MONETARY POLICY

Dr.V.Raman Nair
Director
SCMS – COCHIN
 Introduction

What is Monetary Policy?

Types of Policies
Objectives
Monetary Measures
 What is Monetary Policy

The term Monetary policy refers to actions

taken by a government, central bank, or monetary
authority of a country to affect monetary
magnitudes or other financial conditions.
It is the process used to control (i) the supply of
money, (ii) availability of money, and (iii) cost of
money or rate of interest to attain a set of objectives
oriented towards the growth and stability of the
economy.
 What is Monetary Policy

Aims to attain a set of objectives oriented towards

the growth and stability of the economy.
Operates on monetary magnitudes or variables
such as money supply, interest rates and
availability of credit.
Ultimately operates through its influence on
expenditure flows in the economy.
MP affects liquidity and by affecting liquidity, and
thus credit, it affects total demand in the economy.
 Types of Policies

 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.
 Expansionary policy is traditionally used to combat
unemployment in a recession by lowering interest rates
 Contractionary policy decreases the total money supply.
 Contractionary policy involves raisinginterest rates to
combat inflation.
 Monetary policy is contrasted with fiscal policy, which refers
to government borrowing, spending and taxation.
 Types of Policies

Monetary Policy: Target Market Variable: Long Term Objective:

Interest rate on overnight

Inflation Targeting A given rate of change in the CPI
debt
Price Level Interest rate on overnight
A specific CPI number
Targeting debt
Monetary
The growth in money supply A given rate of change in the CPI
Aggregates

The spot price of the

Fixed Exchange Rate The spot price of the currency
currency
Low inflation as measured by the gold
Gold Standard The spot price of gold
price

Mixed Policy Usually interest rates Usually unemployment + CPI change

 Policy of various nations
 Australia - Inflation targeting
 Brazil - Inflation targeting
 Canada - Inflation targeting
 Chile - Inflation targeting
 China - Monetary targeting and targets a currency basket
 Eurozone - Inflation targeting
 Hong Kong - Currency board (fixed to US dollar)
 India - Multiple indicator approach
 New Zealand - Inflation targeting
 Norway - Inflation targeting
 Singapore - Exchange rate targeting
 South Africa - Inflation targeting
 Switzerland - Inflation targeting
 Turkey - Inflation targeting
 United Kingdom - Inflation targeting, alongside secondary targets on 'output and
employment'.
 United States - Mixed policy (and since the 1980s it is well described by the “Taylor
rule,” which maintains that the Fed funds rate responds to shocks in inflation and
output)
 Objectives

MP is a part of general economic policy of the govt.Thus

MP contributes to the achievement of the goals of
economic policy.
 Inflation Control
 Credit Growth
 Full Employment
 Price Stability
 Economic Growth
 Stable exchange rate
 Healthy BoP
 Greater equality in distribution of income & wealth
 Financial stability
 Backgrounder: Monetary Policy Framework in India

Prior to mid-1980s: Direct Instruments of Monetary

Control (based on credit budgeting)

Mid-1980s to 1998 : Monetary targeting Framework

suggested by Sukhmoy Chakaravarty Report (based on
money demand stability & money multiplier
predictability)

1998 Onwards – Multiple Indicator Approach

 Major Institutional Changes After 1991

 Interest rates freed

 Exchange rate: from managed to free float
 Full current account convertibility & substantial liberalization
of capital account
 Direct & portfolio investment encouraged
 Premium on stock market issues freed
 Automatic monetization of budget deficits stopped
 Yields on gilts made market determined
 Private and foreign banks encouraged
 How Did the RBI Respond?

 Reserve Requirements (CRR) cut from 15.0% in 1989-1993

to 4.5% in June 2003
 Directed investments in gilts (SLR) brought down from
38.5% in 1990-92 to statutory minimum of 25.0% by Oct.
1997
 In April 1997, refinance rate (bank rate) activated and then
brought it down from 11% (12.0% in Oct 1991) to 6.0% in
April 2003
 In June 1988 new monetary aggregates suggested
 In Dec.1997 fixed reverse rate repo introduced that helped
establish an informal corridor for short-term interest rates;
in June 2000 LAF established
 RBI announced that from 1998-99 it would follow a
multiple indicator approach
 How Was Monetary Transmission Impacted?

 Money demand became less stable and money multiplier less

predictable than before
 Disequilibrium in money markets started affecting short-term
interest rates
 Relatively, rate channels gained importance over quantum
channels
 Evidence of increased integration amongst financial markets
 Term structure is still segmented. FX-market efficiency holds
only at short-end.
Current Operating Framework & Operating Procedures

 Mix of targeting bank reserves and short-term interest rates

 Bank reserves are targeted through reserve requirements as well

as open market operations

 Open market operations are primarily used to keep short-term

interest rates in an informal corridor set by reverse repo & repo
rates

 The central bank conducts fixed rate repo operations under LAF
on daily basis
 Measures

Least Inflation Policy

Interest Rates
CRR and SLR
Monetary Base
Reserve Requirements
 Monetary Magnitudes

 The Reserve Bank of India defines the monetary aggregates as:

 Reserve Money (M0): Currency in circulation + Bankers’ deposits
with the RBI + ‘Other’ deposits with the RBI = Net RBI credit to the
Government + RBI credit to the commercial sector + RBI’s claims on
banks + RBI’s net foreign assets + Government’s currency liabilities to
the public – RBI’s net non-monetary liabilities.
 M1: Currency with the public + Deposit money of the public (Demand
deposits with the banking system + ‘Other’ deposits with the RBI).
 M2: M1 + Savings deposits with Post office savings banks.
 M3: M1+ Time deposits with the banking system = Net bank credit to
the Government + Bank credit to the commercial sector + Net foreign
exchange assets of the banking sector + Government’s currency
liabilities to the public – Net non-monetary liabilities of the banking
sector (Other than Time Deposits).
 M4: M3 + All deposits with post office savings banks (excluding
National Savings Certificates).
Growth of M3 and Differential Contribution of Components
 Credit Policy

 Central Bank may directly affect the money supply to

control its growth.
 Or it might act indirectly to affect cost and availability of
credit in the economy.
 In modern times the bulk of money in developed economies
consists of bank deposits rather than currencies and coins.
 So central banks today guide monetary developments with
instruments that control over deposit creation and influence
general financial conditions.
 Credit policy is concerned with changes in the supply of
credit.
 Central Bank administers both the Credit and Monetary
policy
 Price Stability: The Dominant Objective

 There is convergence of views in developed and developing

economies, that price stability is the dominant objective of
monetary policy.
 Price stability does not mean complete year-to-year price
stability which is difficult to attain.
 Price stability refers to the long run average stability of prices.
 Price stability involves avoidance of both inflationary and
deflationary pressures.
 Price Stability: The Dominant Objective Contd..

 Price Stability contributes improvements in the standard of

living of people.
 It promotes saving in the economy while discouraging
unproductive investment.
 Stable prices enable exports to compete in international
markets and contribute to the strengthening of BoP.
 Price stability leads to interest rate stability, and exchange
rate stability (via export import stability).
 It contributes to the overall financial stability of the
economy.
Instruments
Operation of Monetary Policy
1. Discount Rate
(Bank Rate)

2.Reserve Ratios Operating

Target
3. Open Market
Operations
• Monetary Base
• Bank Credit Intermediate
• Interest Rates Target
•Monetary
Aggregates(M3)
Ultimate
•Long term Goals
interest rates
•Total Spending
• Price Stability
Etc.
 Instruments of Monetary Policy

Variations in Reserve Ratios

Discount Rate (Bank Rate)
(also called rediscount rate)
Open Market Operations (OMOs)
Other Instruments
 Cash Reserve Ratio

 In terms of Section 42 (1) of the Reserve Bank of India Act,

1934 the Reserve Bank having regard to the needs of
securing the monetary stability in the country, prescribes
the CRR for Scheduled Commercial Banks (SCBs) without
any floor or ceiling rate.
 At present, effective from the fortnight beginning February
13, 2010 the CRR is prescribed at 5.50 per cent of a bank's
total of demand and time liabilities adjusted for the
exemptions.
 At present no incremental CRR is required to be maintained
by Banks.
 Since reserves are high-powered money or base money, by
varying CRR, RBI can reduce or add to the bank’s required
reserves and thus affect bank’s ability to lend.
 Cash Reserve Ratio

 Demand Liabilities include all liabilities which are payable

on demand that include current deposits, demand liabilities
portion of savings bank deposits, margins held against letters
of credit/guarantees, balances in overdue fixed deposits, cash
certificates and cumulative/recurring deposits, outstanding
Telegraphic Transfers (TTs), Mail Transfer (MTs), Demand
Drafts (DDs), unclaimed deposits, credit balances in the Cash
Credit account and deposits held as security for advances
which are payable on demand. Money at Call and Short Notice
from outside the Banking System should be shown against
liability to others.
 Cash Reserve Ratio

Time Liabilities are those which are payable

otherwise than on demand that include fixed
deposits, cash certificates, cumulative and recurring
deposits, time liabilities portion of savings bank
deposits, staff security deposits, margin held against
letters of credit, if not payable on demand, deposits
held as securities for advances which are not payable
on demand and Gold deposits.
 Cash Reserve Ratio

 Other Demand and Time Liabilities (ODTL) include

interest accrued on deposits, bills payable, unpaid dividends,
suspense account balances representing amounts due to other
banks or public, net credit balances in branch adjustment
account, any amounts due to the "Banking System" which are
not in the nature of deposits or borrowing. Such liabilities may
arise due to items, like (i) collection of bills on behalf of other
banks, (ii) interest due to other banks and so on.
 Participation Certificates issued to other banks, the balances
outstanding in the blocked account pertaining to segregated
outstanding credit entries for more than 5 years in inter-
branch adjustment account, the margin money on bills
purchased / discounted and gold borrowed by banks from
abroad, also should be included in ODTL.
 Cash Reserve Ratio
 Liabilities not to be included for DTL/NDTL computation

 (a) Paid up capital, reserves, any credit balance in the Profit & Loss Account of the bank, amount of any loan
taken from the RBI and the amount of refinance taken from Exim Bank, NHB, NABARD, SIDBI.
 (b) Net income tax provision.
 (c) Amount received from DICGC towards claims and held by banks pending adjustments thereof.
 (d) Amount received from ECGC by invoking the guarantee.
 (e) Amount received from insurance company on ad-hoc settlement of claims pending judgment of the Court.
 (f) Amount received from the Court Receiver.
 (g) The liabilities arising on account of utilization of limits under Bankers Acceptance Facility (BAF).
 (h) District Rural Development Agency (DRDA) subsidy of Rs.10,000/- kept in Subsidy Reserve Fund
account in the name of Self Help Groups.
 (i) Subsidy released by NABARD under Investment Subsidy Scheme for Construction/Renovation/Expansion
of Rural Godowns.
 (j) Net unrealized gain/loss arising from derivatives transaction under trading portfolio.
 (k) Income flows received in advance such as annual fees and other charges which are not refundable.
 (l) Bill rediscounted by a bank with eligible financial institutions as approved by RBI.
 (m) Provision not being a specific liability arising from contracting additional liability and created from profit
and loss account.
 (n) Scheduled Commercial Banks are not required to include inter-bank term deposits/term borrowing
liabilities of original maturities of 15 days and above and up to one year in "Liabilities to the Banking System"
(item 1 of Form "A"). Similarly banks should exclude their inter-bank assets of term deposits and term
lending of original maturity of 15 days and above and up to one year in "Assets with the Banking System"
(item III of Form A) for the purpose of maintenance of CRR. The interests accrued on these deposits are also
exempted from reserve requirements.
 Cash Reserve Ratio

 Exempted Categories

 i. Liabilities to the banking system in India as computed

under Clause (d) of the Explanation to Section 42(1) of the
RBI Act, 1934.

 ii. Credit balances in ACU (US$) Accounts.

 iii. Transactions in Collateralized Borrowing and Lending

Obligation (CBLO) with Clearing Corporation of India Ltd.
(CCIL).

 iv. Demand and Time Liabilities in respect of their

Offshore Banking Units (OBUs).
 Cash Reserve Ratio

 Procedure for Computation of CRR

 In order to improve the cash management by banks, as a measure of
simplification, a lag of one fortnight in the maintenance of stipulated CRR
by banks has been introduced with effect from the fortnight beginning
November 06, 1999.
 Maintenance of CRR on Daily Basis
 With a view to providing flexibility to banks in choosing an optimum
strategy of holding reserves depending upon their intra fortnight cash
flows, all Scheduled Commercial Banks are required to maintain
minimum CRR balances up to 70 per cent of the average daily required
reserves for a reporting fortnight on all days of the fortnight with effect
from the fortnight beginning December 28, 2002.
 No Interest Payment on Eligible Cash Balances maintained by
SCBs with RBI under CRR
 In view of the amendment carried out to RBI Act 1934, omitting sub-
section (1B) of section 42, the Reserve Bank of India does not pay any
interest on the CRR balances maintained by Scheduled Commercial Banks
with effect from the fortnight beginning March 31, 2007.
 Cash Reserve Ratio

Penalties
 From the fortnight beginning June 24, 2006, penal interest will be
charged as under in cases of default in maintenance of CRR by
Scheduled Commercial Banks:
 In cases of default in maintenance of CRR requirement on a daily
basis which is presently 70 per cent of the total CRR requirement,
penal interest will be recovered for that day at the rate of three per
cent per annum above the Bank Rate on the amount by which the
amount actually maintained falls short of the prescribed minimum
on that day and if the shortfall continues on the next succeeding
day/s, penal interest will be recovered at a rate of five per cent per
annum above the Bank Rate.
 Statutory Liquidity Ratio

 Consequent upon amendment to the Section 24 of the

Banking Regulation Act, 1949 through the Banking Regulation
(Amendment) Act, 2007 replacing the Regulation
(Amendment) Ordinance, 2007, effective January 23, 2007,
the Reserve Bank can prescribe the Statutory Liquidity Ratio
(SLR) for SCB in specified assets.
 The value of such assets of a SCB shall not be less than such
percentage not exceeding 40 per cent of its total demand and
time liabilities in India as on the last Friday of the second
preceding fortnight as the Reserve Bank may, by notification
in the Official Gazette, specify from time to time.
 Statutory Liquidity Ratio
 Reserve Bank has decided that all SCBs shall continue to maintain a uniform SLR of
25 per cent on their total net demand and time liabilities (NDTL), valued in
accordance with the method of valuation specified by the Reserve Bank of India from
time to time:
 a) in cash, or
 b) in gold valued at a price not exceeding the current market price, or
 c) in unencumbered investment in the following instruments which will be
referred to as “statutory liquidity ratio (SLR) securities":
 Dated securities issued up to September 8, 2009

 Treasury Bills of the Government of India;

 Dated securities of the Government of India issued from time to time under
the market borrowing programme and the Market Stabilisation Scheme;

 State Development Loans (SDLs) of the State Governments issued from

time to time under their market borrowing programme; and

 Any other instrument as may be notified by the Reserve Bank of India.

 Statutory Liquidity Ratio

Penalties: If a banking company fails to maintain

the required amount of SLR, it shall be liable to pay
to RBI in respect of that default, the penal interest
for that day at the rate of 3 per cent per annum above
the Bank Rate on the shortfall and if the default
continues on the next succeeding working day, the
penal interest may be increased to a rate of 5 per
cent per annum above the Bank Rate for the
concerned days of default on the shortfall.
 Repo And Reverse Repo

Repo rate is the rate at which banks borrow rupees from

RBI against approved securities for meeting their day to
day requirements or to fill short term gap.
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.
The rate charged by RBI for its Repo operations is 5.75%
and Reverse Repo rate is 4.50%.
These types of operations are generally for overnight
operations.
 Repurchase agreements

Definition: selling an asset with an explicit agreement to repurchase the asset after
a set period of time

Example: A bank has deficient reserves and needs to borrow overnight.

1. Bank A sells a treasury security to Bank B at P0
2. Bank A agrees to buy the treasury back at a higher price Pf > P0
3. Bank B earns a rate of return implied by the difference in prices

Pf – P 0 360
iRA = x
P0 days

4. Since the loan is backed by collateral, the rate is usually low

 Discount Rate (Bank Rate)

 Discount rate is the rate of interest charged by the central bank

for providing funds or loans to the banking system.
 Funds are provided through rediscounting of commercial bills.
 Raising Bank Rate raises cost of borrowing by commercial
banks, causing reduction in credit volume to the banks, and
decline in money supply.
 Variation in Bank Rate has an effect on the domestic interest
rate, especially the short term rates.
 Market regards the increase in Bank rate as the official signal
for beginning of a tight money situation.
 current bank rate at which RBI lends to Banks is 6%.
 Open Market Operations (OMOs)

OMOs involve buying (outright or temporary) and

selling of govt securities by the central bank, from or
to the public and banks.
RBI when purchases securities, pays the amount of
money by crediting the reserve deposit account of the
seller’s bank, which in turn credits the seller’s deposit
account in that bank.
 Annual Review Monetary Policy 2010-11

RBI has pursued an accommodative monetary policy beginning

mid-September 2008 in order to mitigate the adverse impact of
the global financial crisis on the Indian economy. Against this
backdrop, the stance of monetary policy of the Reserve Bank for
the 2010-11 will be as follows:
 Anchor inflation expectations, while being prepared to respond
appropriately, swiftly and effectively to further build-up of
inflationary pressures.
 • Actively manage liquidity to ensure that the growth in demand
for credit by both the private and public sectors is satisfied in a
non-disruptive way.
 • Maintain an interest rate regime consistent with price, output
and financial stability.
 First Quarter Review of
Monetary Policy 2010-11
 Monetary policy actions expected to:
 i) Moderate inflation by reining in demand pressures and
inflationary expectations.
 ii) Maintain financial conditions conducive to sustaining growth.

 iii) Generate liquidity conditions consistent with more effective

transmission of policy actions.
 iv) Restrict the volatility of short-term rates to a narrower
corridor.
Highlights
 The repo rate under the Liquidity Adjustment Facility (LAF) has
been raised to 5.75 per cent.
 The reverse repo rate under the LAF has been raised to 4.50 per
cent.
 Expected Outcomes

Reduction in excess liquidity will help anchor

inflationary expectations.
The recovery process will be supported without
compromising price stability.
The calibrated exit will align policy instruments with
the current and evolving state of the economy.
 Recent Challenges to Monetary Policy Design …(i)

 Large capital inflows, which sometimes become unpredictable and

volatile

 Lowering inflation expectations amidst oil price shock

 Handling Asset Price Considerations in Monetary Policy

 Large credit growth driven by consumption as well as investment

demand; possible unknown future financial stability risks in current
debt driven credit boom supported by retail credit
Recent Challenges to Monetary Policy Design …(ii)

 Issues of Autonomy, Accountability, Transparency & Decision-making

structures

 Seeking Greater Central Bank Independence while ensuring monetary-

fiscal coordination

 Continued large fiscal deficits, placing debt management burden on

monetary policy

 FRBM is correcting this… but would bring new challenges for conduct of
monetary operations
 Final Issue: The Issue of Trilemma

 What to emphasize less: free capital mobility, monetary policy

independence or exchange rate misalignments?
 Importance of managing capital account in macro-economic
framework of large & volatile capital flows in an emerging market
 Should we not intervene at all? Should we sterilize or not?
 Is the framework fine?
 Should the operating procedures be altered?
 Stimulus Package

 On the fiscal front, the stimulus by the government in the

second half of 2008-09 has clearly contributed significantly
to the recovery. It may be recalled that the crisis-driven
stimulus by way of reduction in excise levies, interest rate
subventions and additional capital expenditure came on top
of structural measures already built into the budget such as
the Sixth Pay Commission Award and farm debt waiver.
 Since October 2008, Government has launched Stimulus
packages worth $4bn (around Rs.20,000Cr) to combat the
economic slowdown following the collapse of Lehman
Brothers
 Stimulus Package Highlights

 Relaxation in foreign borrowing rules for firms in the real

estate sectors and infrastructure, and increase of foreign
investment limit to $15bn in corporate bonds from
January,2009.
 Decrease in main policy rates by RBI along with
recapitalising state run banks to the tune of $200bn. The
recapitalising process will take place in two years (January
2009 to January 2011) to ensure that banking system does
not suffer from Capital Adequacy constraints)
 An additional expenditure of Rs.20,000Cr in first quarter of
2009 towards rural infrastructure and social security
schemes.
 Stimulus Package Highlights

 An across the board cut of 4% on advalorem Cenvat rate

(excluding petroleum products) was implemented from
January’09 to March ’09.
 Authorised IIFCL (Indian Infrastructure Finance Company
Ltd) to raise Rs.10,000 Cr to refinance bank lending to
infrastructure projects in December, 2008.
 NBFCs, dealing with infrastructure financing were
permitted to access ECD from multilateral or bilateral
financial institutions, under the approval of RBI since
December,2008.
 Since December,2008, FII investment limit in Rupee
denominated Corporate bonds in India was increased from
US$6bn to US$15bn