first, M1, is made up of types of money commonly used for payment, basically currency and checking deposits. The second, M2, includes M1 plus balances that generally are similar to transaction accounts and that, for the most part, can be converted fairly readily to M1 with little or no loss of principal. The M2 measure is thought to be held primarily by households. The third aggregate, M3, includes M2 plus certain accounts that are held by entities other than individuals and are issued by banks and thrift institutions to augment M2-type balances in meeting credit demands; it also includes balances in money market mutual funds held by institutional investors.
MONETARY POLICY OF INDIA
Monetary policy in India underwent significant changes in the 1990s as the Indian Economy became increasing open and financial sector reforms were put in place. in the 1980s,monetary policy was geared towards controlling the qunatam,cost and directions
Of credit flow in the economy. the quantity variables dominated as the transmission Channel of monetary policy. Reforms during the 1990s enhanced the sensitivity of priceSignals of price signals from the central bank, making interest rates the increasingly Dominant transmission channel of monetary policy in India.
The openness of the economy, as measured by the ratio of merchandise trade(exports Plus imports) to GDP, rose from about 18% in 1993-94 to about 26% by 2003-04. Including services trade plus invisibles, external transactions as a proportion of GDP Rose from 25% to 40% during the same period. Along with the increase in trade as a Percentage of GDP, capital inflows have increased even more sharply ,foreign currency.
Assets of the reserve bank of India(RBI) rose from USD 15.1 billion in the march 1994 To over USD 140 billion by march 15,2005.these changes have affected liquidity and Monetary management. Monetary policy has responded continuously to changes in Domestics and international macroecomic conditions. In this process, the current monetary operating framework has relied more on outright open market operations and Daily repo and reserve repo operations than on the use of direct instruments. Overnight Rate are now gradually emerging as the principal operating target.
The Monetary and Credit Policy is the policy statement, traditionally announced twice a year, through which the Reserve Bank of India seeks to ensure price stability for the economy. These factors include - money supply, interest rates and the inflation.
The objectives are to maintain price stability and ensure adequate flow of credit to the Productive sectors of the economy. Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into. The monetary policy affects the real sector through long and variable periods while thefinancial markets are also impacted through short-term implications.
There are four main 'channels' which the RBI looks at:
Quantum Channel: Money supply and credit (affects real output and price level through changes in reserves money, money supply and credit aggregates).
Bank Rate: Bank rate is the minimum rate at which the central bank provides loans to the commercial banks. It is also called the discount rate.
Usually, an increase in bank rate results in commercial banks increasing their lending rates. Changes in bank rate affect credit creation by banks through altering the cost of credit.
Cash Reserve Ratio: All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the cash reserve ratio. The current CRR requirement is 8 per cent.
CRR, or cash reserve ratio, refers to a portion of deposits (as cash) which bank have to keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and secondly it enables that RBI controlling equidity in the system, and thereby, inflation. Besides the CRR, banks are required to invest a portion oftheir deposits in government securities as a part of their statutory liquidity ratio(SLR) requirements.
The government securities (also known as gilt-edged securities or gilts) are bonds issued by the Central government to meet its revenue requirements. Although the bonds are long-term in nature, they are liquid as they can be traded in the secondary market. Since 1991, as the economy has recovered and sector reforms increased, the CRR has fallen from 15 per cent in March 1991 to 5.5 per cent in December 2001. The SLR has fallen from 38.5 per cent to 25 per cent over the past decade.
Bank rate: 6 % CRR; 8 % Repo rate: 7.75% Reverse Repo rate; 6 %
THE AUSTRALIAN MONETARY SYSTEM
Australian monetary system requires no minimum reserves of its banks. This article, based on excerpts from the website of the Reserve Bank of Australia, describes the essential features.
The Monetary Policy Framework
The centerpiece of the policy framework is an inflation target, under which the Reserve Bank sets policy to achieve an inflation rate of 2-3 per cent on average, a rate sufficiently low that it does not materially affect economic decisions in the community.
The target provides discipline for monetary policy decision-making, and serves as an anchor for private sector inflation expectations. The target is agreed between the Bank and the Government.
The Implementation Of Monetary Policy :
Monetary policy is set in terms of an operating target for the cash rate, which is the interest rate on overnight loans made between institutions in the money market. When the Reserve Bank Board decides that a change in monetary policy should occur, it specifies a new target for the cash rate. A decision to ease policy will reflect in a new lower target cash rate, while a decision to tighten policy will reflect in a new higher target level for the cash rate.
A decision by the Reserve Bank Board to set a new target for the cash rate is announced in a media release, which states the new target for the cash rate, together with the reasons why the Board has taken the decision to change it. This media release is distributed through electronic news services on the day on which the change is to take effect, usually at 9.30 am, the time when the Bank normally announces its daily dealing intentions.
The Reserve Bank uses its domestic market operations, sometimes called open market operations, to influence the cash rate. On the days when monetary policy is being changed, market operations are aimed at moving the cash rate to the new target level.
Between changes in policy, the focus of market operations is on keeping the cash rate close to the target, by managing the supply of funds available to banks in the money market - these latter operations are usually referred to as liquidity management.
Monetary Policy And Debt Management :
Sound financial policy requires that the Government fully fund its budget deficit by issues of securities to the private sector at market interest rates, and not borrow from the central bank. Many countries have legislation to deliver this outcome, though in Australia it is effectively achieved by agreement between the Treasury and the Reserve Bank. This arrangement means that there is separation between monetary policy and the Government's debt management, with the Treasury directly responsible for the latter and the Reserve Bank responsible for the former.
It is not possible to ensure that the budget deficit is exactly matched day-by-day by issues of securities to the
market. For one thing, issues generally occur only weekly. To overcome this mismatch between daily spending and financing, the Treasury keeps cash balances with the Reserve Bank which act as a buffer. The Reserve Bank also provides an overdraft facility for the Government that is used to cover periods when an unexpectedly large deficit exhausts cash balances.
The Objective Of Monetary Policy:
In Australia, the objectives of monetary policy are formally established in the Reserve Bank Act. The three main broad objectives are to maintain:
o inflation at the targeted 2% to 3%o full employment at the NAIRU (the non-
accelerated inflation rate of unemployment) between 5% and 7%
o economic growth between 3% and 4% to sustain the living standards and welfare of the people of Australia.
To achieve these objectives and determine whether there is a need to change “monetary stance” (the loosening or tightening of monetary policy) the Reserve Bank Board meets once a month to review a check list of economic indicators. This check list may include:
o levels of consumption expenditureo indicators of future spending, for example, trends
in housing loanso surveys of consumer and business confidenceo trends in employment and unemploymento trends in business investment expenditureo external sector indicators such as the balance of
payments, CAD and fluctuations in the exchange rate.
The trends in the check list are then used to guide the Reserve Bank decisions on monetary stance.
Monetary policy refers to the actions taken by the Reserve Bank of Australia (RBA) to affect monetary and financial conditions in the money market (also known as the cash market) to help achieve economic objectives of low inflation and sustainable growth.
The Reserve Bank is the Government’s monetary authority and is responsible for formulating and administrating monetary policy. To achieve non-inflationary growth the Reserve Bank sets a targeted “cash rate” . For example, the easing in monetary stance during 2001 stimulated aggregate demand and increased economic growth.
However, cash rate increases such as the three 0.25% increases that occurred in May, August and November of 2006, were intended to keep economic growth on target and reduce inflationary pressures.
When GDP growth in the economy fell, and unemployment rose because of the international recession the Reserve Bank reduced interest rates in four separate occasions. The following graph shows this course of interest rates.
(The pink line shows the interest rate. By 2009 the official interest rate in Australia had declined to 3%. This low interest rate was designed to increase growth and investment by lowering he price and cost of borrowing money.)
MONETARY POLICY OF CHINAThe People's Bank of China was formerly the sole
governor of both monetary policies and "commercial" banking but has, as a result of the reforms of the post-1978 period, come to serve as the primary monetary policy making institution in China. It is the Chinese central bank (the equivalent of the U.S. Federal Reserve Banking System or the German Bundesbank). Premier Zhu's concerns about a financial sector crisis were grounded in recognition that China was quietly moving into the grips of a credit squeeze, wherein it was becoming increasingly difficult for firms to find financing for new investment and to pay for replacement of depreciating plant and equipment (old investment), and in some cases to finance operations. This credit squeeze was happening partly as a result of banks having been granted greater autonomy in making loans. These banks, components of an elaborate governmental bureaucracy, had for years acted as state functionaries implementing a political plan for the economy.
In this regard, bank officials approved politically-motivated loans to state-owned enterprises (SOE) that were
also components in the bureaucracy and many of these past loans are in default.
In other words, the bureaucratic machinery had become clogged when the lending process continued to function normally, providing a steady stream of money capital to the SOEs, but the claims (in the form of interest and principal payments) of the banks on SOE surplus value were not met: the flow was going in only one direction. Thus, when given the opportunity, even obligation, to unclog the machinery, the banks decided to sharply cut back on lending and the roll-over of existing debt, creating the first stages of a credit squeeze. This seemed, from the bankers standpoint, to be the most rational response to a situation wherein their loan portfolios were pock-marked with bad loans. Indeed, books and articles in China have made a big deal of the fact that the banks had so many bad loans. It even seemed to be a civic duty for the bankers to get their house in order by tightening the standards for granting new loans or rolling over old ones.
But, of course, the tightening of credit can lead to firms that are viable becoming unviable. It can lead to a wholesale deterioration in the health of the "real sector" of enterprises that produce needed goods. The People's Bank of China decided to head off this credit crunch by cutting the reserve requirement from between 16 and 20 percent (depending upon the size of the bank's asset base and other factors) to a single rate of 8 percent. The money multiplier (MM = 1/RRR, where MM is the money multiplier and RRR is the required reserve ratio) tells us that a cut of this magnitude would double the lending capacity of the banking system.
The hope is that banks will continue to provide loans to "healthy" firms and avoid a financial sector crisis. We will discuss whether or not this is likely to succeed, but a key point that you should consider in
this regard is not only whether or not banks will actually continue lending to the best available borrowers, but whether "healthy" firms would actually want to borrow under current conditions.
If export growth is slowing, foreign direct investment is falling, and firms are starting to show strains in generating enough revenues to pay interest (and maturing principal) on loans, then we can conclude that the demand side of the Chinese economy is weakening.
If the economy is weakening then firms are not as likely to be out aggressively hiring recent graduates or more workers. Some of the former graduate students I worked with in China have confirmed that the employment situation in China is not quite as good as it was in 1996 and 1997. There is some concern that the employment situation could get worse if the government doesn't counteract the aforementioned negative effects on aggregate demand for products and services.
The Zhu administration is not willing to rely solely on monetary policy to keep the economy growing. He has also moved to stimulate spending directly. The Zhu administration has proposed a record budget with about 122 billion dollars in spending for the coming fiscal year. This spending is designed to dramatically boost aggregate demand for goods and services (via the responding multiplier effect) and provide firms with the needed market for their output. If firms can sell their output and generate revenues, then they will be in a better position to pay the interest (and maturing principal) on their loans. The financial sector crisis, hopefully, can be averted and unemployment also reduced.
These policies are designed to avoid the potential social unrest from an economic crisis. Premier Zhu and the rest of the Chinese leadership do not want to see anything like Indonesia's social problems within China's boundaries (or, even, the sort of unrest that is growing in Malaysia).
In order to finance the government fiscal stimulus package, the Zhu administration has decided to take the Keynesian approach of increased deficit spending. Zhu Rongji's administration wants to partly finance the government budget by a record 44 billion dollars in government debt (double the debt issue of only three years ago). This debt would constitute about 36 percent of the total 122 billion dollars of expenditures in this year's budget with the remainder covered by government revenues from taxes and fees. Final approval of administration budgets comes from the national People's Congress, which has shown no inclination for going against the top leadership's proposals.
In a further effort to avoid financial problems, the Zhu administration has also decided to finance a special fund to recapitalize commercial banks (buy bad loans from the commercial banks and, therefore, add more to the capital base of the banks) by issuing almost 33 billion dollars in special 30-year bonds. This is in addition to the aforementioned 44 billion dollars in debt, bringing the total debt issuance to 77 billion dollars. The fact that the government is willing to borrow such a large amount is indicative of the concerns about an economic slow-down. The Chinese leadership has traditionally been much more conservative about their borrowing.
The bond-balance-to-GDP ratio in China has grown from 2.45 percent in 1991 to 4.2 percent last year. It is expected that this ratio will rise to 5.95 percent this year. This ratio is still a relatively modest bond-balance-to-GDP ratio and nothing like what one would find in Thailand or Indonesia or South Korea. However, the trend is somewhat troubling. At the moment, the rate of growth of the Chinese economy continues to exceed this bond-balance-to-GDP ratio,
indicating that the Chinese economy can generate enough revenues to continue paying for the debt.
In addition, the ratio of bond-balance-to-household-savings is expected to be about 9 percent this year, not a particularly large number either (especially given the relatively few options for Chinese household savers). This means the Chinese government should be able to find a ready market for these bonds. And China's overall debt load is miniscule compared to that of a country like Italy, which has a debt-to-GDP ratio of about 120%. These factors indicate that the Chinese government still has some flexibility in using debt to finance public expenditures and infrastructure investments. However, this also indicates that the current leadership is willing to "mortgage" future revenues to pay for current spending. In other words, the current leadership is so concerned about the impact of an economic slowdown that they are willing to borrow much more heavily than has been traditional among the post-1949 governments and let someone else figure out how to pay the interest and principal. Does this sound familiar?
China has avoided the worse of the Asia-wide economic crisis. Growth has slowed but is still both positive and greater in magnitude than the growth rates of most countries. If the pragmatic modernists are correct in their assumption that continued "modernization" is a prerequisite for social progress (for reinforcing socialism and clearing the path for communism), then we can view their current policies as not only an attempt to avoid social unrest and keep the leftists at bay, but also as consistent with their overall philosophy of building "socialism with Chinese characteristics."
MONETARY POLICY OF SINGAPORE
The key objective of Singapore's monetary policy is to maintain price stability for sustained economic growth. Since 1981, monetary policy in Singapore has been centered on the exchange rate. This reflects the fact that in the small and open Singapore economy where imports and exports amount to more than twice GDP, the exchange rate is the most effective tool in controlling inflation.
The MAS manages the Singapore dollar (S$) exchange rate against a trade-weighted basket of currencies of Singapore's major trading partners and competitors. The composition of this basket is reviewed and revised periodically to take into account changes in Singapore's trade patterns. This trade-weighted exchange rate is
maintained broadly within an undisclosed target band, and is allowed to appreciate or depreciate depending on factors such as the level of world inflation and domestic price pressures. MAS may also intervene in the foreign exchange market to prevent excessive fluctuations in the S$ exchange rate.
Monetary policy is reviewed on a semi-annual basis to ensure that it is consistent with economic fundamentals and market conditions, thereby ensuring low inflation for sustained economic growth over the medium term. The MAS publishes a semi-annual Monetary Policy Statement (MPS) in April and October which explains its assessment of Singapore's economic and inflationary conditions and outlook, and sets out its monetary policy stance for the following six months.
Singapore's exchange rate-based monetary policy system and its experience since its adoption are reviewed in MAS' monograph on Singapore's Exchange Rate Policy .
In the context of Singapore's open capital account, the choice of the exchange rate as the focus of monetary policy would necessarily imply that domestic interest rates and money supply are endogenous. As such, MAS' money market operations are conducted mainly to ensure that sufficient liquidity is present in the banking system to meet banks' demand for reserve and settlement balances.
The key aspects of MAS' monetary policy operations, viz. foreign exchange and money market operations, and the various factors and considerations underlying them, are discussed in MAS' monograph on Monetary
Policy Operations in Singapore .
MONETARY POLICY OF JAPANMonetary policy pertains to the regulation, availability,
and cost of credit, while fiscal policy deals with government expenditures, taxes, and debt. Through management of these areas, the Ministry of Finance regulated the allocation of resources in the economy, affected the distribution of income and wealth among the citizenry, stabilized the level of economic activities, and promoted economic growth and welfare.
The Ministry of Finance played an important role in Japan's postwar economic growth. It advocated a "growth first" approach, with a high proportion of government spending going to capital accumulation, and minimum government spending overall, which kept both taxes and deficit spending down, making more money available for private investment. Most Japanese put money into savings accounts, mostly postal savings.
In the postwar period, the government's fiscal policy centers on the formulation of the national budget, which is the responsibility of the Ministry of Finance. The ministry's Budget Bureau prepares expenditure budgets for each fiscal year based on the requests from government ministries and affiliated agencies. The ministry's Tax Bureau is responsible for adjusting the tax schedules and estimating revenues. The ministry also issues government bonds, controls government borrowing, and administers the Fiscal Investment and Loan Program (FILP), which is sometimes referred to as the "second budget."
Three types of budgets are prepared for review by the National Diet each year. The general account budget
includes most of the basic expenditures for current government operations. Special account budgets, of which there are about forty, are designed for special government programs or
institutions where close accounting of revenues and expenditures is essential: for public
enterprises, state pension funds, and public works projects financed from special taxes. Finally, there are the budgets for the major affiliated agencies, including public service corporations, loan and finance institutions, and the special public banks. Government fixed investments in infrastructure and loans to public and private enterprises are about 15 % of GNP. Loans from the Fiscal Investment and Loan Program, which are outside the general budget and funded primarily from postal savings, represent more than 20 % of the general account budget, but their total effect on economic investment is not completely accounted for in the national income statistics. Government spending, representing about 15 % of GNP in 1991, was low compared with that in other developed economies. Taxes provided 84.7 % of revenues in 1993. Income taxes are graduated and progressive.
The principal structural feature of the tax system is the tremendous elasticity of the individual income tax. Because inheritance and property taxes are low, there is a slowly increasing concentration of wealth in the upper tax brackets. In 1989 the government introduced a major tax reform, including a 3 % consumer tax. This tax has been raised to 5 % by now.
After the breakdown of the economic bubble in the early 1990s the country's monetary policy has become a major reform issue. US economists have called for a reduction in Japan's public spending, especially on infrastructure projects, to reduce the budget deficit. To force a reduction of the loan program, partially financed through postal savings, then-Prime Minister Junichiro Koizumi aimed to push forward postal privatization. The postal deposits, by far the largest deposits of any bank in the world, would help strengthening the private banking sector instead.
The Budget Bureau of the Ministry of Finance is at the heart of the political process because it draws up the national budget each year. This responsibility makes it the ultimate focus of interest groups and of other ministries that compete for limited funds. The budgetary process generally begins soon after the start of a new fiscal year on April 1. Ministries and government agencies prepare budget requests in consultation with the Policy Research Council. In the fall of each year, Budget Bureau examiners reviews these requests in great detail, while top Ministry of Finance officials work out the general contours of the new budget and the distribution of tax revenues. During the winter, after the release of the ministry's draft
budget, campaigning by individual Diet members for their constituents and different ministries for revisions and supplementary allocations becomes intense. The coalition leaders and Ministry of Finance officials consult on a final draft budget, which is generally passed by the Diet in late winter..
THE UNITED STATES MONETARY SYSTEM
During the colonial period, coins from different European countries were used and circulated throughout the colonies. Spanish coins were the dominate currency and because of the scarcity of coins, much of the trade and commerce was accomplished by bartering and trade, and commodities such as rice, tobacco, animal skins, and rum, were actually used as money.
Paper notes and other currencies were issued by some of the colonies with varying rates of discount which made them little more than worthless and not acceptable for most
purchases or for payment of any kind.
During the American Revolution, the Continental Congress issued the first unified currency which was declared redeemable in gold and silver but after the war and independence, redemption became almost nil because of excessive printing of the notes over metal reserves and the notes lost almost all of their value.
Because of a sharp rise in population and a big increase in trade and commerce, the newly formed United States government started looking at ways to institute a strong, stable, central monetary policy.
It wasn't until 1792 that Congress was given the power to create and establish a national monetary system. At that time, Congress passed the Coinage Act and made the dollar the nation’s primary monetary unit.
The Coinage Act of 1792 was based on the use of gold and silver reserves but because of the scarcity of the precious metals at the time, adjustments in value occurred frequently.
Throughout U.S. history, especially after gold was discovered in California, revision of the coinage laws and the mint ratio of gold and silver coins increased or decreased as the economics of the times dictated.
In 1913, the Federal Reserve Act was passed authorizing the establishment of regional Federal Reserve Banks (Federal Reserve System) that issue money to member banks by drawing on their own deposits or by borrowing commercial paper if their deposit balances with the Federal Reserve are insufficient..
The United States monetary system is designed to have the flexibility to meet the needs of the general population and to stimulate the economy when stimulation is deemed necessary.
CONCLUSIONTo sum up, despite sound fundamentals and no
direct exposure to the sub-prime assets, India was affected by global financial crisis reflecting increasing globalization of the Indian economy. The policy response has been swift. While fiscal stimulus cushioned the deficiency in demand, monetary policy augmented both domestic and foreign exchange liquidity. The expansionary policy stance of the Reserve Bank was manifested in significant reduction in CRR as well as the policy rates.
The contraction of the Reserve Bank’s balance sheet resulting from the decline in its foreign assets necessitated active liquidity management aimed at expanding domestic assets, which was ensured through OMO including regular operations under the LAF, unwinding of MSS securities, introduction of new and scaling up of existing refinance facilities. In addition, sharp reductions in CRR besides making available primary liquidity raised the money multiplier and ensured steady increase in money supply.
The liquidity injection efforts of the Reserve Bank could be achieved without compromising either on the eligible counterparties or on the asset quality in the Reserve Bank’s balance sheet. Moreover, the Reserve Bank’s balance sheet did not show any unusual increase, unlike that of several other central banks.
At present, the focus around the world and also in India has shifted from managing the crisis to managing the recovery. The key challenge relates to the exit strategy that needs to be designed, considering that the recovery is as yet fragile but there is an up tick in inflation, though largely from the supply side, which could engender inflationary expectations. Thus, the Reserve Bank has initiated the first phase of exit in its October 2009 Review of monetary policy in a calibrated manner mainly by withdrawal of unconventional measures taken during the crisis.