Monetary Policies & its transmission mechanism

1. A Report on Monetary Policies & its transmission mechanism
Under the guidance of
Prof. (Dr.) A.K.Mishra
Dean SW, Faculty FMS
IMIS,Bubaneswar
as a part of academic project of
Institute of Management and Information Science, Bhubaneswar
PGDM (MKTG),Term-III for the core paper
Financial Market & Services(FMS C-304)
by Gopal Kumar(13DM041)
Anurag Guha(13DM040)
Utsho Chowdhary(13DM039)
Pritish k.Biswal(13DM037)

2. Executive Summary
Due to the down turn in the economy worldwide and in India. It is imperative to
study and understand the monetary technicalities. The optimism about Indian
economic growth portends well for Indian banks. There are however, challenges in
retaining profitability and growth in the next decade. It basically identifies two
critical and complex challenges thrown at the economy
1.Monetary policy
2.It's Transmission mechanism
This report highlights major facets of monetary policy and the transmission
mechanism and articulates suggestive measures for potential success.
Table of contents
Monetary Policy: Definition & Objective
Monetary operations
Monetary Transmission Mechanism: Diagram
Issues in monetary transmission
Monetary transmission channels
Conclusion: Key characteristics of a successful monetary policy
References
Monetary Policy

3. Monetary policy is a process by which monetary authority of the country, usually
the Central Bank controls the supply of money in the economy by exercising its
control over interest rates to maintain price stability and achieve high economic
growth. In India RBI(Reserve Bank of India) is the central monetary authority.
Other Objectives of the monetary policy as stated by RBI are:
Price Stability: It implies promoting economic development with considerable
emphasis on price stability. The centre of focus is to facilitate the environment
which is favourable to the architecture that enables the developmental projects to
run swiftly while also maintaining reasonable price stability.
Prevailing rates are as follows
Rates Prevailing Rate Expected
GDP 4.7% 4.9%
CPI 6.73% 6.0%
WPI 5.8% 5.7%
Inflation 9.30% 8.30%
Controlled expansion of Bank Credit:One of the important functions of RBI is the
controlled expansion of bank credit and money supply with special attention to
seasonal requirement for credit without affecting the output.
Promotion of Fixed Investment:Goal here is to increase the productivity of
investment by restraining non essential fixed investment.
Restriction of Inventories: Overfilling of stocks and products becoming out dated
due to excess of stock often results is sickness of the unit. To avoid this problem
the central monetary authority carries out this essential function of restricting the
inventories. The main objective of this policy is to avoid over-stocking and idle

4. money in the organization.
Promotion of Exports and Food Procurement Operations: Monetary policy pays
special attention in order to boost exports and facilitate the trade. It is an
independent objective of monetary policy.
Desired Distribution of Credit: Monetary authority has control over the decisions
regarding the allocation of credit to priority sector and small borrowers. This
policy decides over the specified percentage of credit that is to be allocated to
priority sector and small borrowers.
Equitable Distribution of Credit: The policy of Reserve Bank aims equitable
distribution to all sectors of the economy and all social and economic class of
people.
To Promote Efficiency: It is another essential aspect where the central banks pay a
lot of attention. It tries to increase the efficiency in the financial system and tries to
incorporate structural changes such as deregulating interest rates, ease operational
constraints in the credit delivery system, to introduce new money market
instruments etc.
Reducing the rigidity: RBI tries to bring about the flexibilities in the operations
which provide a considerable autonomy. It encourages more competitive
environment and diversification. It maintains its control over financial system
whenever and wherever necessary to maintain the discipline and prudence in
operations of the financial system.
Monetary Operations
Monetary operations involve monetary techniques which operate on monetary
magnitudes such as money supply, interest rates and availability of credit aimed to

5. maintain Price Stability, Stable exchange rate, Healthy Balance of
Payment,Financial Stability, Economic Growth, Stable Exchange Rate.RBI
monitors and regulates the monetary policy of the country stabilizes the price by
controlling inflation.
Open Market Operations:An open market operation is an instrument of monetary
policy which involves buying or selling of government securities from or to the
public and banks. This mechanism influences the reserve position of the banks,
yield on government securities and cost of bank credit. The RBI sells government
securities to contract the flow of credit and buys government securities to increase
credit flow. Open market operation makes bank rate policy effective and maintains
stability in government securities market.
Cash Reserve Ratio:Cash Reserve Ratio is a certain percentage of bank
deposits which banks are required to keep with RBI in the form of reserves or
balances .Higher the CRR with the RBI lower will be the liquidity in the system
and viceversa.RBI is empowered to vary CRR between 15 per cent and 3 per cent.
But as per the suggestion by the Narshimam committee Report the CRR was
reduced from 15% in the 1990 to 5 per cent in 2002. As of October 2013, the CRR
is 4%.
Statutory Liquidity Ratio:Every financial institution has to maintain a certain
quantity of liquid assets with themselves at any point of time of their Net time and
demand liabilities(NDTL). These assets can be cash, precious metals, approved
securities like bonds etc. The ratio of the liquid assets to time and demand
liabilities(NDTL) is termed as the Statutory liquidity ratio. There was a reduction
of SLR from 38.5% to 25% because of the suggestion by Narshimam Committee.
The current SLR is 23%.
Bank Rate Policy:The bank rate, also known as the discount rate, is the rate of
interest charged by the RBI for providing funds or loans to the banking system.
This banking system involves commercial and co-operative banks, Industrial
Development Bank of India, IFC, EXIM Bank, and other approved financial
institutes. Funds are provided either through lending directly or rediscounting or

6. buying money market instruments like commercial bills and treasury bills. Increase
in Bank Rate increases the cost of borrowing by commercial banks which results
into the reduction in credit volume to the banks and hence declines the supply of
money. Increase in the bank rate is the symbol of tightening of RBI monetary
policy. Prevailing Bank Rate is 9%.
Credit Ceiling:In this operation RBI issues prior information or direction that loans
to the commercial banks will be given up to a certain limit. In this case commercial
bank will be tight in advancing loans to the public. They will allocate loans to
limited sectors. Few example of ceiling are agriculture sector advances, priority
sector lending.
Credit Authorization Scheme:Credit Authorization Scheme was introduced in
November, 1965 when P C Bhattacharya was the chairman of RBI. Under this
instrument of credit regulation RBI as per the guideline authorizes the banks to
advance loans to desired sectors.
Moral suasion:Moral Suasion is just as a request by the RBI to the
commercial banks to take so and so action and measures in so and so trend of the
economy. RBI may request commercial banks not to give loans for unproductive
purpose which does not add to economic growth but increases inflation.
Repo Rate & Reverse Repo Rate:Repo rate is the rate at which RBI lends to
commercial banks generally against government securities. Reduction in Repo rate
helps the commercial banks to get money at a cheaper rate and increase in Repo
rate discourages the commercial banks to get money as the rate increases and
becomes expensive.Prevailing repo rate is 8%.
Reverse Repo rate is the rate at which RBI borrows money from the commercial
banks. The increase in the Repo rate will increase the cost of

7. borrowing and lending of the banks which will discourage the public to borrow
money and will encourage them to deposit. As the rates are high the availability of
credit and demand decreases resulting to decrease in inflation.Prevailing reverse
repo rate is 7%.
Marginal Standing Facility Rate: Under this scheme, Banks are able to borrow up
to 2% of their respective NDTL outstanding at the end of second preceding
fortnight. The rate of interest on the amount accessed from this facility wef 7th oct
2013 has been fixed at 9%.
Transmission Mechanism

8. Official Interest Rate
Expectations Money Market Rates
Money, Credit Exchange ratesAsset Prices Bank Rates
Supply and demand in goods and labour marketsWage and Price-Setting
Domestic Prices Import Prices
Price Developments
Monetary Transmission Mechanism
the process through which changes in monetary policy instruments affect output
and inflation. Moreover, the transmission lags are not only long but often also
found to be variable. The variability of the lags has been accentuated by the
ongoing financial deregulation, liberalization and innovations in a large number of
economies.
 Reflecting the process of financial liberalization, there have been changes in
operating procedures of monetary policy
 Like other Emerging Market Economies (EMEs), monetary policy in India
has witnessed significant changes in its operating procedures and
instruments. A multiple indicator approach has been put in place in lieu of
the earlier monetary targeting approach. With gradual deregulation of
financial markets and a move towards indirect instruments of monetary
management, short-term interest rates have emerged as instruments of
conveying the monetary policy stance. At the same time, rigidities in the
market rates of interest have blunted the effectiveness of monetary policy
actions.

9. Issues in Monetary Transmission
For monetary policy to be effective, it is, therefore, essential to have a broad
understanding of these channels and the associated lags. Monetary policy affects
output and prices through its influence on key financial variables such as interest
rates, exchange rates, asset prices, credit and monetary aggregates. At the same
time, changes in the structure of the economy tend to alter the effects of a given
monetary policy measure. This requires central banks to continuously reinterpret
monetary transmission channels.
The recent literature has also focused on the role of transparency in the
transmission mechanism. A part of the impetus to greater transparency can be
attributed to the framework of inflation targeting followed by a number of
economies. A key feature of inflation targeting vis-à-vis the previous regimes is the
focus on transparency. However, even central banks that do not follow an inflation
targeting regime have increasingly realized that transparency adds to the credibility
of their policy actions. Transparency buttresses the credibility of a central bank and
this raises the effectiveness of central bank policy actions.
Monetary Transmission Channels
the channels through which money affects output and prices have been subject to
intense debate and widespread research since long. The theoretical underpinnings
of direct influence of money supply on the general prices can be traced back to the
quantity theory of money (QTM) and there is no denying of this fact except adding
structural factors as additional arguments in the price determination.
A synthetic framework delineating Channels of Monetary Transmission in Path
Diagram
The traditional interest rate can be presented as

10. where,M=money,r=real interest rate, I=real investment, and Y=real output
By extending the traditional interest rate channel to foreign exchange and equity
markets, the exchange rate channel and the asset prices channels of monetary
transmission as discussed in the previous section can be presented in following
M ^ => r i => Depreciation = > Net Exports t => Y^
and,
M ^= > P e ^ = > Q^ = > l ^ = > Y^
Where Pe=equity price,Q=Tobin’s Q
The monetary transmission channel through wealth effect can be depicted as
M^ => Pe ^ => Wealth ^ => Consumption Spending ^ => Y ^
the credit channels are broadly categorized as bank lending channel and bank
balance sheet channel. The bank lending channel can be presented as,
M^ => Bank Deposits^ => Bank Lending^ => 1 ^ => Y ^
Our estimations of path analysis for annual data are based on the path model
graphically depicted in the path. In this model, the credit channel operates through
the normal Money-* Deposit—* Credit—• Investment—•Output route.
The Monetary Policy Instruments

11. The Monetary Policy Instruments
Standing Facilities Open Market Operations Reserve Requirements
Deposit
facility
Marginal
Lending
facility
Main refinancing
operations
Longer-term
refinancing
operations
Fine-tuning
Operations
Structural
Operations
Reserve Base
Deposits, Debt securities
and money market paper
Reserve Ratio
For the majority of the items
to which the reserve base
applies
Remuneration
Reserve holdings will be
remunerated at the rbi’s rate on
its main refinancing operations
To achieve its primary objective of maintaining price stability, the central bank(rbi)
has at its disposal a set of monetary policy instruments.
Open Market Operations
 Open market operations represent the most important instrument. They serve
to steer interest rates,
 to manage the liquidity situation in the money market, and
 to signal the monetary policy stance
Conclusion
Key characteristics of a successful monetary policy

12. Monetary Policy aims to
 Preserve the functioning of the transmission mechanism
 Be forward looking and pre-emptive
 Focus on the medium term
 Firmly anchor inflation expectations
 Be broadly based
* It requires properly functioning money markets if its transmission
mechanism is to work. An effective transmission depends on the behaviour
of banks and on their willingness to ensure smooth exchanges of liquidity in
the interbank market. Dysfunctional money markets can weaken the
influence of monetary policy on the outlook for price stability;
* The policy needs to be forward-looking and pre-emptive. Changes in policy
today will only affect the price level after a number of quarters or years. So a
central bank needs to ensure that the impact of the decisions and actions it
takes today will maintain price stability in the future;
* It should have a medium-term orientation to avoid excessive activism and
the introduction of unnecessary volatility into the real economy. Monetary
policy cannot prevent some short-term volatility in inflation rates, caused,
for example, by changes in international commodity prices;
* It should firmly anchor inflation expectations. To that end, a central bank
should specify its goal, elaborate and keep to a consistent and systematic
method for conducting monetary policy, and communicate clearly and
openly. These help it to be credible, which is essential if it is to influence the
expectations of businesses and households.
* Monetary policy has to be broadly based and take into account all relevant
information in order to understand the factors affecting the economy
References
www.rbi.org.in
www.ecb.europa.eu
www.investopedia.com
www.indiabulls.com
www.articles.economictimes.indiatimes.com