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    ACKNOWLEDGEMENT

    We would like to express our heartfelt feelings and convey our immense thanks to

    all those who gave us there moral support and shared their insights with us while

    we were preparing this project.

    First and foremost, we are highly thankful and indebted to our faculty Prof

    Joydeep Ghosh, IILM Graduate School of Management who has always been there

    to encourage and help us wheneverwe needed his help. We owe special thanks

    to himfor providing his unending support & co-operation.

    Last but not least, we will ever remain grateful and indebted to our parents, our

    teachers & our friends who have always been the source of unending inspiration,

    encouragement & guidance in pursuit of excellence & learning process

    throughout our life.

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    TABLE OF CONTENTS

    y An Overview

    y History of Monetary Policy

    y Introduction

    y Macroeconomics / Monetary Policy

    y Uses of Monetary Policy

    y The Monetary Policy Effect

    y Types of Monetary Policy

    y Tools of Monetary Policy

    y Macroeconomics & Monetary Development Second Quarter Review 2009-10

    y Monetary Transmission Mechanism

    y Recent Developments

    y Expansionary Monetary Policy

    y Contractionary Monetary Policy

    y Monetary Policy & Inflation

    y Conclusion

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    AN OVERVIEW

    Monetary policy rests on the relationship between the rates of interest in

    an economy that is the price at which money can be borrowed and the total

    supply of money. Monetary policy uses a variety of tools to control one or both ofthese to influence outcomes like economic growth, Inflation, Exchange rates with

    other currencies and unemployment. Where currency is under a monopoly of

    issuance or where there is a regulated system of issuing currency through banks

    which are tied to a central bank, the monetary authority has the ability to alter

    the money supply and thus influence the interest rate in order to achieve policy

    goals.

    A policy is referred to as contractionary if it reduces the size of the money

    supply or raises the interest rate. An expansionary policy increases the size of the

    money supply, or decreases the interest rate. Furthermore, monetary policies aredescribed as follows:-

    y Accommodative if the interest rate set by the central monetary

    authority is intended to create economic growth.

    y Neutral if it is intended neither to create growth nor combat

    inflation; or tight if intended to reduce inflation.

    There are several monetary policy tools available to achieve these ends:

    y Increasing interest rates by fiat

    y Reducing the monetary base

    y Increasing reserve requirements.

    All have the effect of contracting the money supply and if reversed, expand the

    money supply. Since 1970s, monetary policy has generally been formed

    separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system

    still ensured that most nations would form the two policies separately.

    The primary tool of monetary policy is open market operations. This entails

    managing the quantity of money in circulation through the buying and selling ofvarious credit instruments, foreign currencies or commodities. All of these

    purchases or sales result in more or less base currency entering or leaving market

    circulation. Usually, the short term goal of open market operations is to achieve a

    specific short term interest rate target. In other instances, monetary policy might

    instead entail the targeting of a specific exchange rate relative to some foreign

    currency or else relative to gold.

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    The other primary means of conducting monetary policy includes the

    following:-

    y Discount window lending (lender of last resort)

    y Fractional deposit lending (changes in the reserve requirement)

    y Moral suasion (cajoling certain market players to achieve specified

    outcomes)

    y Open mouth operations (talking monetary policy with the market).

    Monetary policy is the process by which the government, central bank or

    monetary authority of a country controls the supply of money, Availability of

    money, Cost of money or rate of interest. It is important for policymakers to make

    credible announcements and degrade interest rates as they are not important

    and irrelevant in regards to monetary policies. If private agents believe that

    policymakers are committed to lowering inflation, they will anticipate future

    prices to be lower than otherwise. If an employee expects prices to be high in the

    future, he or she will draw up a wage contract with a high wage to match these

    prices. Hence, the expectation of lower wages is reflected in wage-setting

    behavior between employees and employers (lower wages since prices are

    expected to be lower) and since wages are in fact lower there is no demand pull

    inflation because employees are receiving a smaller wage and there is no cost

    push inflation because employers are paying out less in wages.

    In order to achieve this low level of inflation, policymakers must have credible

    announcements; that is, private agents must believe that these announcements

    will reflect actual future policy. If an announcement about low-level inflation

    targets is made but not believed by private agents, wage-setting will anticipate

    high-level inflation and so wages will be higher and inflation will rise. A high wage

    will increase a consumer's demand (demand pull inflation) and a firm's costs (cost

    push inflation), so inflation rises. Hence, if a policymaker's announcements

    regarding monetary policy are not credible, policy will not have the desired effect.

    If policymakers believe that private agents anticipate low inflation, they have an

    incentive to adopt an expansionist monetary policy (where the marginal benefit

    of increasing economic output outweighs the marginal cost of inflation); however,

    assuming private agents have rational expectations, they know that policymakers

    have this incentive. Hence, private agents know that if they anticipate low

    inflation, an expansionist policy will be adopted that causes a rise in inflation.

    Consequently, (unless policymakers can make their announcement of low

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    inflation credible), private agents expect high inflation. This anticipation is fulfilled

    through adaptive expectation (wage-setting behaviour); so, there is higher

    inflation (without the benefit of increased output). Hence, unless credible

    announcements can be made, expansionary monetary policy will fail.

    Announcements can be made credible in various ways. One is to establish anindependent central bank with low inflation targets (but no output targets).

    Hence, private agents know that inflation will be low because it is set by an

    independent body. Central banks can be given incentives to meet their targets

    (for example, larger budgets, a wage bonus for the head of the bank) in order to

    increase their reputation and signal a strong commitment to a policy goal.

    Reputation is an important element in monetary policy implementation. But the

    idea of reputation should not be confused with commitment. While a central

    bank might have a favorable reputation due to good performance in conducting

    monetary policy, the same central bank might not have chosen any particularform of commitment (such as targeting a certain range for inflation). Reputation

    plays a crucial role in determining how much markets would believe the

    announcement of a particular commitment to a policy goal but both concepts

    should not be assimilated. Also, note that under rational expectations, it is not

    necessary for the policymaker to have established its reputation through past

    policy actions; as an example, the reputation of the head of the central bank

    might be derived entirely from his or her ideology, professional background,

    public statements, etc. In fact it has been argued (add citation to Kenneth Rogoff,

    1985. "The Optimal Commitment to an Intermediate Monetary Target" in'Quarterly Journal of Economics' #100, pp. 1169-1189) that in order to prevent

    some pathologies related to the time-inconsistency of monetary policy

    implementation (in particular excessive inflation), the head of a central bank

    should have a larger distaste for inflation than the rest of the economy on

    average. Hence the reputation of a particular central bank is not necessary tied to

    past performance, but rather to particular institutional arrangements that the

    markets can use to form inflation expectations.

    Despite the frequent discussion of credibility as it relates to monetary policy, the

    exact meaning of credibility is rarely defined. Such lack of clarity can serve to leadpolicy away from what is believed to be the most beneficial. For example,

    capability to serve the public interest is one definition of credibility often

    associated with central banks. The reliability with which a central bank keeps its

    promises is also a common definition. While everyone most likely agrees a central

    bank should not lie to the public, wide disagreement exists on how a central bank

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    can best serve the public interest. Therefore, lack of definition can lead people to

    believe they are supporting one particular policy of credibility when they are

    really supporting another.

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    HISTORY OF MONETARY POLICY

    For many centuries there were only two forms of monetary policy i.e.,

    Decisions about coinage and Decisions to print paper money to create credit.

    Interest rates now thought of as part of monetary authority were not generallycoordinated with the other forms of monetary policy during this time. With the

    creation of the Bank of England in 1694 which acquired the responsibility to print

    notes and back them with gold, the idea of monetary policy as independent of

    executive action began to be established. The goal of monetary policy was to

    maintain the value of the coinage, print notes which would trade at par to

    prevent coins from leaving circulation.

    The establishment of central banks by industrializing nations was associated

    then with the desire to maintain the nation's peg to the gold standard, and totrade in a narrow band with other gold-backed currencies. To accomplish this

    end, central banks as part of the gold standard began setting the interest rates

    that they charged, both their own borrowers, and other banks that required

    liquidity. The maintenance of a gold standard required almost monthly

    adjustments of interest rates.

    During the 1870-1920 periods the industrialized nations set up central

    banking systems, with one of the last being the Federal Reserve in 1913. By this

    point the role of the central bank as the "lender of last resort" was understood. Itwas also increasingly understood that interest rates had an effect on the entire

    economy, in no small part because of the marginal revolution in economics, which

    focused on how many more, or how many fewer, people would make a decision

    based on a change in the economic trade-offs.

    Monetarist macroeconomists have sometimes advocated simply increasing

    the monetary supply at a low, constant rate, as the best way of maintaining low

    inflation and stable output growth. However, when U.S. Federal Reserve

    Chairman Paul Volcker tried this policy, starting in October 1979, it was found tobe impractical, because of the highly unstable relationship between monetary

    aggregates and other macroeconomic variables.

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    INTRODUCTION

    Monetary Policy can be broadly defined as "the deliberate effort by the Central

    Bank to influence economic activity by variations in the money supply, in

    availability of credit or in the interest rates consistent with specific nationalobjectives." The objectives that are achieved through monetary policy are: price

    stability, exchange stability, full employment and maximum output and high rate

    of growth. Monetary authorities use open market operations, bank rate policy,

    reserve requirement changes and selective credit control as instruments to

    achieve the objectives mentioned above. But, there are problems in

    implementing monetary policy. They are: lags in monetary policy, presence of

    financial intermediaries, contradiction in objectives and underdeveloped nature

    of money and capital markets. Monetary targeting refers to the practice of

    formulating monetary policy in terms of target growth of money stock.

    The basic objectives of the monetary policy of a developing country are to attain a

    maximum level of sustained economic growth, along with domestic price stability

    and realistic foreign exchange rates. In India, the monetary policy always aims at

    price stability and growth. Apart from these two important goals, the Reserve

    Bank of India has made conscious attempts in recent years to maintain efficiency

    in the foreign exchange market, and curb destabilizing speculative activities.

    Central Banks in open economies manage reserve flows, exchange rate andmonitor international financial developments. Fiscal policy and monetary policy

    are interrelated because fiscal policies of the government determine the

    directions of the monetary policy (whether the RBI follows a tight money and

    credit policy or not), and the fiscal policies have to be devised depending on the

    monetary control required. Similarly, they deal with regulatory mechanisms and

    with maneuvering the economy in periods of inflation and recession.

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    Macroeconomics/Monetary Policy

    Monetary policy concerns three main methods of Government intervention

    in an economy. These are changes in the money supply, the rate of interest and

    the exchange rate. They are grouped like this as they directly affect aggregatedemand (but also indirectly affect supply in a variety of ways).

    Money Supply

    This does exactly what it says on the tin! A government can increase the

    money supply by printing money or providing incentives for banks to increase the

    lending of money (not changing interest rates). These results in an increase in the

    amount of disposable income people will have to spend on goods and services.

    This shifts aggregate demand, as AD = C + I + G + (X - M), with consumer spending

    represented by 'C'.

    Consequences of changing the Money Supply:

    y Since increasing the money supply can affect AD, then ceteris paribus (cp.)

    inflation in prices will result at the same time as an increase in output, as

    can be shown on any demand and supply diagram. A central bank must

    decide whether the benefits of demand-side economic growth outweigh

    the costs of potential demand-pull inflation.

    y This resultant inflation could cause the currency to depreciate against

    others, as fewer goods and services can be bought for the same nominal

    amount of money. This means that the exchange rate is lower, increasing

    the price of imports and increasing the competitiveness of exports with

    their associated effects on the economy!

    Interest Rates

    This is the major method of monetary policy used today, although this was not

    always the case. The rate of interest is a return on savings set by the national

    bank, meaning that if an individual saves a sum of money in a bank, they will

    receive a rate of interest similar to that set by the central bank. Because of this, a

    change in the rate of interest will result several macroeconomic effects. A rise in

    interest rates will:

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    y Reduce consumption and investment, and consequently AD. This is due to

    the fact that individuals and firms will be more inclined to save wages and

    profits than invest or spend them, as the return on saving per year is

    greater

    y

    Raise the cost of borrowing from banks, as the rate of interest onrepayments is greater. This could further reduce spending and investment

    y Encourage foreign investment in domestic institutions and firms to

    increase, as a high rate of return on savings is attractive. High demand for

    the currency will raise its value (like any other product). This would lead to

    an increase in the price of exports and a fall in the price of imports,

    resulting in an increase in imports and fall in exports as they are less

    competitive globally. This would lead to a fall in AD ( X - M )

    The major purpose of a rise in interest rates is to 'cool down' an economy that isoverheating i.e. to reduce inflationary pressure due to high aggregate demand

    and no complementary increase in long run aggregate supply.

    The exact opposite applies to a fall in interest rates. A cut in interest rates is often

    used to aid economic recovery and boost consumer demand, make exports more

    competitive, and encourage capital investment by firms.

    USES OF MONETARY POLICY

    y Monetary policy cannot change long-term trend growth.

    y There is no long-term tradeoff between growth and inflation. (High

    inflation can only hurt growth).

    y What monetary policy at its best can deliver is low and stable inflation,

    and thereby reduces the volatility of the business cycle.

    y When inflationary pressures build up: raise the short-term interest rate (the

    policy rate) which raises real rates across the economy which squeezes

    consumption and investment.

    y The pain is not concentrated at a few points, as is the case with

    government interventions in commodity markets.

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    The Monetary Policy Effect

    In recent years, a good deal of research effort has been directed at the estimation

    of the responses of different kinds of spending to changes in monetary policy. The

    expenditures that are most likely to be affected by monetary policy are thosefinanced to a substantial extent by the use of credit.

    These include business investment in new plant and equipment; inventory

    investment; residential construction; consumer purchases of durable goods such

    as automobiles, electrical appliances, and furniture; and capital outlays by state

    and local governments.

    The paper by Michael J. Hamburger surveys a number of econometric studies that

    have been made of each of these categories of expenditures.

    These studies have uncovered considerable evidence that residential construction

    and business investment in plant and equipment are significantly affected by

    monetary policy. There are also indications of significant effects on consumer

    purchases of durable goods and on state and local government expenditures;

    although less research has been directed at the responses of these sectors. There

    is more uncertainty about the effects of monetary policy on inventory

    investment.

    We can make two generalizations regarding the effects of monetary policy. First,to the extent that it influences affect the various types of expenditures, the

    effects appear to work primarily through interest rates. Second, there are

    substantial time lags between changes in interest rates and the resulting changes

    in expenditures, although the lags seem to vary somewhat from one category of

    expenditures to another. This is so because it is takes some time to change ones

    expenditure from one level to another.

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    TYPES OF MONETARY POLICY

    In 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 TargetingInterest rate on

    overnight debtA specific CPI number

    Monetary AggregatesThe growth in money

    supply

    A given rate of change

    in the CPI

    Fixed Exchange RateThe spot price of the

    currency

    The spot price of the

    currency

    Gold Standard The spot price of gold

    Low 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 toexchange 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

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    exchange rate unless the management of the relevant foreign currencies is

    tracking the exact same variables (such as a harmonized consumer price index).

    INFLATION TARGETING

    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.

    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. Something similar to price level targeting was tried by Sweden in

    the 1930s, and seems to have contributed to the relatively good performance of

    the Swedish economy during the Great Depression.

    MONETARYAGGREGATES

    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.

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    GOLD STANDARD

    The gold standard is a system in which the price of the national currency as

    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.

    TOOLS OF MONETARY POLICY

    Monetary Base

    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 thecentral bank disburses/collects this hard currency payment, it alters the amount

    of currency in the economy, thus altering the monetary base.

    Reserve Requirements

    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 beheld 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.

    Interest rates

    The contraction of the monetary supply can be achieved indirectlyby increasing

    the nominal interest rates. Monetary authorities in different nations have

    differing levels of control of economy-wide interest rates. In the United States,

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    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 monetarybase and the interest rate because they are both modified by a single tool open

    market operations; one must choose which one to control.

    Currency board

    A currency board is a monetary arrangement which pegs the monetary base of a

    country to that of an 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 thanone 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.

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    Macroeconomic andMonetary Developments - Second Quarter

    Review 2009-10

    y

    The accommodative monetary policy stance adopted by the Reserve Bankin response to the global financial crisis, particularly post-September 2008,

    continued in 2009-10. The aim of this policy stance was to maintain ample

    rupee liquidity, comfortable dollar liquidity and ensure flow of credit to

    productive areas of the economy. Reflecting the accommodative policy

    stance, the liquidity conditions remained in surplus on a sustained basis,

    which was absorbed by the Reserve Bank through reverse repo operations

    under the LAF. Growth in broad money (M3) also remained high at 18.9 per

    cent (as on October 09, 2009), supported by high growth in deposits (by

    19.4 per cent). On the sources side, monetary expansion was driven by thelarge borrowing programme of the Government, while bank credit to the

    commercial sector continued to decelerate (with a growth of 10.7 per

    cent).

    y The accommodative monetary policy stance of the Reserve Bank has

    continued during 2009-10 so far to support the emerging recovery. While

    broad money growth witnessed some moderation in recent period,

    availability of surplus liquidity in the system was evident in the large daily

    absorption through reverse repo by the Reserve Bank.

    y Monetary and liquidity conditions during 2009-10 so far have been

    conditioned by the continuation of accommodative monetary policy stance

    of the Reserve Bank to support a faster economic recovery. Broad money

    growth (year-on-year) witnessed some moderation during the second

    quarter of 2009-10 but still remained above the Reserve Banks projected

    trajectory of 18.0 per cent for 2009-10. On the sources side of monetary

    expansion, banking systems credit to the Government continued to be the

    major driver as bank credit to the commercial sector continued to exhibit

    deceleration. On the component side of monetary expansion, the key driver

    was the high growth in aggregate deposits.

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    y The important measures which reflect the accommodative monetary policy

    stance include reduction of the repo and reverse repo rates, reduction of

    the CRR and the SLR, and institution of several sector-specific liquidity

    facilities. Since October 11, 2008, the Reserve Bank reduced CRR by a

    cumulative 400 basis points to 5.0 per cent of net demand and timeliabilities (NDTL), repo rate by 425 basis points to 4.75 per cent and the

    reverse repo rate by 275 basis points to 3.25 percent. The nature of

    injection of liquidity through unwinding of MSS and reduction of CRR

    ensured the attainment of the Reserve Banks objective of maintaining

    ample liquidity in the system without expanding the balance sheet of the

    Reserve Bank or compromising on the quality of the assets in the balance

    sheet.

    y

    O

    n a year-on-year (y-o-y) basis, M3 growth was 18.9 per cent as onO

    ctober9, 2009 as compared with 20.9 per cent a year ago. The growth in M3

    mainly reflected the sustained expansion in aggregate deposits during this

    period. Within aggregate deposits, time deposits registered a growth (y-o-

    y) of 20.9 per cent as on October 9, 2009 as compared with 21.6 per cent a

    year ago (Table 4.1 and Chart IV.1). Banks mobilised large time deposits

    during the third quarter of 2008-09, as investors reallocated their portfolios

    in favour of bank deposits with the intensification of financial crisis and

    increase in risk perception in the face of snowballing uncertainty. This

    period also witnessed a shift from demand deposits to time deposits.Demand depositsthat posted a sharp decline in the last two quarters of

    2008-09 and registered a growth of only 0.5 per cent at end-March 2009

    witnessed a turnaround. Demand deposits expanded by 10.3 per cent (y-o-

    y) as on October 9, 2009 as compared with 17.7 per cent a year ago. The

    net outflows from small savings schemes that started in December 2007

    continued up to July 2009 (the latest period for which the data are

    available) (Chart IV.2). Growth in currency with the public moderated to

    16.2 per cent (y-o-y) as on October 9, 2009 as compared with 20.1 per cent

    a year ago, mainly reflecting the impact of moderation in economic activityon currency demand.

    y On a financial year basis, growth in M3 during 2009-10 (up to October 9,

    2009) was 8.0 per cent as compared with 7.7 per cent during the

    corresponding period of the previous year.

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    y Analysts expect RBI to first raise Cash Reserve Ratio and then hike interest

    rates. In the mid-term review, RBI raised its forecast on March-end

    headline inflation rate to 6.5% with an upward bias from around 5% earlier,

    but kept the growth projection for 2009-10 unchanged at 6% with upward

    bias. India's headline inflation rate based on the Wholesale Price Index is

    currently at 1.21%.

    y The Reserve Bank of India, the country's central bank, took limited steps

    toward tightening monetary policy when it increased slightly the

    percentage of deposits Indian banks must invest in government bonds, and

    ended several measures meant to boost bank liquidity. Since last October,

    the bank has reduced its main lending rate to banks to 4.75% from 9% and

    reduced the amount of cash banks must keep with RBI to 5% of deposits

    from 9%. Combined, the RBI's moves have injected an estimated $120

    billion in liquidity into the economy.

    y In its mid-term review of the Annual Policy Statement, RBI kept all key

    interest rates unchanged, but raised the Statutory Liquidity Ratio to be kept

    by banks to 25% of their net demand and time liabilities from current 24%.The finance minister also said RBI Governor D. Subbarao had assured him

    that interest rates will be kept unchanged.

    .

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    The Monetary Transmission Mechanism

    The monetary transmission mechanism is the process by which changes in the

    monetary policy of the economy (taking place in the money market) affect

    aggregate demand for goods and services (in the goods market). This transmission

    mechanism has been explained in the diagram above.

    Change in Real Money supply M/P

    In moving from E3 to E2, increase in output raises the demand for money

    as greater demand has to be checked by to higher interest rates.

    Portfolio disequilibrium as there is excess supply of money.

    People are holding more money than they want.

    Output expands from OY1 to OY2

    Portfolio adjustments made to restore equilibrium. People

    reduce their money holdings by buying other assets (Bonds)

    Change in asset prices and interest rates. Bond prices rise

    and interest rates decline. Economy moves from E1 to E3.

    At lower interest rate, investment rises leading to increased

    aggregate demand. Economy moves from E3 to E2.

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    Initially the economy is operating at E1. Increase in real money supply generates

    portfolio disequilibrium. The increase in money supply creates an excess supply of

    money. At the prevailing interest rate oi1 and level of income OY1, people are

    holding more money than they want. This causes the portfolio holders to adjust

    their asset portfolio. The portfolio holders reduce their money holdings by buying

    other assets (such as bonds). As the money market adjusts rapidly, bond prices

    rise and interest rates fall and the economy moves from E1 to E3. The point E3 is

    on LM2 curve implying that the money market has cleared (is in equilibrium).However at E3 there has been a decline in interest rate leading to increased

    investment thereby leading to increased aggregate demand. As existing

    inventories run down, firms start expanding output and the economy moves from

    E3 to E2 on LM2. The interest rate also rises because increase in output raises the

    demand for money and this greater demand for money is checked by higher

    E1

    E2

    E3

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    interest rates. Equilibrium is finally restored at E2 where IS1 intersects LM2

    determining an equilibrium level of income OY2 and equilibrium interest rate oi2.

    RECENT DEVELOPMENTS

    These days we are experiencing a lot of arguments relating to changes in

    monetary policy. With signs of economic recovery as well as inflation rate

    acceleration, RBI is experiencing a deliberate state about finalizing its monetary

    policy. If it adopts a monetary tightening stance then the market will not take it

    positively however if it takes a soft stance then the inflation rate will go up.

    However according to recent developments The Reserve Bank of India is expected

    to keep interest rates unchanged on Tuesday, opting to support a nascent

    economic recovery instead of tackling rising prices.

    Higher prices caused by increasing food costs after a poor monsoon, along with

    the fragile economic recovery, has confronted the central bank with a dilemma

    about when to take the first steps to tighten monetary policy. Some economists

    believe there is a chance the bank might opt to drain some liquidity from the

    banking system as a first step to tame inflation by hiking the cash reserve ratio

    the percentage of funds banks must hold in reserve.

    The central bank had gradually reduced CRR from 9 per cent to 5 per cent easing

    liquidity to minimize the impact of the global financial meltdown on the Indian

    economy. At present, the repo rate (the rate at which banks borrow from RBI) is

    at 4.75 per cent and reverse repo rate stands at 3.25 percent.

    On Tuesday, RBI ended its soft monetary policy aimed at easing the credit

    crisis last year and in doing so becoming the third central bank in the world to

    withdraw liquidity-boosting measures after Israel and Australia. It maintained the

    repo rate @ 4.75%, reverse repo rate @ 3.25%, Cash Reserve Ratio @ 5% but it

    surprised the market it is choice of instrument to announce the exit of an easy

    money policy. The Statutory Liquidity ratio has been raised from 24% to 25%.

    Now in its review it has made loans to commercial real estate more expensive,

    forced banks to invest more in govt. bonds and has asked lenders to set aside

    more funds for bank loans. An increase in lending rates is now imminent if

    consumer and asset price remain high. However RBI will wait for stronger data

    before taking more aggressive measures.

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    EXPANSIONARYMONETARYPOLICYExpansionary monetary policy is monetary policy that seeks to increase the size of

    the money supply. In most nations, monetary policy is controlled by either a

    central bank or a finance ministry. Neoclassical and Keynesian economicssignificantly differ on the effects and effectiveness of monetary policy on

    influencing the real economy; there is no clear consensus on how monetary policy

    affects real economic variables (aggregate output or income, employment). Both

    economic schools accept that monetary policy affects monetary variables (price

    levels, interest rates). Monetary policy relies on a number of tools: Monetary

    Base, Reserve requirements, Discount window lending and interest rates.

    Monetary policy tools

    y Monetary base: Expansionary policy can be implemented by increasing

    the size of the monetary base. This directly increases the total amount of

    money circulating in the economy. In the United States, the Federal

    Reserve can use open market operations to increase the monetary base.

    The Federal Reserve would buy bonds in exchange for hard currency. When

    the Federal Reserve disburses this hard currency payment, it adds that

    amount of currency to the money supply, thus increasing the monetary

    base.

    y Reserve requirements: The monetary authority exerts regulatory

    control over banks. Expansionary policy can be implemented by allowing

    banks to hold a lower proportion of their total assets in reserve. 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 requiring a lower proportion of total assets to be held as liquid cash the

    Federal Reserve increases the availability of loanable funds. This acts as an

    increase in the money supply.

    y Discount window lending: Many central banks or finance ministries

    have the authority to lend funds to financial institutions within their

    country. The funds expand the monetary base. By extending new loans the

    monetary authority can directly increase the size of the money supply. By

    advertising that the discount window will increase future lending, the

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    monetary authority can also indirectly increase the money supply by raising

    risk-taking by financial institutions.

    y Interest rates: The expansion of the monetary supply can be achieved

    indirectly by decreasing the nominal interest rates.

    Monetary policy and the real economy

    As noted above, the relationship between monetary policy and the real economy

    is uncertain (expansionary monetary policy should not be confused with

    economic expansion, which is an increase in economic output in the real

    economy). Any change to the real economy resulting from an expansionarymonetary policy is subject to time lags and effects from other economic variables;

    in addition, there are possible side effects of expansion, including inflation.

    CONTRACTIONARYMONETARYPOLICY

    Contractionary monetary policy is monetary policy that seeks to reduce the size of

    the money supply. They are fiscal policies, like lower spending and higher taxes

    that reduce economic growth. In most nations, monetary policy is controlled by

    either a central bank or a finance ministry. Neoclassical and Keynesian economicssignificantly differ on the effects and effectiveness of monetary policy on

    influencing the real economy; there is no clear consensus on how monetary policy

    affects real economic variables (aggregate output or income, employment). Both

    economic schools accept that monetary policy affects monetary variables (price

    levels, interest rates). Monetary policy relies on a number of tools: monetary

    base, reserve requirements, discount window lending and interest rates.

    Policy tools

    y Monetary base: Contractionary policy can be implemented by reducing

    the size of the monetary base. This directly reduces the total amount of

    money circulating in the economy. A central bank can use open market

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    operations to reduce the monetary base. The central bank would typically

    sell bonds in exchange for hard currency. When the central bank collects

    this hard currency payment, it removes that amount of currency from the

    economy, thus contracting the monetary base.

    y Reserve requirements: The monetary authority exerts regulatory control

    over banks. Contractionary policy can be implemented by requiring banks

    to hold a higher proportion of their total assets in reserve. 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 requiring a higher proportion of total assets to be held as liquid cash, a

    central bank or finance ministry reduces the availability of loanable funds.

    This acts as a reduction in the money supply.

    y 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 the central bank can directly reduce the size of the

    money supply. By advertising that the discount window will be reduced for

    future lending, the central bank can also indirectly reduce the money

    supply by reducing risk-taking by financial institutions.

    y Interest rates: The contraction of the monetary supply can be achieved

    indirectly by increasing the nominal interest rates.

    Monetary policy and Inflation

    Monetary policy can be used to control inflation. Inflation is defined as continuing

    increases in price levels. Since price level is a monetary variable, monetary policy

    can affect it. Contractionary monetary policy has the effect of reducing inflation

    by reducing upward pressure on price levels.

    Note that inflation can also be affected by fiscal policy. However, contractionary

    fiscal policy is often politically unpopular, because it involves spending cuts and

    tax increases. Thus, politicians favor the use of monetary policy to control

    inflation.

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    Conclusion

    Handled by the Central Bank, Monetary Policy of a country is the primary tool for

    efficient macroeconomic management. As per the advanced estimates of the

    Central Statistical Organisation (CSO), the performance of the Indian economy

    during 2007-08 has shown a robust growth of 8.7 per cent.

    Monetary policy is the process by which the government, central bank, or

    monetary authority of a country controls

    (i) The supply ofmoney,

    (ii) availability of money, and(iii) cost of money or rate ofinterest,

    in order to attain a set of objectives oriented towards the growth and stability of

    the economy.

    The Monetary Policy also aims at quickly responding to the ongoing adverse

    global developments on sustainable basis, as also to the domestic situation

    resulted by the apprehensions about the inflation, financial stability and growth

    momentum, with both conventional and non-conventional measures.

    Reserve Bank of India Governor D. Subbarao has released the review and update

    on the monetary policy for the current fiscal on 27 Oct. 2009.

    y Bank Rate =6% (No Change)

    y Repo Rate = 4.75% (No change)

    y Reverse Repo Rate = 3.25% (No change)

    y Cash Reserve Ratio : 5% (No Change )

    y Statutory Liquidity Ratio = 24% ( No change )