MONETARY POLICY Dr. Raj Agrawal

INTRODUCTION To regulate the supply of money. To regulate cost & availability of credit. To understand objectives, targets & instrument. Goals of monetary policy refer to its objective.

OBJECTIVES Ensuring price stability - Better suited to control the inflation rate. Economic growth – Promotes economic growth ensuring availability of credit. Exchange rate stability – Exchange rate of rupee by demand & supply is determined by demand for & supply of foreign exchange.

ESSENTIAL FUNCTIONS OF MONEY  Medium of Exchange: Hence permits a time interval between buying & selling commodities.  Store of Value: Able to perform function as Medium of Exchange because it retains value over time.  Standard of Deferred Payment: Loans & future payments are agreed & contracted in money terms.  Unit of Account: the unit of account in which prices quoted and accounting records kept.

FINANCIAL SYSTEM OF INDIA Financial system is regulated by independent regulators in the sectors of banking, insurance, capital markets, competition and various services sectors. In a number of sectors Government plays the role of regulator. RBI(established in 1935)is regulator for financial and banking system, formulates monetary policy and prescribes exchange control norms. India has a two-tier structure of financial institutions with thirteen all India financial institutions and forty-six institutions at the state level.

BANKING TERMS CASH RESERVE RATIO(CRR): Cash Reserve Ratio is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes with the Reserve Bank of India.  The higher the CRR required, the lower the money available for lending.  If the government wants to stimulate higher economic activity and encourage higher spending to achieve economic growth, they will lower CRR.

STATUTORY LIQUIDITY RATIO(SLR): Statutory liquidity ratio is the statutory reserve that is set aside by banks for investment in cash, gold or government approved securities valued at a price not exceeding the current market price.  Any reduction in the SLR level increases the amount of money available with banks for lending to individuals, companies or other banks. Any hike in the SLR has the opposite effect.

REPO RATE: Repo rate is the rate at which our banks borrow rupees from RBI.  A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive. 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 their money are in safe hands with a good interest.

MONEY MULTIPLIER Mathematical relationship between the monetary base and money supply of an economy. Explains the increase in the amount of cash in circulation by the banks ability to lend out of their depositor’s funds. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.

HOW IT WORKS RM is the base money created by the RBI whenever it mops up foreign exchange from the market or lends to the Government and banks against purchase of securities. This primary rupee liquidity gets incorporated into the system either as currency with the public or as additional cash with banks.

HOW IT WORKS The surplus cash (over and above their reserve requirement) is lent out by banks to the public. The end-result is that every unit of `base' money generates multiple units of `broad money' through successive rounds of deposit- cum-credit creation

DEMAND FOR FUNDS The same base money ended up circulating more number of times to cater to the broad money requirement of a resurgent economy. To the extent this additional money does not go out to borrowers and gets successively re- deposited or re-lent, it weakens the money multiplier.

THE MYTH The money multiplier concept implicitly assumes that the Fed controls the money supply by setting the required reserve ratio, and then issuing enough reserves to enable aggregate bank lending to a multiple of that ratio. The money multiplier concept represents a misunderstanding about how the credit money supply grows.

CURRENT SCENARIO RBI ( )  Confidence and return to normal functioning.  The Reserve Bank has reviewed the current and evolving macroeconomic situation and liquidity conditions.  On October 20, 2008, the Reserve Bank announced a reduction in the repo rate from 9.0 to 8.0 per cent.

Maintaining price stability and sustaining the growth momentum. If sustained, would further reduce inflationary pressures. Domestic financial markets have been functioning normally. In order to provide further comfort on liquidity and to impart flexibility in liquidity management to banks.

 The objective is to maintain appropriate liquidity in the system such that all legitimate requirements of credit are met, consistent with the objective of price and financial stability.  The Reserve Bank will continue to closely monitor the developments in the global and domestic financial markets and will take swift and effective action as appropriate.