Monetary Policy Iimm

7/27/2019 Monetary Policy Iimm

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Monetary Policy



Objectives of monetary policy

1. Maximum feasible output

2. High rate of economic growth

3. Fuller employment

4. Price stability

5. Greater equality in the distribution of

income and wealth

6. Healthy balance of payments



Monetary policy

• MP is a programme of action taken by the

monetary authorities generally the central

bank, to control and regulate the supply of

money with the public and flow of creditwith a view to achieve predetermined

macroeconomic goals.



Limitations of monetary policy

• Time lag

• Problems in forecasting : Some units of an

economy are beyond the scope of

monetary policy (unorganized markets,

parallel economy)

• Underdeveloped money and capital

market



The Reserve Bank

• The Reserve Bank serves as the nation’s

central bank.

It is designed to oversee the banking

system.

It regulates the quantity of money in the

economy.

It was created in 1935 to restoreconfidence in the nation’s banking system.



Three Primary Functions

of the RBI

• Regulates banks to ensure they follow

central laws intended to promote safe and

sound banking practices.• Acts as a banker’s bank, making loans to

banks and as a lender of last resort.

• Conducts monetary policy by controllingthe money supply.



Instruments of monetary policy

• Quantitative credit control:-

1. Open market operations

2. Bank Rate Policy

3. Reserve Requirement changes

• Selective / Qualitative Credit Control:-

1. Direct Action2. Changes in margin requirements

3. Regulation of consumer credit

4. Moral suasion



Open-Market Operations

• Open-Market Operations

• The money supply is the quantity of money

available in the economy.

• The primary way in which the RBI changes themoney supply is through open-market

operations.

• The RBI purchases and sells government

securities.





Banks and The Money Supply

• Reserves are deposits that banks have

received but have not loaned out.

• In a fractional reserve banking system, banks

hold a fraction of the money deposited asreserves and lend out the rest.

• When a bank makes a loan from its reserves,

the money supply increases

• The reserve ratio is the fraction of deposits that

banks hold as reserves.



Money Creation

• The money supply is affected by the amountdeposited in banks and the amount that banks

loan.

Deposits into a bank are recorded as both assetsand liabilities.

The fraction of total deposits that a bank has to

keep as reserves is called the reserve ratio.

Loans become an asset to the bank.



Money Creation

•This T-Account shows a

bank that…

accepts deposits,

keeps a portion asreserves,

and lends out the rest.

•It assumes a reserveratio of 10%.

Assets Liabilities

First National Bank

ReservesRs 100.00

Loans

Rs 900.00

DepositsRs 1000.00

Total Assets

Rs 1000.00

Total Liabilities

Rs 1000.00



Money Creation with Fractional-Reserve Banking

• When one bank loans money, that money

is generally deposited into another bank.

• This creates more deposits and more

reserves to be lent out.

• When a bank makes a loan from its

reserves, the money supply increases.

• The money multiplier is the amount of

money the banking system generates with

each rupee of reserves.



Assets Liabilities

First National Bank

Reserves

Rs100.00

Loans

Rs900.00

Deposits

Rs1000.00

Total Assets

Rs100.00

Total Liabilities

Rs1000.00

Assets Liabilities

Second National Bank

Reserves

Rs90.00

Loans

Rs810.00

Deposits

Rs900.00

Total Assets

Rs900.00

Total Liabilities

Rs900.00

Money Supp ly = Rs1900.00!

Money Creation



The Money Multiplier How much money is eventually createdin this economy?

Original deposit = Rs 1000.00 First National lending = Rs 900.00 [=0.9 x 1000.00] Second National lending = Rs 810.00 [=0.9 x 900.00] Third National lending = Rs 720.90 [=0.9 x 810.00]

Total money supply

= Rs 10,000



The Money Multiplier

The money multiplier is the reciprocal of the

reserve ratio:

M = 1/R

•With a reserve requirement, R = 20% or 1/5,

•The multiplier is 5.



Tools of Monetary Control

• Reserve Requirements

• The RBI also influences the money supply with

reserve requirements.

• Reserve requirements are regulations on the

minimum amount of reserves that banks must

hold against deposits.




• Changing the Reserve Requirement

• The reserve requirement is the amount (%) of

a bank’s total reserves that may not be loaned

out.• Increasing the reserve requirement decreases the

money supply.

• Decreasing the reserve requirement increases the

money supply.




• Changing the Discount Rate

• The discount rate is the interest rate the RBI

charges banks for loans.

• Increasing the discount rate decreases the moneysupply.

• Decreasing the discount rate increases the money

supply.



Selective Control

• Qualitative Tools / Selective credit control:

1. Moral suasion

2. Direct action3 Fixation of maximum limit on advances to

individual borrowers.

Documents

Monetary Policy Iimm