CHAPTER –3 (UNIT –3)

Chapter -3
Unit-3
MONETARY POLICY

Introduction
Monetary policy refers to the use of monetary policy instruments which are at the
disposal of the central bank.

to regulate the
availability
cost and use of money and
credit

so as to promote
economic growth,
price stability,
optimum levels of output and employment,
balance of payment equilibrium,
stable currency or
any other goal of government’s economic policy.

Reserve Bank of India conducts monetary policy by adjusting the supply of money,
usually through buying or selling securities in the open market.

Easing Tightening

Monetary Policy Monetary Policy

Lower Raises
Interest Interest
Rate Rate

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CHAPTER –3 (UNIT –3

Monetary Policy
Framework

Operating
Objectives Analytics
Procedure

Focus Focus Focus

on on on
Achieving transmission operating targets
objectives Mechanism & instruments.

Objectives

Economic Growth

Adequate Flow of credit

Moderate interest rates

to encourage investments

efficient Market for

Government securities

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Analytics / Transmission

It describe How changes made by

Reserve bank
Flow
through to
Economic Activities & Inflation

changes
to Interest Rate
Monetary policy

changes in Economic activities

interest rates & Inflation

Channels of Monetary Policy

transmission

Saving Cash Asset price Exchange

& Flow & Rates
Investment Channel Wealth Channel
Channel Channel

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Saving & investment

I. channel

Affects

Consumption Business
investment
Housing
investment

Lower interest rate

on on on
Bank Deposit Bank Loans Bank Loans

Reduce incentive encourage HH Increase

to to Investment
Household for Borrow because
saving Money cost of
Therefore For Assets Borrowings
increase such as Housing &
Consumption Demand For
G&S

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II. Cash Flow channel

Affects

Cash Holding

Of

House holds & Businesses

Lower interest rates

on on
Banks loans Bank Deposits

Reduce Burden Reduce Amount

of of
Debt Repayments income that get
Thus from Deposits
increasing Amount Thus
of cash Available Restrict Spending
(having larger effect) (effect Low effect)

Results
Increase in spending

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III. Asset price & Wealth

channel

Affect

Consumption & Investment

Lower interest rates

on
Bank Loan

Support
Asset prices

Increasing Demand for Assets

Increased Increased
Asset price Asset price

Increase Value Increases

of people’s Wealth
Collateral
Thus Increase in
Increases
Borrowings
Consumption Investment

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IV. Exchange Rate channel

Affects

Export-oriented & Economic Activity

Sector Inflation

Lower Interest rates

Reduce return Depreciation of

to of
investor earn from
Asset in India
Export Import
Demand of Asset Cheaper Expensive
Decreases
As Well Indian Rupees Economic
Activities

Rupee Value Depreciates

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Summing
up

Interest Rate

Asset Currency
Saving
Cash price Depreciate
Holding &
Wealth Export
Investment
Import

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Operating Procedures & Instruments

Tools of Monetary Policy

Quantitative Qualitative
tools tools

Impact Money supply Impact Money supply

in the entire of a specific sector
Economy. of the Economy.

attitinave
Qualitative
tools

Reserve Ratios Open Market operations

(OMO)

CRR SLR
Cash Reserve Statutory Liquidity
Ratio Ratio

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Cash Reserve Ratio (CRR)

Cash Reserve Ratio (CRR) – It refers to the fraction of the total net demand and time
liabilities (NDTL) of a scheduled commercial bank in India which it should maintain as cash
deposit with the Reserve Bank irrespective of its size or financial position.

Commercial Bank Central Bank

Deposits

CRR 6 % 60
1000 – 60 = 940 kept with
available with bank RBI
in the Form
of cash
Point
to Bank can Never lend it to Anyone
be Nor
Noted it can earn interest or profit on
CRR.

Commercial credit
CRR Bank interest
INFLATION Rate
creation

Commercial credit
CRR Bank interest
RECESSION Rate
creation

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Statutory Liquidity Ratio (SLR)

Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion as a stipulate
percentage of their total Demand and Time Liabilities (DTL) / Net DTL (NDTL) in liquid assets
such as gold or RBI approve securities such as government securities

Commercial Bank

Deposits

Bank Kept with itself

1000 – in the Form of
Available with Bank. Liquid Asset

Gold Government
Securities
Point
Bank allowed to earn interest
to on
be these securities; However
Noted it is very
Low.

Commercial credit
INFLATION SLR Bank interest
Rate
creation

Commercial
RECESSION SLR Bank interest
credit
creation
Rate

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Open Market Operations (OMO)

In order to control money supply, the RBI buys and sells government securities in the open
market. These operations conducted by the Central Bank in the open market are referred to
as Open Market Operations.

INFLATION

Central Bank Commercial Bank

Securities
Sell

RECESSION

Central Bank Commercial Bank

Securities
Buy

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Qualitative
tools

Margin Moral Selective

Requirement Suasion credit
control

Margin Requirements

Margin requirements — the RBI prescribes a certain margin against collateral, which in turn
impacts the borrowing habit of customers. When the margin requirements are raised by the
RBI, customers will be able to borrow less.

Margin = Value of Amount of Loan

Securities Sanctioned

Margin Loan credit

INFLATION creation

Margin Loan credit

RECESSION creation

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Moral Suasion Selective credit control

RBI convines Banks controlling credit

to by
keep Money in Govt. securities Not lending to
Rather than selective industries
certain other sectors or
speculative Businesses.

Market Stabilization (MSS)

Scheme

Policy Rate Marginal standing

Facility Rate
(MSF)
Bank Rate Liquidity Adjustment
Facility (LAF)

Repo Rate Reverse Repo Rate

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Bank rate — The interest rate at which RBI lends long term funds to banks is referred to as
the bank rate. However, presently RBI does not entirely control money supply via the bank
rate. It uses Liquidity Adjustment Facility (LAF) – repo rate as one of the significant tools
to establish control over money supply. Bank rate is used to prescribe penalty to the bank if
it does not maintain the prescribed SLR or CRR.

Central Bank Commercial Bank

Long Term Fund

Bank Rate

recommendations of Narsimham Committee on banking sector reforms the RBI introduced

Liquidity Adjustment (LAF). RBI uses LAF as an instrument to adjust liquidity and money
supply.
The following types of LAF are:

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Repo rate

Repo rate: Repo rate is a collaterised lending rate at which banks borrow from RBI on a short-
term basis against a repurchase agreement. Under this policy, banks are required to provide
government securities as collateral and later buy them back after a pre-defined time

Central Bank Commercial Bank

Short Term Fund

7
Y Repo Rate pm

Commercial credit
INFLATION Repo rate Bank Funding
Expensive
creation

Commercial credit
RECESSION Repo rate Bank Funding
Cheaper
creation

Reverse Repo rate

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Reverse Repo Rate : It is the reverse of repo rate, i.e., this is the rate RBP pays to banks in
order to keep additional funds in RBI. It is linked to repo rate in the following way:

Reverse Repo Rate = Repo rate — 1

Central Bank Commercial Bank

Surplus Fund

Rev. Reporate

Commercial Bank credit

INFLATION Reverse
Repo rate
pork surplus
with RBI
creation

Commercial Bank credit

RECESSION Reverse
Repo rate
pork surplus
with RBI
creation

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Marginal Standing Facility (MSF) Rate: MS Rate is the penal rate at which the Central Bank
lends money to banks, 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 Banks availing MSF
Rate can use a maximum of 1% of SLR securities

Central Bank Commercial Bank

Lending
Max. 1% of SLR

I Penal Rate
in

MSF Rate = Repo Rate + 1

The organizational structure

of
Monetary Policy Decisions

The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for giving a
statutory backing to
setting up a Monetary Policy Committee (MPC) and
the Monetary Policy Framework Agreement (MPFA)

The Monetary Policy Committee (MPC) consisting of six members shall determine policy rate
to achieve the inflation target through debate and majority vote by panel of experts.

The Monetary Policy Framework Agreement is an agreement reached between the Government
of India and the Reserve Bank of India (RBI) on the maximum tolerable inflation rate the RBI
should target to achieve price stability

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The amended RBI Act (2016) provides for a statutory basis for the implementation of the
‘flexible inflation targeting framework’. Announcement of an official target range for inflation
is known as inflation targeting.

The Expert Committee under Urijit Patel to revise the monetary policy framework, in its report
in January, 2014 suggested that RBI abandon the ‘multiple indicator’ approach and make
inflation targeting the primary objective of its monetary policy.

Inflation targeting

Announcement of an office target range

For
Inflation is called Inflation targeting

It is set by Govt. of India, once in every 5 years.

Accordingly

Central Govt. RBI Failure

Notified Mandated Factors
to
4% CPI Publish If
Inflation target Av. Inflation
from Monetary is
5/8/2016 to 31/3/2021 Policy
Report
More Less
upper Lower every than than
tolerance tolerance 6 Months upper Lower
6% 2% limit limit
explaining
forecast of inflation For Any
for 3
6 – 18 months consecutive
Quarters

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 Multiple Choice Questions
CHAPTER -3 (UNIT -3)

Chapter -3 (Unit –3)

MONETARY POLICY

1. What is monetary policy? (d) Control inflationary pressures

(a) Government policies that 6. The interest rate at which the central
regulate international trade bank lends money to commercial banks is
(b) Government policies that control known as the:
fiscal deficits (a) Prime rate
(c) Central bank policies that manage the (b) Discount rate
money supply and interest rates (c) Federal funds rate
(d) Central bank policies that control (d) Treasury rate
inflation 7. Open market operations refer to the
2. The primary goal of monetary policy is to: central bank's buying and selling of:
(a) Achieve full employment (a) Government securities in the
(b) Control the government's secondary market
budget deficit (b) Foreign currencies in the foreign
(c) Stabilize the stock market exchange market
(d) Maintain price stability and economic (c) Commodities in the stock market
growth (d) Real estate properties
3. The central bank can expand the money 8. An increase in the reserve requirement by
supply by: the central bank will lead to:
(a) Selling government bonds in (a) An increase in money supply and
the open market lower interest rates
(b) Raising the reserve requirements for (b) A decrease in money supply and lower
banks interest rates
(c) Decreasing the discount rate (c) An increase in money supply and
higher interest rates
(d) Lowering interest rates on loans to (d) A decrease in money supply and
banks higher interest rates
4. When the central bank buys government 9. In a situation of economic recession, the
securities in the open market, it is central bank is likely to implement:
conducting: (a) Expansionary monetary policy
(a) Tight monetary policy (b) Contractionary monetary policy
(b) Expansionary monetary policy (c) Fiscal policy
(c) Contractionary monetary policy (d) A fixed exchange rate policy
(d) Fiscal policy 10. Quantitative easing (QE) is a monetary
5. Contractionary monetary policy is policy tool used by central banks to:
designed to (a) Increase inflation
(b) Reduce unemployment (a) Reduce the budget deficit
(c) Stimulate economic growth (b) Control inflation
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CHAPTER -3 (UNIT -3)

(c) Lower interest rates (d) The money supply is unable to keep
(d) Increase the money supply and up with rising demand in the economy
stimulate economic growth 13. A central bank's target for inflation is
11. he term "moral suasion" in the context of often expressed through:
monetary policy refers to the central (a) The GDP growth rate
bank's ability to: (b) The unemployment rate
(a) Influence consumer behavior (c) The consumer price index (CPI) or the
through advertising campaigns inflation rate
(b) Persuade commercial banks to comply (d) The exchange rate
with its policy recommendations 14. During periods of economic expansion, a
(c) Control international trade central bank may pursue a policy of:
agreements (a) Tightening money supply and raising
(d) Limit speculative trading in financial interest rates
markets (b) Expanding money supply and
12. The "liquidity trap" is a situation where: lowering interest rates
(a) Interest rates are extremely (c) Reducing government spending and
high, leading to reduced investment increasing taxes
(b) Interest rates are extremely low, (d) Decreasing money supply and
leading to ineffective monetary policy increasing government spending
(c) Inflation is very low or negative,
causing deflationary pressures

Answer Key
1 C 2 D 3 D 4 B 5 D 6 B 7 A 8 D 9 A 10 D

11 B 12 B 13 C 14 A

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