MONETARY POLICY

Monetary Policy Mechanism

Objectives of Monetary Policy
Tools of Monetary Policy
• Monetary policy refers to the use of
instruments within the control of the central
bank to influence the level of aggregate
demand for goods and services.
• Monetary policy is the process a government,
central bank, or monetary authority of a country
uses to control
– the supply of money
– availability of money
– cost of money or rate of interest
• 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 of these, to influence outcomes like
economic growth, inflation, exchange rates with
other currencies and unemployment.
• The beginning of monetary policy as such
comes from the late 19th century, where it was
used to maintain the gold standard.
 Measures of money Stock
• The Reserve Bank of India employs four
measures of money stock, namely, M1, M2, M3
and M4.
– M1 : Money Supply. The components of money
supply are currency with the public and deposits
(demand deposits with banks and other deposits with
RBI)
– M2 : Is M1+ Post Office Savings Bank Deposits
– M3 : Is M1 + Time deposits with the banks and also
referred as aggregate monetary resources
– M4 : Is M3 + the total post office deposits.
• Monetary policy is referred to as either
being an expansionary policy, or a
contractionary policy
– expansionary policy increases the total supply
of money in the economy by decreasing the
interest rates
– contractionary policy decreases the total
money supply by increasing the intetrest
rates.
 monetary policies are described as
follows:
• accommodative, if the interest rate set by
the central monetary authority is intended
to create economic growth
• neutral, if it is intended neither to create
growth nor combat inflation
• tight if intended to reduce inflation.
 Objectives of Monetary Policy
• Monetary policy is an arm of economic policy and in
that sense, the objectives of monetary policy are no
different from the overall objectives of economic
policy.
• The broad objectives of monetary policy in India
have been:
– to regulate monetary expansion so as to maintain a
reasonable degree of price stability; and
– to ensure adequate expansion in credit to assist
economic growth.
 Objectives of Monetary Policy
• Price Stability.
– Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation. Effort
successful if monetary policy able to maintain steady rate of inflation.

• Credit Availability.
– General availability of loans or credit.

• Stability of Exchange rate.

– Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected changes
that cause damage, making policy formulation difficult.
• Full Employment.
– The movement of workers between jobs is referred to as frictional unemployment. All
unemployment beyond frictional unemployment is classified as unintended unemployment.
Reduction in this area is the target of macroeconomic policy.
• High Rate of Economic Growth.
– Economic growth is enhanced by investment in technological advances in production.
Encouragement of savings supplies funds that can be drawn upon for investment.
• Distribution of Money.
 Instruments of Monetary Policy
• Open Market Operations
• Reserve Requirements
• Lending by Central Bank
• Repo Rates
 Open Market Operations
• Open market operations are the means of
implementing monetary policy by which a RBI controls its
national money supply by buying and selling government
securities, or other financial instruments.
• Open market operations are conducted simply by
electronically increasing or decreasing ('crediting' or
'debiting') the amount of money that a bank has in its
reserve account at the central bank.
• Newly created money is used by the central bank to buy
in the open market a financial asset, such as
government bonds, foreign currency, or gold.
 Reserve Requirements
• A reserve requirement is a percentage indicating
how much a bank needs to hold in reserves vis-
à-vis its outstanding deposits.
– Cash Reserve Ratio (CRR) is the rate at which banks
are required to maintain their reserves with the central
bank on fortnightly basis.
– Statutory Liquidity Ratio (SLR) is the rate at which
banks are required to maintain their reserves in
Government securities.
 CRR
• CRR was introduced in 1950 primarily as a measure to ensure safety and
liquidity of bank deposits.

• Important and effective tool for directly regulating the lending capacity of
banks and controlling the money supply in the economy.

• When the RBI feels that the money supply is increasing and causing an
upward pressure on inflation, the RBI has the option of increasing the CRR
thereby reducing the deposits available with banks to make loans and hence
reducing the money supply and inflation.

• The RBI has the authority to impose penal interest rates on the banks in
respect of their shortfalls in the prescribed CRR.

• The CRR is applicable to all scheduled banks including the scheduled

cooperative banks and the Regional Rural Banks (RRBs).

• RBI had recently effected hike in CRR to 5.5%

 SLR
• It is percentage of deposits the bank has
to maintain in form of gold, cash or other
approved securities.
• Statutory Liquidity Ratio (SLR) is the
binding requirement on banks to keep at
least certain portion (currently fixed at
25%) of their deposits in liquid assets,
mainly government bonds.
 Difference between CRR and SLR
• SLR restricts the bank’s leverage in pumping
more money into the economy. On the other
hand, CRR, is the portion of deposits that the
banks have to maintain with the Central Bank.
• The other difference is that to meet SLR, banks
can use cash, gold or approved securities
whereas with CRR it has to be only cash. CRR
is maintained in cash form with RBI, whereas
SLR is maintained in liquid form with banks
themselves.
 Government Bonds
• Bonds are debt instruments that are issued by
companies, municipalities and governments to raise
funds for financing their capital expenditure. By
purchasing a bond, an investor loans money for a fixed
period of time at a predetermined interest rate. While the
interest is paid to the bond holder at regular intervals, the
principal amount is repaid at a later date, known as the
maturity date. While both bonds and stocks are
securities, the principle difference between the two is
that bond holders are lenders, while stockholders are the
owners of the organization.
 Government Bonds
• These are fixed-income debt securities issued by the
government. Government bonds are further categorized
on the basis of the term (maturity duration).
– Government Bills: These are government bonds with a maturity
period of less than one year.
– Government Notes: These are government bonds with a
maturity period from one year to ten years.
– Government Bonds: These are government bonds with a
maturity period that exceeds ten years.
– Municipal Bonds: These are debt securities issued by state
governments and their agencies.
– Corporate Bonds: These are debt instruments issued by a
company and backed by its ability to generate profits or by the
current value of its physical assets.
 Bond Price Variations
• Interest rate: When interest rates in the market rise, newly issued
bonds become more lucrative (offer higher yields). This makes
existing bonds less competitive and exerts pressure on the price of
existing bonds. Thus interest rates and bond prices move in
opposite directions.

• Inflation: High inflation erodes the value of the return that is earned
when the bond matures. Thus inflation and bond prices also move in
opposite directions.

• Financial health of the issuer: The financial health of the company or

government that has issued the bond impacts bond prices. If the
issuer is financially healthy, investors have greater confidence in
receiving the interest payments and principal amount at maturity.
Investors typically stay in touch with the ratings issued by reputed
credit rating agencies, such as Moody’s and Standard & Poor’s.
 Lending by Central Bank (RBI)
• A central bank, reserve bank, or monetary
authority is a banking institution granted the
exclusive privilege to lend a government its
currency.
• Like a normal commercial bank, a central bank
charges interest on the loans made to
borrowers, primarily the government of
whichever country the bank exists for.
• It is a bank that can lend money to other banks
in times of need.
 REPO Rates
• Discount rate at which the central bank
repurchases government securities from
commercial banks, depending on the level of
money supply it decides to maintain in the
country’s monetary system.
• To expand the money supply, the central bank
decreases repo rates( so banks can swap their
holdings of government securities for cash), to
contract the money supply it increases the repo
rates.
 REPO Rates
• Whenever the banks have any shortage of funds they can
borrow it from RBI. Repo rate is the rate at which our
banks borrow rupees from RBI. A reduction in the repo
rate will help banks to get money at a cheaper rate. When
the repo rate increases borrowing from RBI becomes more
expensive.

• When RBI lends money to bankers against approved

securities for meeting their day to day requirements or to
fill short term gap.It takes approved securities as security
and lends money.These types of operations are generally
for overnight operations.