Monetary policy

Dr. Alice Mani Jacob

Govt. Policy for Stabilisation

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Monetary policy -types

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Monetary Policy -

▪ A deliberate programme of action

■ Undertaken by the monetary
authorities, normally the central
bank,
■ To control and regulate the demand
for and supply of money
■ With the public and the flow of
credit with a view to achieving
predetermined macroeconomic
goals.

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What is it?

■ The use of money supply by the

appropriate authority (i.e.
Central bank) to achieve certain
economic goals.

■ Change in money supply leads to

a change in the rate of interest

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Definition of monetary policy
Discretionary act undertaken by the
authorities designed to influence
(a) the supply of money
(b) cost of money or rate of interest
and
(c) the availability of money.

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The use of monetary policy
instruments
■ At the disposal of the central
bank
■ To regulate the availability,
cost and use of money and
credit
■ Deliberate

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Purpose

■ To promote economic growth,

■ Price stability,
■ Optimum levels of output and
employment,
■ Balance of payments
equilibrium,
■ Stable currency or
■ Any other goal of government's
economic policy.

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Meaning

■ Monetary policy influences the

supply of money the cost of money
(the rate of interest ) and the
availability of money

■ In order to achieve the socio-

economic objectives of the
economy.

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A demand-side’ macroeconomic
policy
■ Action undertaken by the
monetary authorities
■ To control and regulate the
demand for and supply of
money with the public, and
the flow of credit
■ For achieving predetermined
macroeconomic goals

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What do the monetary
authorities do?

■ ‘Demand-side’ macroeconomic
policy
■ Directly control the money
supply and
■ Indirectly regulate the
demand for money.

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Expansionary Monetary
Policy(easy Money Policy)
■ Adopted when the economy is in
a recession
■ Increase in money supply
■ Interest rates will decline.
■ Stimulate consumption and
investment spending
■ Raise aggregate demand and,
hence, level of income and
employment.

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Contractionary Monetary
Policy
■ Tight money policy
■ Applied during inflation
■ To curtail aggregate demand
and spending
■ Decrease the money supply
■ Increasing the interest rates

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The monetary policy
instruments
■ Are the various tools that a
central bank can use to
influence
■ Money market and Credit
conditions and
■ Pursue its monetary policy
objectives.

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For implementing monetary
policy
■ The central bank can act
directly, using its regulatory
powers, or
■ Indirectly, using its influence
on money market conditions
as the issuer of reserve
money (currency in
circulation and deposit
balances with the central
bank).

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The Monetary Policy Framework
Components
■ The objectives of monetary
policy,
■ The analytics of monetary
policy which focus on the
transmission mechanisms, and
■ The operating procedure
which focuses on the
operating targets and
instruments.

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Objectives of Monetary Policy

■ Generally coincide with the

overall objectives of economic
policy.
■ Establishment and maintenance
of stability in prices
■ The great depression
■ Major shift in the objective of
governments’ economic policy

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Objectives- Contd

■ Maintenance of full
employment
■ Economic stability
■ Maintenance of a judicious
balance between price
stability and economic
growth

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More Objectives

■ Rapid economic growth

■ Debt management
■ Moderate long term
interest rates
■ Exchange rate stability and
■ External balance of
payments equilibrium

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More Objectives

■ Ensuring an adequate flow of

credit to the productive
sectors,
■ Sustaining a moderate
structure of interest rates to
encourage investments, and
■ Creation of an efficient
market for government
securities.

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2. Analytics of Monetary Policy

■ ‘Monetary Transmission Mechanism’

■ The process or channels through

which the change of monetary
aggregates affects the level of
product and prices is known as
‘Monetary Transmission Mechanism’

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Monetary Transmission
Mechanism’
■ Describes how policy-induced
changes in the nominal money
stock or in the short-term
nominal interest rates
■ Impact real variables such as
aggregate output and
employment.

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■ Monetary transfer mechanism
that is a channel for the
decisions of monetary policy
to affect real GDP and
inflation

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■ Monetary transmission
mechanism is a mechanism
indicating
■ the interaction between
monetary policy and real
economy,
■ i.e. ‘monetary change affected’
total demand and production in
what ways and in what measure.

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■ Generally discussed from
Keynesian and monetarist
point of view.

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Mishkin, F. 1995.

■ Symposium on the monetary

transmission

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Mainly four different
mechanisms
■ Through which monetary policy
influences the price level and the
national income
■ (A) the interest rate channel,
■ (B) the exchange rate channel,
■ (C) the quantum channel (e.g.,
Relating to money supply and
credit),
■ (d) the asset price channel i.e. Via
equity and real estate prices.

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Keynesian Interest Rate
Channel
■ Works through the effect of real
interest rate developments on
aggregate demand

■ Traditional Keynesian view:

monetary policy can influence
the real cost of borrowing by
setting nominal short term
interest rates

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Route

■ A change in the official interest rate

set by the monetary policy
committee
■ Banks/ financial institutions react
by
■ Changing savings and loan rates
■ Effect on the expectations of both
firms and individuals
■ Affect spending of consumers /firms
■ Aggregate demand change

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How ?

■ Changes in nominal interest

rates lead to corresponding
real interest rate changes due
to price rigidities
■ Changes in real interest rate (
real cost of borrowing) will
have impact on investment/
consumption decisions

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Contractionary monetary
policy
■ Reduce money supply
■ Increase in interest rates
■ Increases the cost of capital /real
cost of borrowing
■ firms cut back on investment
■ Households face higher real
borrowing costs
■ Cut back on their purchases
■ Reduce aggregate demand /output

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Expansionary monetary
policy
■ Increase money supply
■ decrease in interest rates
■ decreases in cost of capital for firms
■ Reduce cost of borrowing for
households
■ Increase investments and
consumption
■ Increase aggregate demand and
output

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Expansionary Monetary Policy

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The exchange rate channel.

■ Appreciation of the
domestic currency
■ Net exports to fall
■ Fall in Domestic output
and employment

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Uncovered interest parity

■ Predicts that the currencies of

countries with relatively high
interest rates today should
depreciate over time
■ This adjustment acts to
equalise returns on domestic
and foreign assets measured in
a common currency.

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Depreciation -

■ Exports become cheap

■ Imports become costly
■ Effect More demand for
domestic goods from residents
■ More demand for exports
■ Domestic output and
employment increases

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Transmission

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Credit channels

■ The bank lending channel

■ An open market operation – sale of
securities
■ Contraction in the supply of bank
reserves
■ A contraction in bank credit
■ Cut back on investment spending
■ Decline in the aggregate output and
employment
■ following a monetary contraction.

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The balance sheet channel

■ Increase in interest rates

■ Cost of credit rises
■ Increase in the payments that
the firm must make to repay its
floating rate debts
■ Reduce the capitalized value of
the firm’s long‐lived assets
■ Decline in output and
employment.

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The asset price channel

■ Increase in the short‐term

nominal interest rates
■ Debt instruments are more
attractive than equities for
investors
■ A fall in equity prices
■ Reduction in household financial
wealth, leading to fall in
consumption, output, and
employment.

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Operating Procedures and
Instruments
■ Three major aspects,
1) Choosing the operating
target,
2) Choosing the intermediate
target,
3) Choosing the policy
instruments.

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The operating target

■ Refers to the variable (for e.g.

Inflation) that monetary policy
can influence with its actions.
■ Eg.the monetary policy
instruments (reserve money and
short-term money market
interest rates or weighted
average call rate (WACR)).

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■ The intermediate targets (e.g.
monetary aggregates and
short-term and long-term
interest rates)

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The intermediate target

■ Is a variable which the central

bank can hope to influence to
a reasonable degree through
the operating target and
■ Which displays a predictable
and stable relationship with
the goal variables
■ (e.g. Economic stability)

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The monetary policy
instruments
■ Are the various tools that a
central bank can use to
influence money market and
credit conditions and pursue
its monetary policy objectives.

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‘Operating Procedures’

■ The day-to-day implementation

of monetary policy by central
banks through various
instruments is referred to as
‘operating procedures’.
■ For example, liquidity
management is the operating
procedure of the Reserve Bank
of India

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The monetary policy
instruments
■ Are the various tools that a
central bank can use
■ To influence money market
and credit conditions and
■ Pursue its monetary policy
objectives

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The direct instruments
comprise
1. The prescribed cash reserve
ratios and liquidity reserve
ratios
2. Directed credit which takes
the form of prescribed targets
for allocation of credit to
preferred sectors (for e.g.
Credit to priority sectors), and
3. Administered interest rates

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The indirect instruments

■ Repos
■ Open market operations
■ Standing facilities, and
■ Market-based discount
window.

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Cash Reserve Ratio (CRR)

■ Fraction of the total net

demand and time liabilities
(NDTL) of a scheduled
commercial bank
■ All scheduled commercial
banks only
■ Does not pay any interest on
the CRR balances

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How it works?

■ Higher the CRR with the RBI,

lower will be the liquidity in
the system and vice versa.
■ During deflation, the RBI
reduces the CRR
■ During inflation, the RBI
increases the CRR to contain
credit expansion.

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■ CRR: 3%
■ SLR: 18.00%

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■ Base Rate: 7.40% -9.00%
■ MCLR (Overnight): 6.65% - 7.15%
■ Savings Deposit Rate: 2.70% -
3.00%
■ Term Deposit Rate > 1 Year: 4.90%
- 5.50%

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Statutory Liquidity Ratio
(SLR)
■ A prudential measure.
■ A stipulated percentage of
their total demand and time
liabilities (NDTL)
■ Cash
■ Gold, or
■ Investments
in unencumbered instruments

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■ Dated Government securities are
long term securities and carry a
fixed or floating coupon (interest
rate) which is paid on the face value,
payable at fixed time periods
(usually half-yearly).
■ They are issued at face value.

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Effective from January 23,
2007
■ Reserve Bank can prescribe
the SLR for SCBs in specified
assets.
■ The value of such assets of a
SCB shall not be less than
such percentage not exceeding
40 per cent of its total DTL in
India

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Reserve Ratios

■ As on 15 th July, 2020 ,
the SLR was 18 per
cent.

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Instruments

• Treasury-bills of the Government

of India.
• Dated securities
State Development Loans (SDLs)
issued by State Governments
under their market
borrowings programme.
Other instruments as notified by
the RBI.

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Liquidity Adjustment
Facility(LAF)
■ From June 2000,
■ A central bank is a ‘bankers’
bank.’
■ It provides liquidity to banks
when the latter face shortage of
liquidity.
■ Discount window. Withdrawn.
■ Avail of liquidity in case of
requirement

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Liquidity Adjustment
Facility(LAF)
■ RBI provides financial
accommodation to the
commercial banks through
repos/reverse repos
■ In India, the fixed repo rate
quoted for sovereign securities
in the overnight segment of
Liquidity Adjustment Facility
(LAF) is considered as the policy
rate.

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Liquidity Adjustment Facility

■ has repo and term repo as the

major liquidity injecting
instruments
■ Repo-pledging securities above
SLR requirements

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Eligible securities

■ are first class securities

(including government bonds,
T Bills, State Development
Loans etc) held by a bank over
the SLR requirement.

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■ Policy Repo Rate: 4.00%
■ Reverse Repo Rate: 3.35%
■ Marginal Standing Facility
Rate: 4.25%
■ Bank Rate: 4.25%

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■ The RBI has cut policy rates
by 115 basis points since
February.

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Policy rate

■ The RBI uses the single

independent ‘policy rate’
which is the repo rate (in
the LAF window) for
balancing liquidity
■ The policy rate is in fact,
the key lending rate of the
central bank in a country.

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Term Repo- 1 to 13 days

■ Interest rate is Variable,

depending upon auctions but
higher than repo rate.
■ 0.75% of the banks’ NDTL

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LTRO –Long term repo at Repo
Rate- 1 year and 3 years.
■ Rs 1 lakh crore into the banking
system through auctions with
long term maturity periods
(compared to one day repos)
■ CBS (E-KUBER) platform
■ At repo rate
■ No restriction on maximum
amount

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Implication

■ Higher Liquidity
■ Lowering of short term
interest rates

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Marginal Standing Facility
(MSF)
■ The reserve bank of India,
■ being a bankers’ bank,
■ acts as a lender of last resort.
■ additional amount of overnight
money from the central bank
over and above what is available
to them through the LAF window
by dipping into their statutory
liquidity ratio (SLR) portfolio up
to a limit

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On March 27, 2020 -COVID
Upto 3 percent
■ Banks allowed to avail of funds
under the marginal standing
facility (MSF) by dipping into
the statutory liquidity ratio
(SLR) by up to an additional
one per cent of net demand
and time liabilities (NDTL),
i.E., Cumulatively up to 3 per
cent of NDTL.

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■ This dispensation provides
increased access to funds to
the extent of ₹1.49 lakh crore,

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Additional amount of overnight
money
■ Marginal Standing Facility
(MSF) Scheme introduced by
Reserve Bank with effect from
May 09, 2011.
■ The eligible entities may
borrow up to two per cent of
their respective NDTL
outstanding at the end of the
second preceding fortnight

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Thus

■ Marginal Standing Facility is

an overnight liquidity support
provided by RBI to commercial
banks with a higher interest
rate over the repo rate.

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■ MSF can be used by a bank
after it exhausts its eligible
security holdings for
borrowing under other options
like the LAF repo

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■ Under MSF, banks can borrow
funds from the RBI by
pledging government
securities within the limits of
the SLR

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■ The working of MSF is thus is
indirectly related with SLR
■ The working of MSF is thus is
indirectly related with SLR

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Who can borrow ?

■ All Scheduled Commercial

Banks having
■ Current Account and SGL
(subsidiary general ledger)
Account with Reserve Bank,

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■ Additionally, the eligible
entities may also continue to
access overnight funds under
this facility against their
excess SLR holdings

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■ In the event, the banks’ SLR
holding falls below the
statutory requirement up to
two per cent of their NDTL,
banks will not have the
obligation to seek a specific
waiver for default in SLR
compliance arising out of use
of this facility

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Reverse repo

■ Central banks use reverse

repos to add more money to
the money supply via open
market operations.

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■ A reverse repo is the mirror
image of a repo
■ In a reverse repo, securities
are acquired with a
simultaneous commitment to
resell

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Interest

■ Under the Reverse

Repo , banks deposit excess
funds with the RBI and earn
interest for it.

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■ RBI has reduced the reverse repo
rate by a total of 115 basis
points bringing it down from 4.90%
to 3.35%.
■ Objective ?
■ Discourage banks from parking
money

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■ Reverse Repo is a mechanism
to absorb the liquidity in the
market
■ the securities acquired under
a reverse repo
transaction shall be reckoned
for SLR, if they are approved
securities

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The Market Stabilization
Scheme (MSS)
■ The Market Stabilization
Scheme (MSS) was launched in
April 2004.
■ During 2002-2004, there were
huge capital inflows into
India.
■ This led to an appreciation of
the rupee (because demand for
Indian rupee increased).

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■ RBI had to intervene in the
foreign currency market.
■ By buying us dollars with
Indian rupee.
■ (To increase the supply of
Indian rupees and devalue the
rupee)

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■ Increased the liquidity in the
economy and had the
potential to stoke inflation.
■ To combat this, the rbi sold
government securities to
withdraw the excess liquidity.
■ This withdrawal of excess
liquidity is also known as
sterilisation.

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■ The selling of Government
securities depleted the limited
stock of securities held by the
RBI.
■ As per the MoU, the
Government of India has
authorized the RBI to issue
Government securities up to a
specified ceiling.

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■ MSS (Market Stabilisation
Scheme) securities are issued
with the objective of providing
the RBI with a stock of
securities with which it can
intervene in the market for
managing liquidity.

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■ These securities are issued not
to meet the government's
expenditure. These are special
bonds floated on behalf of the
government by the RBI for the
specific purpose of mop ping up
the excess liquidity in the
system when regular
government bonds prove
inadequate

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■ The bonds issued under MSS
have all the attributes of the
existing treasury bills and
dated securities.

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Revision

■ Open Market Operations

(OMO) is buying and selling of
Government securities to
manage money supply in the
economy.
■ Thus, it is used to both inject
and withdraw liquidity
■ Part of government borrowing

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MSS

■ MSS is only selling of

Government securities to
withdraw excess liquidity.
■ The money raised through the
selling of securities is kept in
a separate account known as
MSS account,

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■ The amount kept in the MSS
account is only used for
redemption of securities
issued under the MSS. This
money is not used by the
Government to meet its
expenditure requirement.
■ It is not a part of Government
borrowing,

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Market Stabilisation Scheme
(MSS)
■ Bank Rate
■ Open Market Operations
■ The Reserve Bank of India (RBI)
Act, 1934 was amended on June
27, 2016,
■ Monetary Policy Committee
(MPC).
■ empowered six-member
Committee

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How?

■ The Reserve Bank’s Monetary

Policy Department (MPD) assists
the MPC in formulating the
monetary policy.
■ The views of key stakeholders in
the economy and analytical
work of the Reserve Bank
contribute to the process for
arriving at the decision on the
policy repo rate.

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Bank Rate

■ From march , 2011

■ The liquidity adjustment facility
(LAF) is the key element in the
operating framework of the RBI.
■ The repo rate is the single policy
rate to unambiguously signal the
stance of monetary policy to
achieve macro-economic
objectives of growth with price
stability.

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The Bank Rate

■ Will be the rate at which the RBI

will provide liquidity under a
new collateralised exceptional
standing facility (ESF) up to one
per cent of NDTL of banks to be
carved out of the required
statutory liquidity ratio (SLR)
portfolio.
■ The bank rate will constitute
the upper bound of the corridor.

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Open Market Operations

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Open Market Operations

■ August 25, 2020,

simultaneous purchase and
sale of government securities
under Open Market Operation
(OMO) for an aggregate
amount of ₹20,000 crores in
two tranches of ₹10,000 crores
each

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Targeted Long Term Repo
Operations (TLTROs)
■ TLTROs of up to three-year
tenor of appropriate sizes for a
total amount of up to ₹
1,00,000 crore.
■ The funds availed under this
tranche of TLTRO would have
to be deployed within 30
working days from the date of
the operation.

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The organisational structure
for monetary policy decisions
■ The Monetary Policy Framework
Agreement 2016
■ setting up a Monetary Policy
Committee (MPC).
■ The Monetary Policy Framework
Agreement is an agreement
reached between the
Government of India and the
Reserve Bank of India (RBI)

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■ on the maximum tolerable
inflation rate that the RBI
should target to achieve price
stability
■ lower tolerance limit of 2 per
cent.
■ upper tolerance limit of 6 per
cent

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■ 4 per cent Consumer Price
Index (CPI)
■ RBI abandon the ‘multiple
indicator’ approach and make
inflation targeting the primary
objective of its monetary
policy.

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■ ‘flexible inflation targeting
framework’.

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The Monetary Policy
Committee (MPC)
■ the RBI Governor
(Chairperson), the RBI Deputy
Governor in charge of
monetary policy, one official
nominated by the RBI Board
■ the remaining three central
government nominees
representing the Government
of India

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Named to MPC

■ Professor, Jayanth Verma,

■ Ashima Goyal
■ Shashanka Bhide

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