monetary policy (updated on 30th jan 2011)

8/6/2019 MONETARY POLICY (Updated on 30th Jan 2011)

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MONETARY POLICY

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. Objectives of monetary policy: 1. Price stability (Maintenance of domestic

price level) Fluctuations in prices affect investment decisions.It also leads to increasing income disparities.

However, monetary policy alone cannot ensure the maintenance ofdomestic prices, as several other factors such as ------------

erratic monsoons

Changes in tastes,

Fluctuations in world prices etc affect domestic prices.


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. 2. Credit availability

3. Stability of Exchange Rate (value) --Fluctuation in exchange rate of a currency affects foreign

trade and investment .It is, therefore, important that the rate of exchange ismaintained without violent fluctuations.

4. Full Employment


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. 5. High Rate of Economic Growth

6. Distribution of Money.

7. Reducing the impact of businesscycles(slumps and booms) by manipulation of credit andinterest policy.


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. Nature of monetary policy:

To ensure price stability in the economy.

Factors include to ensure stability in theeconomy:

1. Money supply, commonly referred to as M3.

2. Interest rates

3. Inflation.


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. RBI has been using different control

measures, popularly called Credit

Control measures. These control measures can be classified into

two categories --------

1. General (Quantitative) Controls.

2. Selective(Qualitative) Controls.


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General credit controls:

General Controls affect the total quantity of credit andthe economy generally.

General control include:

(Tools of Monetary Policy) (a) Bank Rate the rate at which banks rediscount bills with RBI.

(b) Repo Rate

(c ) Reverse Repo Rate

(d) Open Market Operations

(e) CRR (f) SLR

(g) Refinance policy


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. Bank Rate is the rate at which central bank of the

country (in India it is RBI) allows finance to commercialbanks.

Bank Rate is a tool, which central bank uses for short-termpurposes

Any revision in bank rate by the RBI is a signal to banks torevise deposit rates as well as PLR.

Now the Prime Lending Rate(PLR) is decided by commercialbanks with reference to bank rate and the deposit position of

each bank.


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Repo rate 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 fromRBI.

A reduction in the repo rate will help banks to getmoney at a cheaper rate.

When the repo rate increases borrowing from RBI becomes moreexpensive.

RBI occasionally resorts to the Repo route to fine-tune the liquidityposition, without resorting to major policy instruments such as changes

in CRR and Bank Rate. However, markets are bound to react to frequent changes in the Repo

rates and this will be reflected in corresponding changes in the depositand lending rates of commercial banks.


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. Money market Instruments Money market refers to the short term( 6-12 months)

borrowings and lendings

whereas capital market refers to longer-termlending/borrowing.

Chakravarthy Committee and Narasimham Committee hadrecommended reform of indian money market.

RBI has introduced new money market instruments suchas


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RBI has introduced new money marketinstruments such as

i. 182 days treasury bills which are sold through auctions. Theycarry attractive rates of interest and practically no risk and aretherefore popular with commercial banks.

ii. 364 days treasury bills were also introduced in 1992.

iii. Dated government securities with maturities up to 10 yearshave also been introduced primarily to develop a secondarymarket.

iv. Repurchase options(Repos)provide an opportunity for RBIto repurchase government securities from commercial banks.

v. Reverse repos are government securities sold throughauction at fixed cut-off rate of interest.

vi. *Liquidity Adjustment Facility(LAF) refers to RBIspolicy of using Repos and Reverse Repos to adjustliquidity on a day-to-day basis.


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. Indian Financial System : Financial system covers the whole gamut(length or range) of

demand for and supply of funds for productive purposes.

The financial system promotes economic development throughmobilising savings and channelising these to investmentavenues.

The indian financial system consists of both short-term andlong-term instruments. Money markets which deal with short-term instruments (discussed in the previous slide).

Capital market deals with long-term finances.


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. The main players in indian capital markets

are:

Banks, indigenous(home-grown) and commercial,

Insurance companies,Ex- LIC(formed in sep 1956), GIC (formed in Nov 1972).

Development Finance Institutions(DFI), Ex- ICICI, IDBI &SIDBI and

Non-Banking Finance Companies(NBFCs).


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. The IRDA ( IRDA Act,1999 ) is vested with

regulatory powers in respect of the insurancesector

SEBI (set up in 1988)in respect of the Capitalmarkets and

RBI for the banking sector.


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. repo or "repurchase agreement" Essentially, a repurchase agreement is an agreement between

one party and another in which the former sells a security (like

a bond) to the latter with a promise to buy it back after aparticular period.

Repurchase options(Repos)provide an opportunity for RBIto repurchase government securities from commercial banks.

Reverse repos are government securities sold throughauction at fixed cut-off rate of interest.

*Liquidity Adjustment Facility(LAF) refers to RBIspolicy of using Repos and Reverse Repos to adjustliquidity on a day-to-day basis.


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. Repo

A repurchase agreement or ready forward deal is a securedshort-term (usually 15 days) loan by one bank to anotheragainst government securities.Legally, the borrower sells the securities to the lending bankfor cash, with the stipulation that at the end of the borrowingterm, it will buy back the securities at a slightly higher price,the difference in price representing the interest.


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. For instance, a bank may enter into a repo with RBI,

selling a security to RBI and then tell RBI that I will buythis security back from you after 3-months.

RBI tells the bank...OK I will pay Rs. 100 for thissecurity now but when you buy it back from me, pleasepay me Rs. 103.


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. Generally, repos are used for managing domestic liquidity

in the economy.

While a bank rate has a direct impact on borrowing costsfor banks, repo rates have a more of a fine-tuning(minor

change or modification) impact. Contracts for the sale of future repurchase of financial assets

(most often Treasury Securities) is known as Repo.

Rate at which the commercial banks borrows from RBI is calledBank Rate.


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. Furthermore,

repos are short-term agreements and are entered into bybanks to meet short-term shortfalls in their liquiditypositions.

In the recessionary period (before last year) with the rate cutsits around 3.25% , the cost of funds could become cheaper andliquidity ample.


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Reverse Repo rate Reverse Repo rate is the rate at which Reserve Bank of

India (RBI) borrows money from banks.

Banks are always happy to lend money to RBI since theirmoney are in safe hands with a good interest.

An increase in Reverse repo rate can cause the banks totransfer more funds to RBI due to this attractive interestrates.


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. Reverse Repo rate is the rate at which banks park

their short-term excess liquidity with the RBI.

The RBI uses this tool when it feels there is toomuch money floating in the banking system.

An increase in the reverse repo rate means that theRBI will borrow money from the banks at a higherrate of interest.

As a result, banks would prefer to keep their moneywith the RBI


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.

Thus, we can conclude that Repo Rate signifies the rate atwhich liquidity is injected in the banking system by RBI,

whereas Reverse repo rate signifies the rate at which the

central bank absorbs liquidity from the banks.


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. Cash Reserve Ratio(CRR):

Every commercial bank is required to keep a certainpercentage of its demand and time liabilities (deposits)

with the RBI(either cash or book balance). The RBI varies this ratio as and when it perceives the

need to increase or decrease money supply.

RBI is empowered to fix the CRR at a rate rangingbetween 3% and 15%.


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. At present CRR is 6%(26th Jan 2011).

Like the Bank rate , CRR is also subject to frequentchanges as RBI intervenes from time to time to correctmonetary or exchange rate imbalances.

Lowering of the CRR means that more money comes intocirculation.


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. Statutory Liquidity Ratio(SLR): Commercial banks are also required to keep (in addition to

CRR) a certain percentage of their net demand and timeliabilities (NDTL) as liquid assets in the shape of cash, gold or

approved securities.

As most of the SLR money is kept in treasury bills, governmenthad, in the past, been using SLR as a means to mobilise lowcost resources.

This abuse of SLR leads to distortion in the interest rate andcredit supply.

In order to overcome this, Narasimham Committeerecommended that SLR should be brought down to 25%(earlierit is around 38%).


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. Open Market Operations(trading in securities) An important instrument of credit control, the Reserve Bank of

India purchases and sells securities in open market operations.

In times of inflation, RBI sells securities to mop up the excessmoney in the market.

Similarly, to increase the supply of money, RBI purchasessecurities.

Traditionally RBI was not resorting to this method. However,after the large inflow of foreign funds since 1991, RBI has hadto step in to sterilize the flow to avoid excess liquidity.


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Selective Credit Controls:Selective Credit Controls:

Selective Credit Controls:Selective Credit Controls:

When thereWhen there is a shortage of institutional credit available for

the business sector,

the large and financially strong sectors or industriestend to capture the lions share in the total institutional credit.

As, a result,As, a result, priority sectors and essential industries arestarved(hungry) of necessary funds,

while the bank credit goes to the non-priority sectors.


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. In order to curb this tendency, the central bank resorts to

credit rationing measures.

Generally two measures are adopted --------

1. imposition of upper limits on the credit available to large

industries and firms. 2. Charging a higher or progressive interest rate on the

bank loans beyond a certain limit.

This is done with a view to making banking credit availableto the essential and priority sectors.


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.

It can increase or decrease the supply of currency as well as -----------------------------------interest rate, carry out openmarket operations, control credit and vary the reserverequirements.

THE Monetary Policy is different from Fiscal Policy as the --------------------------------------------------------Monetary Policybrings about a change in the economy by changing moneysupply and interest rate.


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.

Def of Fiscal Policy:

It may be defined as the deliberate change in government

revenue and expenditure to influence the level ofnational output and prices.

FOR Instance , at the time of recession thegovernment can increase expenditures or cut taxes inorder to generate demand.


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.

ON the other hand, the government can reduce itsexpenditures or raise taxes during inflationary times.

Fiscal Policy aims at changing aggregate demand by suitablechanges in thegovernment spending and taxes.

THE annual Union Budget showcases the governmentsFiscal Policy.


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Role of Monetary policy

A reduction in interest rates would force banks to lowertheir lending rates and borrowing rates.

So if you want to place a deposit with a bank or take aloan, it would offer it at a lower rate of interest.

On the other hand, if there were to be an increase ininterest rates, banks would immediately increase theirlending and borrowing rates.


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.

Since the rates of interest affect the borrowingcosts of corporate and as a result, their bottomlines (profits), the monetary policy is very

important to them also.


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.

Since the financial sector reforms commenced-----------------------------

the RBI has moved towards a market-determined

interest rate scenario. This means that banks are free to decide on interest

rates on term deposits and loans.

Being the central bank, however, the RBI would havea say and determine direction on interest rates as it is

an important tool to control inflation.


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Monetary policy operations

1. Liquidity Management

2. Interest Rate policy BPLR(FROM 2004,Benchmark Prime LendingRates)

3. Credit Delivery (corporates and house holds-agri, SMEs and

infra )RBI takes initiatives to ensure flow ofadequate bank credit at reasonable rates ofinterest.


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SOME (Tools of)Monetary Policy Terms:

CRR:

1.It ensures that a portion of bank deposits is totallyrisk-free

2.and secondly it enables that RBI control liquidity in thesystem, and thereby, inflation.

Besides the CRR, banks are required to invest a portionof their deposits in government securities as a part oftheirstatutory liquidity ratio (SLR) requirements.


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.

Since 1991, as the economy has recovered and sectorreforms increased----------------

the CRR has fallen from 15 per cent in March 1991 to 5.5per cent in December 2001.

The SLR has fallen from 38.5 per cent to 25 per centover the past decade.

Lowering of CRR means that more money comes intocirculation. CRR is currently 5%.

If central bank increase reserve requirements, (CRR andSLR), banks credit creation capacity will come down,(i.e.) banks would not be in a position to lend moremoney to the public in that situation.


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.

CRR is the rate at which banks are required to maintain theirreserves with the central bank on fortnightly basis.

SLR refers to the rate at which banks are required to maintaintheir reserves in government securities .

Also through SLR, RBI compels the commercial banks toinvest in government securities like government bonds.


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What impact does a cut in CRR have on interestrates?

From time to time, RBI prescribes a CRR or the minimumamount of cash that banks have to maintain with it.

The CRR is fixed as a percentage of total deposits.As more money chases the same number of borrowers,interest rates come down.


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.

Whenever you see an increase on inflation,there will be an increase of interest rate also.

CRR and SLR is the same -------------------they reduce the capacity of commercialbanks to expand credit to business andindustry and thus are ------ anti-inflationary.


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.

Finally Monetary Policy refers to the set of measuresadopted by the central bank (RBI) for monetarymanagement.

Instruments of monetary policy are ---------

Bank rate, which is the rate at which RBI lends to commercial banks;

Open Market Operations, which is used by RBI either to pump inmore money into the market(by buying securities) or absorb excessliquidity in the system (by selling securities);

Manipulation of reserve ratios, SLR and CRR.


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.

M1, M2, M3 and other measuresof liquidity


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.

The first one is M1, consists of currency with the public(i.e. notes and coins in

circulation minus cash with banks )

plus(+) demand deposits with banks (i.e. deposits which can

be withdrawn without notice)

plus (+) other deposits with RBI (which are in practicenegligible amounts).

This is called narrow money.


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.

The second, M2, M1 plus (+) time liabilities portion of Savings deposits with

banks

plus(+) Certificates of Deposits (CDs) issued by banks

Plus(+) Term Deposits maturing within a year.


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.

The third concept M3 M2 Plus(+) Time deposits with banks with maturity of over one

year

plus(+) call/term borrowing of the banking system.

This is known as broad money.

In addition to the above, RBI has introduced a new concept ofliquid resources (designated as L1, L2 and L3) which comprise,apart from M3 , deposits with Post Offices, Fis and NBFCs.


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.

Functions of RBIFunctions of RBI RBI was established in April 1935 under the RBI Act,1934.

Its important functions are---------------------------

Bank of issue: RBI has the sole right to issue bank notes ofall denominations. Note of Rupee One and coins are issued byRBI as agent of the Government.

Banker to the government : RBI transacts governmentbusiness on behalf of central and state governments.

Lender of the last resort: Commercial banks can approach

RBI for temporary loans or for rediscounting bills of exchange.Usually , such a situation occurs when the banks are notable to maintain the statutory reserves.

The rate charged by bank is know as the bank rate.


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.

Monetary Control through controlling the credit,changing the bank rate, open market operations andprescribing reserve ratios(repo, reverse repo, CRR andSLR).

Foreign exchange operations are controlled by RBI,which has the responsibility to maintain the official rateof exchange.

RBI also has supervisory functions over commercialbanks, co-operative banks and non-banking finance

companies(NBFCs).


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On 10-02-2010

Bank Rate : 6.0%

Repo Rate : 4.75% ,

The policy rates, both the repo rate and the reverse repo ratehave been retained at their current levels.

Reverse Repo Rate : 3.25% CRR : 5.75% ,

As a result of the CRR increase, about Rs.36,000 crore of excessliquidity will be absorbed from the system.

SLR : 25.0%

PLR (Prime lending rate): 12.75% ------- 13.25%

Savings Bank Rate : 3.5%

Deposit Rate : 7.50% ------ 9.60%

monetary policy (updated on 30th jan 2011)

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