2. Monetary policy is the process by which the
government, central bank or monetary authority of a
country controls
(i) the supply of money
(ii) availability of money
(iii) cost of money or rate of interest
in order to attain a set of objectives oriented
towards the growth and stability of the economy
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3. To ensure a stable currency value
Price stability
Economic stability or full employment
Rapid economic growth
Balance of payments equilibrium
Greater equality in distribution of
income & wealth
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4. To maintain continuously low rate of interest
To create a continuous market for
government securities
To provide credit at differential rate of interest
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5. There is convergence of views in developed and
developing economies, that price stability is the
dominant objective of monetary policy.
Price stability does not mean complete year-to-year
price stability which is difficult to attain.
Price stability refers to the long run average stability
of prices.
Price stability involves avoidance of both inflationary
and deflationary pressures.
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6. Price Stability contributes improvements in the
standard of living of people.
It promotes saving in the economy while
discouraging unproductive investment.
Stable prices enable exports to compete in
international markets and contribute to the
strengthening of BoP.
Price stability leads to interest rate stability, and
exchange rate stability (via export import stability).
It contributes to the overall financial stability of the
economy.
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7. It depends mainly on two factors
1. level of monetized economy
2. level of development of capital
market
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8. Expansionary policy
expansionary policy increases the total supply of money in
the economy
used to combat unemployment in a recession by lowering
interest rates.
Contractionary policy
contractionary policy decreases the total money supply
involves raising interest rates in order to combat inflation
increasing interest rates slows the economy by making funds
more expensive to firms, and promotes consumer savings
which decreases revenues by firms.
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9. Open market operations
Bank rate
Variable reserve ratio
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10. Open Market Operations involve buying
(outright or temporary) and selling of
government securities by the central
bank, from or to the public and banks.
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11. Open-Market Operations
Buying Securities
From commercial banks...
Bank gives up securities
RBI pays bank
Banks have increased reserves
From the public...
Public gives up securities
Public deposits check in bank
Banks have increased reserves
Buying increases the money supply and lowers
rates
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12. Selling Securities
To commercial banks...
RBI gives up securities
Bank pays for securities
Banks have decreased reserves
To the public...
RBI gives up securities
Public pays by check from bank
Banks have decreased reserves
Selling decreases the money supply and
increases rates
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13. Banks are required to maintain a certain
percentage of their deposits in the form of
reserves or balances with the RBI
It is called Cash Reserve Ratio or CRR
Since reserves are high-powered money or
base money, by varying CRR, RBI can reduce
or add to the bank’s required reserves and
thus affect bank’s ability to lend.
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14. Raising the Reserve Ratio
Banks must hold more reserves
Banks decrease lending
Money supply decreases
Lowering the Reserve Ratio
Banks may hold less reserves
Banks increase lending
Money supply increases
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15. Discount rate is the rate of interest charged by the
central bank for providing funds or loans to the banking
system.
Funds are provided either through lending directly or
rediscounting or buying commercial bills and treasury
bills.
Raising Bank Rate raises cost of borrowing by
commercial banks, causing reduction in credit volume to
the banks, and decline in money supply.
Variation in Bank Rate has an effect on the domestic
interest rate, especially the short term rates.
Market regards the increase in Bank rate as the official
signal for beginning of a tight money situation.
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16. Instruments
1. Discount Rate
(Bank Rate)
2.Reserve Ratios Operating
Target
3. Open Market
Operations
• Monetary Base
• Bank Credit Intermediate
• Interest Rates Target
•Monetary
Aggregates(M3)
Ultimate
•Long term Goals
interest rates
•Total Spending
• Price Stability
Etc.
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17. Credit Rationing
Change in lending margins
Moral Suasion
Direct Controls
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18. MONETARY POLICY AND EQUILIBRIUM GDP
Sm1 Sm2 Sm3
Investment
Demand
Real rate of interest, i
10 10
8 8
6 6
Dm
0 0
Quantity of money demanded and supplied Amount of investment, i
AS If the Money Supply
Increases to Stimulate
the Economy…
Interest Rate Decreases
Price level
P3
Investment Increases
P2 AD & GDP Increases
P1 AD3(I=$25) with slight inflation
AD2(I=$20) Increasing money supply
AD1(I=$15) continues the growth –
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Real domestic output, GDP
NVK
but, watch Price Level. 18
19. Time lag
1. Recognition lag
2. Action lag
3. Effect lag
Problem in forecasting
Non Banking financial Intermediaries
Under development of money and Capital
Markets
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