ICSA Civil Services (Prelims) GS Indian Economics Exam 2012: Lecture 8 by Prof. S. Maitra (isastudymat.blogspot.com)

Prof. S. Maitra,

iasstudymat.blogspot.com

What is Monetary Policy?The term monetary policy refers to actions taken by

central banks to affect monetary magnitudes or other financial conditions.

It is concerned with the changing the supply of money stock and rate of interest for the purpose of stabilizing the economy at full employment or potential output level by influencing the level of aggregate demand.

ICSA 2012 GS Indian Economics/Prof. S.Maitra04/18/23 2

Monetary Policy during recession

At times of recession monetary policy involves the adoption of some monetary tools which tends to increase the money supply and lower interest rate so as to stimulate aggregate demand in the economy.


Monetary Policy during inflation

At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money supply or raising the rate of return.


Three objectivesTo ensure the economic stability at full

employment or potential level of output.

To achieve price stability by controlling inflation and deflation.

To promote and encourage economic growth in the economy.


Tools of Monetary PolicyBank rate policy

Open market operations

Changing cash reserve ratio

Undertaking selective credit controls.


Bank Rate PolicyBank rate is the minimum rate at which the central

bank of a country provides loan to the commercial bank of the country.

Bank rate is also called discount rate because bank provide finance to the commercial bank by rediscounting the bills of exchange.

When general bank raises the bank rate, the commercial bank raises their lending rates, it results in less borrowings and reduces money supply in the economy.


LimitationsWell organized money market should exist in the economy. It is not present in India

It is useful during the times of inflation but it does not fullfil its purpose during the time of recession or depression.


Open Market OperationsIt means the purchase and sale of

securities by central bank of the country.

It is useful for the developed countries.

The sale of security by the central bank leads to contraction of credit and purchase there of to credit expansion.


LimitationsWhen the central bank purchases the securities the cash

reserve of member bank will be increased and vice versa.

The bank will expand and contract credit according to prevailing economic and political circumstances and not merely with reference to their cash reserves.

When the commercial bank cash balance increase the demand for loan and advance should increase. This may not happen due to economic and political uncertainty.

The circulation of bank credit should have a constant velocity.


What is CRR? CRR means Cash Reserve Ratio. Banks in India are required to hold a certain proportion of their

deposits in the form of cash. However, actually Banks don’t hold these as cash with themselves, but deposit such cash with Reserve Bank of India (RBI). This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio.

Thus, When a bank’s deposits increase by Rs100, and if the cash reserve ratio is 6%, the banks will have to hold additional Rs 6 with RBI and Bank will be able to use only Rs 94 for investments and lending / credit purpose. Therefore, higher the ratio (i.e. CRR), the lower is the amount that banks will be able to use for lending and investment.

This power of RBI to reduce the lendable amount by increasing the CRR, makes it an instrument in the hands of a central bank through which it can control the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in the banking system.

04/18/23 ICSA 2012 GS Indian Economics/Prof. S.Maitra 11

What is CRR?Consequent upon amendment to RBI act in 2006, RBI can

prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate ( Before this enactment, the Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20 per cent of total of their demand and time liabilities).

RBI uses CRR either to drain excess liquidity or to release funds needed for the growth of the economy from time to time. Increase in CRR means that banks have less funds available and money is sucked out of circulation. Thus we can say that this serves duel purposes i.e.(a) ensures that a portion of bank deposits is kept with RBI and is totally risk-free, (b) enables RBI to control liquidity in the system, and thereby, inflation by tying the hands of the banks in lending money


What is SLR?Every bank is required to maintain at the close of

business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio up to 40%. An increase in SLR also restrict the bank’s leverage position to pump more money into the economy.


Repo RateRepo (Repurchase) rate is the rate at

which the RBI lends shot-term money to the banks against securities. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that in case, 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


Reverse Repo Rate

Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. The banks use this tool when they feel that they are stuck with excess funds and are not able to invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI is ready to borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep more and more surplus funds with RBI.


Repo Rate signifies the rate at which 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


The policy announcements on 03/05/2011, indicates that now repo rate has become the only independent variable policy rate, marking a shift from earlier method of calibrating various policy rates separately. The reverse repo rate -- the rate at which RBI borrows – will be kept 100 basis points lower than the repo rate. On the other hand Marginal Standing Facility (MSF) rate will be kept 100 basis points higher than the repo rate.


Marginal Standing Facility

Under this scheme, Banks will be able to borrow upto 1% of their respective Net Demand and Time Liabilities". The rate of interest on the amount accessed from this facility will be 100 basis points (i.e. 1%) above the repo rate. This scheme is likely to reduce volatility in the overnight rates and improve monetary transmission. This facility has become effective from May 9, 2011


Expansionary Monetary Policy

Problem: Recession and unemployment Measures: (1) Central bank buys securities through open market

operation(2) It reduces cash reserves ratio(3) It lowers the bank rate

Money supply increases Investment increasesAggregate demand increases Aggregate output increases by a multiple of the increase in investment


Tight Monetary Policy

Problem: Inflation Measures: (1) Central bank sells securities through open

market operation (2) It raises cash reserve ratio and statutory liquidity

(3) It raises bank rate(4) It raises maximum margin against holding of stocks of goods

Money supply decreases Interest rate raises Investment expenditure declinesAggregate demand declines Price level falls


Sources of Monetary Mismanagement

Variable time lags concerning the effect of money supply on the national income.

Treating Interest rate as the target of monetary policy for influencing investment demand for stabilizing the economy.


Role of Monetary Policy in Economic GrowthMonetary policy and savings. Monetary policy and investment. Cost of credit..

i) Monetary policy and public investment.ii) Monetary policy and private investment.

iii)Allocation of investment funds. ICSA 2012 GS Indian Economics/Prof. S.Maitra04/18/23 22

Monetary Policy of RBIIn recent years starting from the mid-nineties

promoting economic growth is being given greater emphasis in monetary policy of RBI.

Three sub-periods:Monetary policy of controlled expansion(1951-1972).Monetary policy in the pre-reforms period(1972-1991) .Monetary policy in the post-reforms period(1991-2011).


Monetary Policy of Controlled ExpansionReserve bank’s responsibility in the circumstances is

mainly to moderate the expansion of credit and money supply in such a way as to ensure the legitimate requirements of industry and trade and curb the use of credit for unproductive and speculative purposes.

To ensure controlled expansion, RBI used the instruments:

Changes in bank rateChanges in cash reserve ratioSelective credit control


Monetary Policy in the pre Reform Period (1972—1991)Price situation worsened during the years of 1972- 1974. to contain inflationary pressures RBI further tightened its monetary policy.

It is similar to tight monetary policy


Easy and Liberal Monetary PolicyLiberal monetary policy adopted for

encouraging private sector since 1996.

Two instrument for monetary management BY RBI since 1996:

Reactivation of bank rate. Repo rate system .


Repo Rate SystemIt is introduced through which RBI can add to

liquidity in the banking system. Through repo system RBI buys securities from the bank and there by provide funds to them.

Repo refers to agreement for a transaction between RBI and banks through which RBI supplies funds immediately against government securities and simultaneously agree to repurchase the same or similar securities after a specified time which may be one day to 14 days.


Liquidity Adjustment Facility(LAF)It is the another instrument of monetary

policy from June 2000 to adjust on a daily basis liquidity in the banking system.

Through LAF, RBI regulates short-term interest rates while its bank rate policy serves as a signaling device for its interest rate policy in the intermediate period.


Movements in Key Policy Rates in India


Latest Rates

Bank Rate9.50% (w.e.f. close of business of 13/02/2012) . Increased from 6.00% to 9.50% which was continuing

since 29/04/2003

Cash Reserve Ratio (CRR) 5.50% (wef 28/01/2012) - announced on 24/01/2012

Decreased from 6.00% to 5.50% which was continuing since 24/04/2010

Statutory Liquidity Ratio (SLR)24%(w.e.f. 18/12/2010) Decreased from 25% which

was continuing since 07/11/2009


Latest Rates

Repo Rate under LAF 8.50% (w.e.f.25/10/2011) Increased from 8.25% which was continuing since 16/09/2011

Reverse Repo Rate under LAF * 7.50% (w.e.f. 25/10/2011) Increased from 7.25% which was continuing since 16/09/2011

*Reverse Report rate was an independent rate till 03/05/2011. However, in the monetary policy announced on 03/05/2011, RBI has decided that now onwards the Reverse Repo Rate will not be announced separately, but will be linked to Repo rate and it will always be 100 bps below the Repo rate (till RBI decides to delink the same)


Neutral interest rate“Neutral interest rate”, as a concept, generally

refers to the level of interest rate at which monetary policy stance is neither expansionary nor contractionary. Policy stance can be deemed “neutral” when the real interest rate reaches a level that is consistent with full employment of resources over the medium-term, and hence full capacity output and price stability.


Neutral interest rateThe concept of natural rate of interest was first

introduced into economics by the Swedish economist Knut Wicksell in 1898. This rate, theoretically, essentially relates to:

(i) the rate of interest that equates saving with investment;

(ii) the marginal productivity of capital, and (iii) the rate of interest that is consistent with

aggregate price stability.


Neutral interest rateAlthough natural and neutral rates of interest are used interchangeably, there are major conceptual differences between the two. Moreover, while the former emerges in the market and is not directly observable, the latter essentially is an empirical approximation used in practice for conduct of monetary policy. Thus, the neutral rate of interest is useful as an important benchmark for the actual conduct of monetary policy and also market analysis of monetary policy stance.


Liquidity Management Measures taken by the RBI in 2010--11

Event:End-May 2010: Larger than

anticipated collection for 3G/ BWA spectrum in addition to advance tax outflow resulted in migration of liquidity to central government’s cash balance account with the Reserve Bank


Liquidity Management Measures taken by the RBI in 2010--11Measures:For the period May 28, 2010-July 2, 2010, SCBs were:(i) Allowed to avail additional liquidity support under the

LAF to the extent of up to 0.5 per cent of their Net Demand and Time Liabilities NDTL (for any shortfall in maintenance of SLR arising out of availing of this facility, banks were allowed to seek waiver of penal interest).

(ii) Given access to second LAF (SLAF) on a daily basis.With the persistence of deficit liquidity conditions,

measure (i) was extended up to July 16, 2010 andmeasure (ii) up to July 30, 2010.


Liquidity Management Measures taken by the RBI in 2010--11Event:

End-October 2010: Frictional liquidity pressure due to autonomous factors compounded by banks’ high CRR requirement (since the fortnight ended October 22, 2010 had seen a large increase in NDTL)


Liquidity Management Measures taken by the RBI in 2010--11Measures:(i)The Reserve Bank conducted special SLAF on October 29

and November 1, 2010, a special two day repo auction under the LAF on October 30, 2010, and allowed waiver of penal interest on shortfall in maintenance of SLR (on October 30-31, 2010) to the extent of 1.0 per cent of NDTL for availing additional liquidity support under the LAF.

(ii) The Reserve Bank extended these liquidity easing measures further and conducted SLAF on all days during November 1-4, 2010 and extended the period of waiver of penal interest on shortfall

in maintenance of SLR ( to the extent of 1.0 per cent of NDTL) for availing additional liquidity support under the LAF till November 7, 2010.


Liquidity Management Measures taken by the RBI in 2010--11(iii) The Reserve Bank re-started purchase of

government securities under its open market operations (OMO) from November 4, 2010.

(iv) On November 9, 2010, the Reserve Bank reintroduced daily SLAF and extended the period of waiver of penal interest on shortfall in maintenance of SLR to the extent of 1.0 per cent of NDTLfor availing additional liquidity support under the LAF till December 16, 2010.

(v) On November 29, 2010, the Reserve Bank extended the daily SLAF and allowed additional liquidity support to the SCBs under the LAF to the extent of up to 2.0 per cent of their NDTL till January 28, 2011.


Liquidity Management Measures taken by the RBI in 2010--11

Event:Mid-December 2010: Continued build up in government balances on account of third quarterly advance tax collections


Liquidity Management Measures taken by the RBI in 2010--11Measures:In the mid-Quarter Review of December 2010, the

Reserve Bank:(i) Reduced the SLR of SCBs from 25 per cent of NDTL

to 24 per cent with effect from December 18, 2010. Given the permanent reduction in the SLR, additional liquidity support of 1.0 per cent of NDTL under the LAF would be available from December 18, 2010 till January 28, 2011.

(ii) Announced conduct of OMO auctions for purchase of government securities for an aggregate amount of Rs.48,000 crore in the next one month (staggered as purchases of Rs.12,000 crore per week).


Economy & Finance

ICSA Civil Services (Prelims) GS Indian Economics Exam 2012: Lecture 8 by Prof. S. Maitra (isastudymat.blogspot.com)