monetary policy iimm
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Monetary Policy
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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
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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 creditwith a view to achieve predetermined
macroeconomic goals.
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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
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The Reserve Bank
• The Reserve Bank serves as the nation’s
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 restoreconfidence in the nation’s banking system.
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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 banker’s bank, making loans to
banks and as a lender of last resort.
• Conducts monetary policy by controllingthe money supply.
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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 Action2. Changes in margin requirements
3. Regulation of consumer credit
4. Moral suasion
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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 themoney supply is through open-market
operations.
• The RBI purchases and sells government
securities.
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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 asreserves 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.
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Money Creation
• The money supply is affected by the amountdeposited in banks and the amount that banks
loan.
Deposits into a bank are recorded as both assetsand 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.
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Money Creation
•This T-Account shows a
bank that…
accepts deposits,
keeps a portion asreserves,
and lends out the rest.
•It assumes a reserveratio of 10%.
Assets Liabilities
First National Bank
ReservesRs 100.00
Loans
Rs 900.00
DepositsRs 1000.00
Total Assets
Rs 1000.00
Total Liabilities
Rs 1000.00
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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.
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Assets Liabilities
First National Bank
Reserves
Rs100.00
Loans
Rs900.00
Deposits
Rs1000.00
Total Assets
Rs100.00
Total Liabilities
Rs1000.00
Assets Liabilities
Second National Bank
Reserves
Rs90.00
Loans
Rs810.00
Deposits
Rs900.00
Total Assets
Rs900.00
Total Liabilities
Rs900.00
Money Supp ly = Rs1900.00!
Money Creation
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The Money Multiplier How much money is eventually createdin this economy?
Original deposit = Rs 1000.00 First National lending = Rs 900.00 [=0.9 x 1000.00] Second National lending = Rs 810.00 [=0.9 x 900.00] Third National lending = Rs 720.90 [=0.9 x 810.00]
Total money supply
= Rs 10,000
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The Money Multiplier
The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
•With a reserve requirement, R = 20% or 1/5,
•The multiplier is 5.
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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.
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Tools of Monetary Control
• Changing the Reserve Requirement
• The reserve requirement is the amount (%) of
a bank’s total reserves that may not be loaned
out.• Increasing the reserve requirement decreases the
money supply.
• Decreasing the reserve requirement increases the
money supply.
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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 moneysupply.
• Decreasing the discount rate increases the money
supply.