monetary policy is one of the tools that a national government uses to influence its economy

8/7/2019 Monetary policy is one of the tools that a national Government uses to influence its economy

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rapidly and the currency becomes rapidly worthlesscompared to goods and services it can buy. Very highlevels of inflation or "hyperinflation" is the result. With30-40% monthly inflation rates, citizens buy hard goodsas soon as they receive payment in the currency andthose on fixed income have their investments renderedworthless.

At the other extreme, restrictive monetary policy has

shown its effectiveness with considerable force.Germany, which experienced hyperinflation during theWeimar Republic and never forgot, has maintained a very

stable monetary regime and resulting low levels of inflation. When Chairman Paul Volcker of the U.S. FederalReserve applied the monetary brakes during the highinflation 1980s, the result was an economic downturnand a large drop in inflation

Operations of a Modern Central Bank

The Central Bank attempts to achieve economic stabilityby varying the quantity of money in circulation, the costand availability of credit, and the composition of acountry's national debt. The Central Bank has threeinstruments available to it in order to implementmonetary policy:

1. Open market operations2. Reserve requirements3. The 'Discount Window'



Open market operations are just that, the buying orselling of Government bonds by the Central Bank in theopen market. If the Central Bank were to buy bonds, theeffect would be to expand the money supply and hencelower interest rates, the opposite is true if bonds are sold

Reserve requirements are a percentage of commercial

banks', and other depository institutions', demand

deposit liabilities (i.e. chequing accounts) that must be

kept on deposit at the Central Bank as a requirement of

Banking Regulations

Discount Window is where the commercial banks, and

other depository institutions, are able to borrow reserves

from the Central Bank at a discount rate

QUANTITATIVE MEASURES: Measures which aim to controlthe quantity of money supply directly such as Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and OpenMarket Operations (OMO)

Cash Reserve Ratio: It is a quantitative tool of monetary andcredit policy to regulate the money supply in the economy. Cash reserve ratio (CRR) is that slice of a bank's deposits, whichthe bank has to compulsorily deposit with RBI.

A CRR of six per cent means that out of every Rs 100, bank has to

deposit Rs. 6 with RBI. Interestingly, RBI does not pay

anyinterest on this money to banks. When RBI wants to reduce

liquidity from the system, like in times of high inflation, itincreasesthe CRR.RBI by varying the CRR regulates the lendable funds of commercial banks.

An increase in CRR would also mean that money is being sucked

out of the system. This would mean that funds are hard tocome by



and hence banks will have to pay more to depositors in order to

induce them to keep their funds with banks. This willpush up cost

of funds for banks. The banks therefore will also have to raise

lending rates in order to meet the increased costwhile maintaining their margins. For exampleRBI has increased the CRR of scheduled banks by 6% of their NetDemand and Time Liabilities (NDTL). As a result of thisincrease in the CRR, about 12,500 crore of excess liquidity will beabsorbed from the system.Statutory Liquidity Ratio: It is a quantitative tool of monetary and credit policy to regulate the money supply in the

economy. Under the provision of Banking Regulation Act

governing the banking operations, banks are required to hold

liquidassets such as government securities, or other

unencumbered approved securities, cash or gold, against their

demand and timeliabilities as on the last Friday of second

preceding fortnight in India. This is known as supplementary

reserve requirement orsecondary reserve requirement. The main

objective of this monetary policy instrument is to ensure solvency

of commercialbanks by compelling them to hold low risk assets up

to a stipulated extent. It also helps to regulate the pace of credit

expansionto commercial sector. SLR refers to the ratio of holdings

of the prescribed liquid assets to total time and demand liabilities.

Atpresent, SLR is 25%, means 25 out of 100 are invested in

prescribed liquid assets.The objectives of SLR are:

1.To restrict the expansion of bank credit.

2.To augment the investment of the banks in Government

securities.



3.To ensure solvency of banks. A reduction of SLR rates looks

eminent to support the credit growth in India.Open MarketOperations: A monetary policy instrumentwhich is used by the Reserve Bank mainly with a view to affect

the reserve base of the banks and thereby the extent of monetary

expansion. It also, in the process, helps to create and maintaina

desired pattern of yield on government securities (G-Sec) and to

assist the government in raising resources from the capitalmarket.

Under the RBI Act, the RBI is authorized to purchase and sell the

securities of the Union Government and StateGovernments of any

maturity and the security specified by the Central Government on

the recommendation of Bank's CentralBoard. Presently the RBI

deals only in the securities issued by the Union Government.

Open market operations are by wayoutright sale and purchase of

securities through the Securities Department and repo and

reverse repo transactions.When RBI buys the securities in the open market, It increases theliquidity and reserves of commercial banks, making it

possible for banks to expand their loans and investments. If RBIsells the securities, the effects are reversed.QUALITATIVE MEASURES: They aim to control the quantity of money supply indirectly through cost of credit. These measures are Bank Rate, Repo & Reverse Repo Rates, andInterest Rates etc.Bank Rate:An instrument of general credit control andrepresents the standard rate at which the RBI is prepared to buy

or rediscount bills of exchange or other commercial paper eligible forpurchase under the provisions of the Act. In short, Bank rateis the minimum rate at which the central bank provides loans tothe commercial banks. It is also called the discount rate.



Usually, an increase in bank rate results in commercial banksincreasing their lending rates. Changes in bank rate affect thelending rates through altering the cost of credit. At present Bank rate is 6%.

Repo Rate: Repo and Reverse Repo Rates are Liquidity adjustment Facility (LAF) tools used by RBI. Repo is aninstrument meant for injecting the funds required and Reverse Repo forabsorbing the excess liquidity out of system.In bond markets, interest rates are the most important factor, andthe RBI controls interest rates. RBI uses various rates likerepo, reverse repo and CRR to give direction to interest rates in

the country. Take an exampleRepo refers to 'repurchaseobligation'. In case of tight liquidity conditions (as you saw in 2008), when banks need funding forthe short term, they approach the RBI and ask for a temporary

loan. RBI gives them a loan only after taking some collateral

Monetary Management

Issuer of Currency

Banker and Debt Manager to Government

Banker to Bank

Financial Regulation and Supervision

Foreign Exchange Reserves Management

Foreign Exchange Management

Market Operation

Payment and Settlement System



Monetary policy in international scene

With special reference to u.s stagflation and latin

American hyperinflation

The term "stagflation" -- an economic condition of both continuing inflation and stagnant business activity, together with anincreasing unemployment rate ± in 1970s Inflation seemed to feed on itself. People began to expect continuous increases in theprice of goods, so they bought more. This increased demand pushed up prices, leading to demands for higher wages, whichpushed prices higher still in a continuing upward spiral. The government's ever-rising need for funds swelled the budget deficitand led to greater government borrowing, which in turn pushed upinterest rates and increased costs for businesses and consumerseven further. With energy costs and interest rates high, business investment languished and unemployment rose to uncomfortable

levels. n desperation, President Jimmy Carter (1977-1981) tried to combat economic weakness andunemployment by increasinggovernment spending, and he established voluntary wage and price guidelines to control inflation. Both were largelyunsuccessful. A perhaps more successful but less dramatic attack on inflation involved the "deregulation" of numerous industries,including airlines, trucking, and railroads. These industries had been tightly regulated, with government controlling routes andfaresBut the most important element in the war against inflation was the Federal Reserve Board, which clamped down hard on themoney supply beginning in 1979. By refusing tosupply all the money an inflation-ravaged economy wanted, the Fed

caused interest ratesto rise. Federal Reserve chairman Paul Volcker very sharply increased interest rates from1979-1983 in what was called a "disinflationary scenario." After U.S. prime interest rates had soared intothe double-digits, inflation did come down; these interest rates were the highest long-term prime interestrates that had ever existed in modern capital marketsStarting in approximately 1983, growth began arecovery. Both fiscal stimulus and money supply growth were policy at this time. A five-to-six-year jump inunemployment during the Volcker disinflation suggests Volcker may have trusted unemployment to self-correct and return to its natural rate within a reasonable period

Stagflation undermined faith in a Keynesian consensus, and placed renewed emphasison microeconomic behavior, particularly neoclassical economics with its attempt to root macroeconomicsin microeconomic formalisms. The rise of conservative theories of economics, includingmonetarism, canbe traced to the perceived failure of Keynesian policies to combat stagflation or explain it to thesatisfaction of economists and policy-maker

Latin American imbroglio:

THE ORIGINS OF THE DEBT CRISIS

The decades of the 1960s and 1970s saw real annual economic growth averaging 6.0 percent in Latin America.

Inflation ran between 30-45 percent per year. However, during the 1980s growth averaged barely 1 percent while

inflation soared toward 300 percent per year. In contrast, worldwide growth in the 1980s averaged 3 percent with 5

percent inflation. All the economies have huge income inequalities that have led to significant

political repercussions. Heavy public spending programs have meant sizeable government

budget deficits, which have approached 50 percent of GNP in some countries, induding

Argentina, Brazil and Mexico. as long as real interest rates on the debt remained below the

growth of real exports, the debt-export ratios were manageable and the borrowing could

continue. At the end of the 1970s both the period of strong export growth and low interest



rates came to an abrupt end. Funds could no longer be obtained to service debt without

sharply increasing debt-export ratios. As creditworthiness deteriorated, foreign borrowing all

but ceased. Increasingly, debt servicing had to come from domestic resources, which

contributed to an enormous capital flight. Net inflows of foreign capital during the 1970s

turned into net outflows during the 1980s.

stabilization plans initiated in the mid-1980s, such as Argentina's Austral Plan and

Brazil's Cruzado Plan, attempted to stabilize the currency and rein in inflation by

using a fixed exchange rate as a nominal anchor. As a fixed exchange rate (if

successfully maintained) ties down the level of import prices, policymakers hoped that

this approach would stabilize inflation and inflation expectations more generally. The

new monetary approach in contrast to the structuralist past, the inflation-targeting

approach recognizes the key role of the central bank's monetary policies in

determining the inflation rate. No longer can the monetary authorities claim that

inflation is not under their control. No monetary-policy regime, including inflation

targeting, will succeed in reducing inflation permanently in the face of unsustainable

fiscal policies--large and growing deficits. In light of their painful experiences, Latin

American citizens certainly understand that unchecked deficits will eventually exhaust

the government's capacity to borrow, leading to excess money creation and a breakout

of inflation. Fiscal policy does seem to have become more conservative in the region

in the past decade, although there have been setbacks and variations across countries

http://weeklygk.blogspot.com/All Rights Reserved | Unauthorized Reproduction is ProhibitedQUANTITATIVE MEASURES: Measures which aim to controlthe quantity of money supply directly such as Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and OpenMarket Operations (OMO)Cash Reserve Ratio: It is a quantitative tool of monetary andcredit policy to regulate the money supply in the economy.

Cash reserve ratio (CRR) is that slice of a bank's deposits, whichthe bank has to compulsorily deposit with RBI.

A CRR of six per cent means that out of every Rs 100, bank has to

deposit Rs. 6 with RBI. Interestingly, RBI does not pay

anyinterest on this money to banks. When RBI wants to reduce



Atpresent, SLR is 25%, means 25 out of 100 are invested in

prescribed liquid assets.The objectives of SLR are:

1.To restrict the expansion of bank credit.2.To augment the investment of the banks in Government

securities.

3.To ensure solvency of banks. A reduction of SLR rates looks

eminent to support the credit growth in India.Open MarketOperations: A monetary policy instrumentwhich is used by the Reserve Bank mainly with a view to affect

the reserve base of the banks and thereby the extent of monetary

expansion. It also, in the process, helps to create and maintaina

desired pattern of yield on government securities (G-Sec) and to

assist the government in raising resources from the capitalmarket.

Under the RBI Act, the RBI is authorized to purchase and sell the

securities of the Union Government and StateGovernments of any

maturity and the security specified by the Central Government on

the recommendation of Bank's CentralBoard. Presently the RBI

deals only in the securities issued by the Union Government.

Open market operations are by wayoutright sale and purchase of

securities through the Securities Department and repo and

reverse repo transactions.When RBI buys the securities in the open market, It increases theliquidity and reserves of commercial banks, making itpossible for banks to expand their loans and investments. If RBI

sells the securities, the effects are reversed.QUALITATIVE MEASURES: They aim to control the quantity of money supply indirectly through cost of credit. These measures are Bank Rate, Repo & Reverse Repo Rates, andInterest Rates etc.



Bank Rate:An instrument of general credit control andrepresents the standard rate at which the RBI is prepared to buy or rediscount bills of exchange or other commercial paper eligible for

purchase under the provisions of the Act. In short, Bank rateis the minimum rate at which the central bank provides loans tothe commercial banks. It is also called the discount rate.Usually, an increase in bank rate results in commercial banksincreasing their lending rates. Changes in bank rate affect thelending rates through altering the cost of credit. At present Bank rate is 6%.Repo Rate: Repo and Reverse Repo Rates are Liquidity

adjustment Facility (LAF) tools used by RBI. Repo is aninstrument meant for injecting the funds required and Reverse Repo forabsorbing the excess liquidity out of system.In bond markets, interest rates are the most important factor, andthe RBI controls interest rates. RBI uses various rates likerepo, reverse repo and CRR to give direction to interest rates inthe country. Take an exampleRepo refers to 'repurchaseobligation'. In case of tight liquidity

conditions (as you saw in 2008), when banks need funding forthe short term, they approach the RBI and ask for a temporary loan. RBI gives them a loan only after taking some collateral.

http://weeklygk.blogspot.com/All Rights Reserved | Unauthorized Reproduction is Prohibited

This collateral is Government Securities (G-Secs). So banks give

G-Secs to RBI and take money to meet theirtemporaryrequirements. The interest rate which RBI charges to

banks for such short-term loan is known as the repo rate. After

the short-term period is over, banks have the obligation to repay

the money back to RBI, along with the interest and '' its



G-Secs, hence the word repurchase obligation. In short, Banksborrow from RBI or RBI lends to banks at this rate.

It must be understood that when RBI does not want more money

to go into the economy, it will raise this rate. When repo

rateincreases, the cost of money for banks also increases. Banks in

turn increase the interest rates for their borrowers. This

preventsborrowers from taking loans from banks and thus RBI's

objective of controlling money supply is achieved.Reverse Repo Rate: Reverse repo is that rate which RBI paysto banks. When banks have surplus liquidity and there are not enough borrowings from banks by consumers (as is the

condition now), banks park their surplus money with RBI andearnsome minimum interest. The rate at which RBI pays interest isknown as reverse repo rate.When RBI wants the economy to grow, it will reduce reverse reporate. By this By doing so, it

ill give a signal to banks thatinstead of deploying surplus money

with RBI for a low return they should deploy the same in projectsin the economy, whichwill help to kick-start the economy.In times of ample liquidity, repo rate is practically redundant.Hence you will observe RBI focusing more on cutting reverserepo rates in times of slowdown, as was seen in the recent past.Liquidity Adjustment Facility (LAF): LAF is a monetary policy instrument introduced in 2000 to modulate liquidity

in the system in the short term and to send interest rate signals to

the market. LAF operates through repo and reverse

repotransactions. RBI conducts repo to inject liquidity into the

system through purchase of government securities with

anagreement to sell them at a predetermined date and repo rate.

In the reverse repo transaction RBI sells securities with a view to



absorb excess liquidity with a commitment to repurchase them at

a predetermined date and reverse repo rate.

Other instruments of liquidity management are Open Market

Operations (OMO) in the form of outright purchase/sale of securities and Market Stabilisation Scheme (MSS). Under the

OMO, the RBI buys or sells government bonds in the secondary

market. By absorbing bonds, it drives up bond yields and injects

money into the market. When it sells bonds, it does so to suck

money out of the system.

monetary policy is one of the tools that a national government uses to influence its economy

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