Monetary Policy

Objectives of monetary policy

1. Maximum feasible output 2. High rate of economic growth 3. Fuller employment

4. Price stability
5. Greater equality in the distribution of income and wealth 6. Healthy balance of payments

Monetary policy
MP is a programme of action taken by the monetary authorities generally the central bank, to control and regulate the supply of money with the public and flow of credit with a view to achieve predetermined macroeconomic goals.

Limitations of monetary policy

Time lag Problems in forecasting : Some units of an economy are beyond the scope of monetary policy (unorganized markets, parallel economy) Underdeveloped money and capital market

The Reserve Bank

The Reserve Bank serves as the nations central bank.

It is designed to oversee the banking system. It regulates the quantity of money in the economy. It was created in 1935 to restore confidence in the nations banking system.

Three Primary Functions of the RBI

Regulates banks to ensure they follow central laws intended to promote safe and sound banking practices. Acts as a bankers bank, making loans to banks and as a lender of last resort.

Conducts monetary policy by controlling the money supply.

Instruments of monetary policy

Quantitative credit control:-

1. Open market operations

2. Bank Rate Policy 3. Reserve Requirement changes Selective / Qualitative Credit Control:1. Direct Action 2. Changes in margin requirements 3. Regulation of consumer credit

4. Moral suasion

Open-Market Operations
Open-Market Operations
The money supply is the quantity of money

available in the economy.

The primary way in which the RBI changes the

money supply is through open-market operations.

The RBI purchases and sells government

securities.

Open-Market Operations
Open-Market Operations
To increase the money supply, the RBI buys

government bonds from the public.

To decrease the money supply, the RBI sells

government bonds to the public.

Banks and The Money Supply

Reserves are deposits that banks have received but have not loaned out. In a fractional reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. When a bank makes a loan from its reserves, the money supply increases The reserve ratio is the fraction of deposits that banks hold as reserves.

Money Creation

The money supply is affected by the amount deposited in banks and the amount that banks loan.

Deposits into a bank are recorded as both assets and liabilities. The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio.

Loans become an asset to the bank.

Money Creation
This T-Account shows a bank that accepts deposits, keeps a portion as reserves, and lends out the rest. It assumes a reserve ratio of 10%.

First National Bank

Assets Liabilities

Reserves Deposits Rs 100.00 Rs 1000.00 Loans Rs 900.00 Total Assets Rs 1000.00 Total Liabilities Rs 1000.00

Money Creation with Fractional-Reserve Banking

When one bank loans money, that money is generally deposited into another bank. This creates more deposits and more reserves to be lent out. When a bank makes a loan from its reserves, the money supply increases. The money multiplier is the amount of money the banking system generates with each rupee of reserves.

Money Creation
First National Bank
Assets Liabilities

Second National Bank

Assets Liabilities
Deposits Rs900.00

Reserves Deposits Reserves Rs100.00 Rs1000.00 Rs90.00

Loans Rs900.00 Loans Rs810.00

Total Assets Total Liabilities Total Assets Total Liabilities Rs100.00 Rs1000.00 Rs900.00 Rs900.00

Money Supply = Rs1900.00!

The Money Multiplier

How much money is eventually created in this economy?
Original deposit First National lending Second National lending Third National lending Total money supply = Rs 1000.00 = Rs 900.00 [=0.9 x 1000.00] = Rs 810.00 [=0.9 x 900.00] = Rs 720.90 [=0.9 x 810.00] = Rs 10,000

The Money Multiplier

The money multiplier is the reciprocal of the reserve ratio:

M = 1/R
With The

a reserve requirement, R = 20% or 1/5, multiplier is 5.

Tools of Monetary Control

Reserve Requirements
The RBI also influences the money supply with

reserve requirements.
Reserve requirements are regulations on the

minimum amount of reserves that banks must hold against deposits.

Tools of Monetary Control

Changing the Reserve Requirement
The reserve requirement is the amount (%) of

a banks total reserves that may not be loaned out.

Increasing the reserve requirement decreases the

money supply.
Decreasing the reserve requirement increases the

money supply.

Tools of Monetary Control

Changing the Discount Rate
The discount rate is the interest rate the RBI

charges banks for loans.

Increasing the discount rate decreases the money

supply.
Decreasing the discount rate increases the money

supply.

Selective Control
Qualitative Tools / Selective credit control: 1. Moral suasion 2. Direct action

3 Fixation of maximum limit on advances to individual borrowers.