MONETARY POLICY

FY.BBA – 2017 -18 – PPT - 6

 What is Monetary Policy??

 It is the process by which the central bank or monetary

authority of a country regulates the money supply which in
turn influences interest rates and inflation in order to attain
a set of objectives like general trust in currency, consumption,
liquidity, etc. oriented towards economic growth and stability
of the economy.
 It also aims to meet the credit requirements of different
sectors of the economy thus promoting economic growth.
 Types of Monetary Policy??

 At times of recession loose monetary policy is adopted -

RBI increases the policy rate which tends to increase the
money supply and lower interest rates so as to stimulate
consumption and investments in the economy.
 At the time of inflation tight monetary policy – RBI
decreases the policy rate is adopted to reduce aggregate
spending by decreasing money supply and increasing
interest rates.
Relation between MP and inflation

 Loose MP – inflation increases and interest rates are less

 Tight MP - inflation decrease and interest rates are high

 Impact of rate cut on the economy

 The move will be positive for rate-sensitive sectors such as

banks, auto, capital goods, consumer durables as well as
realty and infrastructure stocks.
 Ease in liquidity conditions will help both PSU as well as
private sector banks to focus on lending, which is very
important to boost economic growth and kick start the capex
cycle of India Inc, which has remained stagnant because of
the higher cost of borrowing.
 Impact of rate cut on the economy

 A reduced rate will ultimately bring down the cost of

borrowing for banks in general, which would help them pass
on the benefit to end consumers, which will then boost
consumption.
 One of the major hurdles faced by the banks was falling
liquidity for transmission of rates. Now the transmission will
improve with ease in liquidity for banks.
Monetary Policy Tools

 Open Market Operations

 Bank rate

 Cash Reserve Ratio

 Statutory Liquidity Ratio

 Repo rate

 Reverse Repo rate

 Marginal Standing Facility

 Open Market Operations

 OMOs refers to buying or selling government securities in the

open market by a central bank in order to increase or
decrease the supply of money
 When the RBI feels there is excess liquidity in the market, it
resorts to sale of securities thereby sucking out the rupee
liquidity.
 Similarly, when the liquidity conditions are tight, the RBI will
buy securities from the market, thereby releasing liquidity into
the market.
Open Market Operations

When RBI buys securities from the market and infuses

liquidity, the consequences are:
 It tends to soften the short term interest rates

 It may tend to increase inflation

 Consequently… If the RBI were to sell bonds instead and

absorb liquidity, the effect would exactly be the
opposite!!
 Bank rate

 Rate at which Central Bank lends money to commercial

Banks.
 The bank rate signals the central bank's long-term outlook
on interest rates. If the bank rate moves up, long-term
interest rates also tend to move up and vice-versa.
 Any increase in Bank rate results in an increase in interest
rate charged by Commercial banks which in turn leads to
low level of investment and low inflation
 Cash Reserve Ratio

 CRR is a portion of the banks’ NDTL or deposits that need to

be kept in their specified current accounts maintained with
RBI. This money earns no interest. The current CRR level is
4%.
 An increase in CRR reduces the cash with commercial banks
which results in low supply of money in the market, higher
interest rate and low inflation.
 Statutory Liquidity Ratio

 Banks are required to invest a certain percentage of their

net time and demand deposits in assets specified by RBI,
including gold not more than one percent of current SLR and
approved government bonds and securities.
 RBI wants banks to hold a part of the money in near cash so
that they can meet any unexpected demand from depositors
at short notice by selling the bonds.
 In times of high growth, an increase in SLR requirement
reduces lendable resources of banks and pushes up interest
rates.
Impact on banks’ lendable resources
 Differences between CRR and SLR

 The important difference between CRR and SLR is that CRR

has to be maintained in cash while SLR can be maintained
either in cash, gold or in assets that RBI suggests. Banks
don’t earn any returns from the money parked in the form
of CRR. However, banks can earn returns from SLR.
 Banks keep CRR in current accounts maintained with RBI
while SLR investments are kept with banks themselves.
 Repo Rate (Repurchase Agreement)
 Repo rate, or repurchase rate, is the rate at which banks
borrow from RBI for short period against pledging securities
with an agreement to buy them back at a predetermined
rate.
 If the RBI wants to make it more expensive for the banks to
borrow money, it increases the repo rate; similarly, if it wants
to make it cheaper for banks to borrow money, it reduces the
repo rate.
 Different instruments can be considered as collateral security
for undertaking REPO transactions and they include
Government dated securities, Treasury Bills.
 Reverse Repo

 Reverse repo rate is the rate of interest at which RBI borrows

funds from banks in the short term. Like the repo, this is done
by RBI selling government bonds to banks with the
commitment to buy them back at a future date.
 RBI can reduce liquidity in the banking system by increasing
repo and reverse repo rate and hence pushing up interest
rates.
 Reverse Repo

 If the reverse repo rate is increased, it means the RBI will

borrow money from the bank and offer them a lucrative
rate of interest. As a result, banks would prefer to keep
their money with the RBI (which is absolutely risk free)
instead of lending it out (this option comes with a certain
amount of risk)
 Consequently, banks would have lesser funds to lend to their
customers. This helps stem the flow of excess money into the
economy
 Importance of Repo & Reverse Repo

 SLR surplus and CRR deficit bank can use the Repo deals as
a convenient way of adjusting SLR/CRR positions
simultaneously.
 SLR deficit and CRR surplus bank can use Reverse Repo for
SLR compliance.
 SLR compliant and CRR surplus bank can use reverse repo
to deposit their short-term excess funds with the RBI and
earn interest on it.
 What is Marginal Standing Facility?

 Marginal standing facility is a window for banks to borrow

from Reserve Bank of India in emergency situation when inter-
bank liquidity dries up completely.
 Banks borrow from the central bank by pledging government
securities at a rate higher than the repo rate. Under this
scheme, Banks can borrow up to 1% of their total deposits
and this can be within the current statutory liquidity ratio of
20.75%. In other words they can borrow even if they are SLR
compliant and not surplus required under repo.
 Objectives of monetary policy

Control of Inflation and Deflation :- Inflation and deflation both are not suitable
for the economy. If the price level is reasonable and there is an adjustment
between the price and cost, rate of out put can increase. Monetary policy is used
to coordinate the cost and price. So price stability is achieved through the
monetary policy.
Exchange Stability :- Monetary policy second objective is to achieve the stable
foreign exchange rate. If the rate of exchange is stable it shows that economic
condition of the country is stable.
Economic Development :- Monetary policy plays very effective role in promoting
economic growth by providing adequate credit to productive sectors.

Equal Distribution of Credit :- Monetary policy should also ensure that

distribution of credit should be equitable and purposeful. The credit priority
should be given to backward areas.
Role of RBI
during
Recession
RBI’s measures during III QUARTER
of 2008-09
 Questions

 Which interest rates of banks are influenced by Monetary

policy?
 Lending rates and Deposit rates

 Which are sources of funds for a bank?

 Public deposits ( CASA & FDs) and RBI

 What is the impact loose Monetary policy?

 Banks reduce deposit rates since they can borrow cheaply
from RBI. Moreover they reduce lending rates but every
bank reduces it based on their liquidity conditions.
 Questions

 Which tools are the policy compliances?

 CRR and SLR

 What is the purpose of rate cut or objective of loose

monetary policy?
 To encourage consumption and investments in the economy.
 Questions

 When RBI will find it difficult to cut rates?

 When inflationary pressures continue to exist due to food
prices, fuel prices, Seventh pay commission, etc.
 Monetary policy influences short term or long term interest
rates?
 It influences short term rates.

 Under what conditions RBI will go for rate cut?

 Over all inflation should be less
 Government should be committed to reduce fiscal deficit
 Causes of Inflation – Demand pull

Demand Side Factors

 Fiscal stimulus

 Black Money

 Seventh pay commission

 Availability of Bank credit at lower interest rates

 High level of consumer spending (Seventh Pay commission)

 Reduction in taxes – more disposable income

 Rising consumer confidence increase in the rate of growth

of property prices , stock prices
Causes of Inflation – Cost push

Supply Side Factors

 Depreciation in exchange rate
 Acceleration in wages
 Rise in food prices
 Import Prices of Essential Commodities
 Inadequate agricultural Production due to monsoon
 GST
Headline inflation

 Headline inflation is a measure of the total inflation within

an economy and is affected by certain components which
may experience sudden inflationary spikes such as food or
energy. As a result, headline inflation may not present an
accurate picture of the current state of the economy.
 WPI is the measure of headline inflation in India. It includes
food, fuel and manufacturing.
 Core inflation

 Core inflation has emerged as an alternative for measuring

inflation derived from Headline inflation. In this, volatile
items like food prices and fuel items are excluded.
 The third category – Manufacturing also includes food
products which tends to be volatile as well and moves in line
with prices of primary articles. So after excluding food
products from manufacturing sector, we get non-food
manufactured products inflation. This represents core
inflation for India
 Important terms related to Inflation

 Deflation: is the opposite of inflation - A sustained fall in

the general price level
 Disinflation: is process of bringing down prices moderately
from their high level to low level by the central bank
through tight monetary policy.
 Monetary Policy
1 Monetary policy involves
changing the interest rate and
influencing the money supply for
the purpose of stabilizing the
economy by influencing the level
of aggregate demand.
Fiscal Policy
Fiscal policy involves the government
changing tax rates and levels of government
spending to influence aggregate demand in
the economy.

2 Monetary policy is usually Fiscal Policy is carried out by the government.

carried out by the Central Bank.
3 Tools of Monetary policy are Tool is Union Budget comprising public
CRR, Bank rate, Repo, Reverse expenditure, Public revenue and Public
repo, SLR & OMOs. borrowing.
4 Tight & Loose Monetary Policy: Expansionary & Contractionary Fiscal Policy:
Tight indicating hike in interest Expansionary indicating higher spending by
rates by the Central Bank. the government in the economy.
5 Major objective is to achieve Major objective is to generate high
price stability. employment
6 Monetary policy is quicker to A decision to increase government spending
implement. Interest rates can be may take time to decide where to spend the
set every month. money.
 Inflation Targeting

 Inflation targeting is a monetary policy in which a central

bank has an explicit target inflation rate for the medium term
and announces this inflation target to the public.
 Inflation targeting means Central Banks are responsible for
using monetary policy to keep inflation close to the agreed
level.
 Inflation targets were introduced to help reduce inflation
expectations and help avoid high inflation which can destabilize
an economy. If there was no inflation target, people could have
higher inflation expectations, encouraging workers to demand
higher wages and firms to put up prices. An inflation target
makes it easier to keep inflation low.
 Inflation Targeting

 India adopted an inflation target of 4% for next five years

under the monetary policy framework in line with the Centre's
focus on macroeconomic stability to boost growth while keeping
prices in check.
 The finance ministry has notified the consumer inflation target
for RBI until March 31, 2021, with an upper tolerance level of
6% and lower limit of 2% .
 When the Reserve Bank of India fails to meet the inflation
target, it will send a report to the central government stating
reasons and remedial actions that will be taken. A breach of
the "tolerance level" for three consecutive quarters will
constitute a failure of monetary policy.
 How is monetary policy decided in India??

 The Monetary Policy Committee (MPC) is a committee of the

Central Bank in India (RBI), headed by its Governor, which is
entrusted with the task of fixing the benchmark policy rate (repo
rate) to contain inflation within the specified target level.
 The MPC replaces the current system where the RBI governor,
with the aid and advice of his internal team and a technical
advisory committee, has complete control over monetary policy
decisions.
 A Committee-based approach will add lot of value and
transparency to monetary policy decisions.
 Contd..

 MPC will be responsible for containing inflation targets at 4%

(with a standard deviation of 2%) in the medium term
 The MPC takes decisions based on majority vote (by those who
are present and voting). In case of a tie, the RBI governor will
have the second or casting vote. The decision of the Committee
would be binding on the RBI.
 MPC has six members, - the RBI Governor (Chairperson), the RBI
Deputy Governor in charge of monetary policy, one official
nominated by the RBI Board and the remaining three members
would represent the Government of India.
Thank You