Monetary policy of India

Monetary policy is the process by which monetary authority of a country, generally a central bank controls the supply of money in the economy by exercising its control over interest rates in order to maintain price stability and achieve high economic growth.[1] In India, the central monetary authority is the Reserve Bank of India (RBI). is so designed as to maintain the price stability in the economy. Other objectives of the monetary policy of India, as stated by RBI, are: Price Stability Price Stability implies promoting economic development with considerable emphasis on price stability. The centre of focus is to facilitate the environment which is favourable to the architecture that enables the developmental projects to run swiftly while also maintaining reasonable price stability. Controlled Expansion Of Bank Credit One of the important functions of RBI is the controlled expansion of bank credit and money supply with special attention to seasonal requirement for credit without affecting the output. Promotion of Fixed Investment The aim here is to increase the productivity of investment by restraining non essential fixed investment. Restriction of Inventories Overfilling of stocks and products becoming outdated due to excess of stock often results is sickness of the unit. To avoid this problem the central monetary authority carries out this essential function of restricting the inventories. The main objective of this policy is to avoid over-stocking and idle money in the organization Promotion of Exports and Food Procurement Operations Monetary policy pays special attention in order to boost exports and facilitate the trade. It is an independent objective of monetary policy. Desired Distribution of Credit Monetary authority has control over the decisions regarding the allocation of credit to priority sector and small borrowers. This policy decides over the specified percentage of credit that is to be allocated to priority sector and small borrowers. Equitable Distribution of Credit The policy of Reserve Bank aims equitable distribution to all sectors of the economy and all social and economic class of people To Promote Efficiency It is another essential aspect where the central banks pay a lot of attention. It tries to increase the efficiency in the financial system and tries to incorporate structural changes such as deregulating interest rates, ease operational constraints in the credit delivery system, to introduce new money market instruments etc. Reducing the Rigidity RBI tries to bring about the flexibilities in the operations which provide a considerable autonomy. It encourages more competitive environment and diversification. It maintains its control over financial system whenever and wherever necessary to maintain the discipline and prudence in operations of the financial system.

how does monetary policy affect inflation? Wages and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to push labor and capital markets beyond their long-run capacities. In fact, a monetary policy that persistently attempts to keep short-term real rates low will lead eventually to higher inflation and higher nominal interest rates, with no permanent increases in the growth of output or decreases in unemployment. As noted earlier, in the long run, output and employment cannot be set by monetary policy. In other words, while there is a trade-off between higher inflation and lower unemployment in the short run, the trade-off disappears in the long run. Policy also affects inflation directly through people's expectations about future inflation. For example, suppose the Fed eases monetary policy. If consumers and businesspeople figure that will mean higher inflation in the future, they'll ask for bigger increases in wages and prices. That in itself will raise inflation without big changes in employment and output.

The Tools of Monetary Policy

1. Open Market Operations 2. Discount Loans 3. Changes in Reserve Requirements

OpenMarketOperations
We have already distinguished between two types of open market operations: Open market purchases = Fed buys US government securities to increase the monetary base. Open market sales = Fed sells US government securities to decrease the monetary base. Thus, the Fed conducts open market operations by buying and selling US government securitiesespecially US Treasury bills. Since the market for US Treasury bills is so active, the Fed can make large purchases and sales quickly and easily, without disrupting the market. Although the FOMC makes decisions on how open market operations are to be conducted, the trades themselves are executed at the Open Market Desk at the Federal Reserve Bank of New York. Open market purchases and sales have permanent affects on the monetary base, but sometimes the Fed will want to change the monetary base only temporarily. At these times, it engages in two other types of transactions: Repurchase Agreement (repo) = The Fed purchases US government securities will an agreement that the seller will buy them back (repurchase them) at a specified price on a specified date, usually within two weeks. A repo is therefore like a temporary open market purchase, temporarily increasing the monetary base. Matched Sale-Purchase Transaction (reverse repo) = The Fed sells US government

securities with an agreement that the buyer will sell them back at a specified price on a specified date, again usually within two weeks. A reverse repo is therefore like a temporary open market sale, temporarily decreasing the monetary base. Hence, in conducting monetary policy, open market operations have a number of advantages: They are under the direct and complete control of the Fed. They can be large or small. They can be easily reversed. They can be implemented quickly. 2

2 Discount Loans
When a bank receives a discount loan from the Fed, it is said to have received a loan at the discount window. The Fed can affect the volume of discount loans by setting the discount rate: A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discount loans. A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discount loans. Discount lending is most important during financial panics: When depositors lose confidence in the financial system, they will rush to withdraw their money. This large deposit outflow puts the banking system in great need of reserves. The Fed stands ready to supply these reserves by making discount loans. In such situations, the Fed acts as a lender of last resort. Hence, in October 1987 and again in September 2001, the Fed made it clear that it would supply additional reserves to the financial system, as necessary, through the discount window. Advantage of discount loans: They allow the Fed to act as a lender of last resort during a financial panic. Disadvantages of using discount loans as a tool for monetary policy during normal times: The volume of discount loans can be influenced by the Fed, but not completely controlled: The Fed cannot be sure how many banks will request discount loans at any given interest rate. Changes in the discount rate must be proposed by the Federal Reserve Banks before being approved by the Board of Governors. Hence, they are neither quickly made nor easily reversed.

Changes in Reserve Requirements

By affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money supply. Disadvantages to using changes in reserve requirements as a tool for monetary policy: Large changes in reserves must be approved by Congress. Hence, large changes cannot be made quickly and easily. Also, if a bank holds only a small amount of excess reserves and the required reserve

ratio is increased, the bank will have to quickly acquire reserves by borrowing, selling securities, or reducing its loans. Each of these three options is costly and disruptive. Hence, changes in reserve requirements can cause problems for banks by making liquidity management more difficult.

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 inf luence 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. Short-term interest rates, such as those on Treasury bills and commercial paper, are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Federal Reserve surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Federal Reserve was going to be holding the federal funds rate lower than had been anticipated. Similarly, short-term inter.

The Effects of Monetary Policy on the Economy

Central banks are the national authorities responsible for providing currency and implementing monetary policy. Monetary policy is a set of actions through which the monetary authority determines the conditions under which it supplies the money that circulates in the economy. Monetary policy therefore has an effect on short-term interest rates. Setting monetary policy goals has been a defining issue for economists and public opinion since the consolidation of central banks as the entities responsible for providing the economies with domestic currency and for implementing monetary policy. Parallel with academic progress and experience in this matter, the understanding of monetary policy has advanced significantly over the last few decades. Currently, it is clear that in both academic circles and among the worlds monetary authorities, monetary policys best contribution to sustained growth is to foster price stability. For that reason, in recent years, the central banks of many countries, including Mexico, have reoriented their

monetary policy objectives, setting price stability as their main goal. This goal has been formalized, in most cases, by establishing low-level inflation targets. The central bank does not control prices directly because these are determined by the supply and demand of many goods and services. Nevertheless, through monetary policy the central bank can influence the price-determination process and thus attain its inflation target. The latter suggests the extreme need for the monetary authority to identify the effects that its actions have on the general economy and, particularly, on the price-determination process. The study of the channels by which these effects take place is known as the monetary policy transmission mechanism. Flow Chart 1 details this mechanism in general terms.

Transmission mechanism of monetary policy

This is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level. The chart below provides a schematic illustration of the main transmission channels of monetary policy decisions.

Change in official interest rates

The central bank provides funds to the banking system and charges interest. Given its monopoly power over the issuing of money, the central bank can fully determine this interest rate.
Affects banks and money-market interest rates

The change in the official interest rates affects directly money-market interest rates and, indirectly, lending and deposit rates, which are set by banks to their customers.
Affects expectations

Expectations of future official interest-rate changes affect medium and long-term interest rates. In particular, longer-term interest rates depend in part on market expectations about the future course of short-term rates. Monetary policy can also guide economic agents expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.

Affects asset prices

The impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as imported goods are directly used in consumption, but they may also work through other channels.
Affects saving and investment decisions

Changes in interest rates affect saving and investment decisions of households and firms. For example, everything else being equal, higher interest rates make it less attractive to take out loans for financing consumption or investment. In addition, consumption and investment are also affected by movements in asset prices via wealth effects and effects on the value of collateral. For example, as equity prices rise, shareowning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may reduce consumption. Asset prices can also have impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks.
Affects the supply of credit

For example, higher interest rates increase the risk of borrowers being unable to pay back their loans. Banks may cut back on the amount of funds they lend to households and firms. This may also reduce the consumption and investment by households and firms respectively.
Leads to changes in aggregate demand and prices

Changes in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply. When demand exceeds supply, upward price pressure is likely to occur. In addition, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets. This in turn can affect price and wagesetting in the respective market.
Affects the supply of bank loans

Changes in policy rates can affect banks marginal cost for obtaining external finance banks differently, depending on the level of a banks own resources, or bank capital. This channel is particularly relevant in bad times such as a financial crisis, when capital is scarcer and banks find it more difficult to raise capital. In addition to the traditional bank lending channel, which focuses on the quantity of loans supplied, a risk-taking channel may exist when banks incentive to bear risk related to the provision of loans is affected. The risk-taking channel is thought to operate mainly via two mechanisms. First, low interest rates boost asset and collateral values. This, in conjunction with

the belief that the increase in asset values is sustainable, leads both borrowers and banks to accept higher risks. Second, low interest rates make riskier assets more attractive, as agents search for higher yields. In the case of banks, these two effects usually translate into a softening of credit standards, which can lead to an excessive increase in loan supply.