monetary policy with respect to BOP

7/29/2019 monetary policy with respect to BOP

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INTRODUCTION

Monetary policy is the process by which the central bank or monetary authority of acountry controls the supply of money, often targeting a rate of interest. Monetary

policy is usually used to attain a set of objectives oriented towards the growth and

stability of the economy. These goals usually include stable prices and low

unemployment. Monetary theory provides insight into how to craft optimal monetary

policy.

Monetary policy is referred to as either being an expansionary policy, or a

contractionary policy, where an expansionary policy increases the total supply of

money in the economy rapidly, and a contractionary policy decreases the total money

supply or increases it only slowly. Expansionary policy is traditionally used to combat

unemployment in a recession by lowering interest rates, while contractionary policy

involves raising interest rates to combat inflation.

Monetary policy is contrasted with fiscal policy, which refers to government

borrowing, spending and taxation.

An attempt to achieve broad economic goals by theregulation of the supply of money.

WHAT IS MONETARY POLICY?

Monetary policy is the management of money supply and interest rates by central

banks to influence prices and employment. Monetary policy works through expansion

or contraction of investment and consumption expenditure.

Monetary policy is the process by which the government, central bank (RBI in India),

or monetary authority of a country controls

(i) the supply of money(ii) availability of money


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(iii) Cost of money or rate of interest , in order to attain a set of objectives orientedtowards the growth and stability of the economy. Monetary theory provides

insight into how to craft optimal monetary policy.



money in the economy, and a contractionary policy decreases the total money supply.

Expansionary policy is traditionally used to combat unemployment in a recession by

lowering interest rates, while contractionary policy involves raising interest rates in

order to combat inflation. Monetary policy is contrasted with fiscal policy, which

refers to government borrowing, spending and taxation

WHY IT IS NEEDED?

What monetary policy at its best can deliver is low and stable inflation, and

thereby reduces the volatility of the business cycle. When inflationary pressures build

up, it is monetary policy only which raises the short-term interest rate (the policy

rate), which raises real rates across the economy and squeezes consumption andinvestment.

The pain is not concentrated at a few points, as is the case with government

interventions in commodity markets.

Monetary policy in India underwent significant changes in the 1990s as the Indian

Economy became increasing open and financial sector reforms were put in place. In

the 1980s, monetary policy was geared towards controlling the quantum, cost and

directions of credit flow in the economy. The quantity variables dominated as the

transmission Channel of monetary policy. Reforms during the 1990s enhanced the

sensitivity of price signals from the central bank, making interest rates the

increasingly Dominant transmission channel of monetary policy in India.


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Balance of payment

BOP The two principal parts of the BOP accounts are the current account and

the capital account.

The current accountshows the net amount a country is earning if it is in surplus, or

spending if it is in deficit. It is the sum of the balance of trade (net earnings on exports

minus payments for imports), factor income (earnings on foreign investments minus

payments made to foreign investors) and cash transfers. It is called

the currentaccount as it covers transactions in the "here and now" - those that don'tgive rise to future claims.

The Capital Accountrecords the net change in ownership of foreign assets. It includes

the reserve account (the foreign exchange market operations of a nation's central

bank), along with loans and investments between the country and the rest of world

(but not the future regular repayments/dividends that the loans and investments yield;

those are earnings and will be recorded in the current account). The term "capital

account" is also used in the narrower sense that excludes central bank foreign

exchange market operations: Sometimes the reserve account is classified as "below

the line" and so not reported as part of the capital account.

Expressed with the broader meaning for the capital account, the

BOP identity assumes that any current account surplus will be balanced by a capital

account deficit of equal size - or alternatively a current account deficit will be

balanced by a corresponding capital account surplus:

The balancing item, which may be positive or negative, is simply an amount that

accounts for any statistical errors and assures that the current and capital accounts

sum to zero. By the principles ofdouble entry accounting, an entry in the current

account gives rise to an entry in the capital account, and in aggregate the two accounts

automatically balance. A balance isn't always reflected in reported figures for the

current and capital accounts, which might, for example, report a surplus for both
http://en.wikipedia.org/wiki/Current_accounthttp://en.wikipedia.org/wiki/Capital_accounthttp://en.wikipedia.org/wiki/Balance_of_tradehttp://en.wikipedia.org/wiki/Factor_incomehttp://en.wikipedia.org/wiki/Capital_account#Central_Bank_operations_and_the_reserve_accounthttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Accounting_identityhttp://en.wikipedia.org/wiki/Double_entry_accountinghttp://en.wikipedia.org/wiki/Double_entry_accountinghttp://en.wikipedia.org/wiki/Accounting_identityhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Capital_account#Central_Bank_operations_and_the_reserve_accounthttp://en.wikipedia.org/wiki/Factor_incomehttp://en.wikipedia.org/wiki/Balance_of_tradehttp://en.wikipedia.org/wiki/Capital_accounthttp://en.wikipedia.org/wiki/Current_account


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accounts, but when this happens it always means something has been missedmost

commonly, the operations of the country's central bankand what has been missed is

recorded in the statistical discrepancy term (the balancing item).

An actual balance sheet will typically have numerous sub headings under the principal

divisions. For example, entries underCurrent account might include:

Tradebuying and selling of goods and services Exportsa credit entry

Importsa debit entry Trade balancethe sum of Exports and Imports

Factor incomerepayments and dividends from loans and investments Factor earningsa credit entry Factor paymentsa debit entry

Factor income balancethe sum of earnings and payments.Especially in older balance sheets, a common division was between visible and

invisible entries. Visible trade recorded imports and exports of physical goods

(entries for trade in physical goods excluding services is now often called

the merchandise balance). Invisible trade would record international buying and

selling of services, and sometimes would be grouped with transfer and factor

income as invisible earnings.


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EVOLUTION OF MONETARY POLICY

The Reserve Bank of India is responsible for formulating and implementing MonetaryPolicy. For explanation of monetary policy, the whole period has been divided into 4 sub

periods

a) Monetary policy of controlled expansion (1951 to 1972)

b) Monetary Policy during Pre Reform period (1972 to 1991)

c) Monetary Policy in the Post-Reforms (1991 to 1996)

d) Easing of Monetary policy since Nov 1996

Monetary policy of controlled expansion (1951 to 1972)

To regulate the expansion of money supply and bank credit to promote growth. To restrict the excessive supply of credit to the private sector so as to control

inflationary pressures.

Following steps were taken:1) Changes in Bank Rates ,SLR2) Margins were increased.

As a result of the above changes, the supply of money increased from 3.4% (1951) to 9.1

(1965)


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Monetary Policy during Pre Reform period (1972 to 1991):

Also known as the Tight Monetary policy: Price situation worsened during 1972 to

1974. Following Monetary Policy was adopted in 70s and 80s which were mainly

concerned with the task neutralizing the impact of fiscal deficit and inflationary pressure.

1) Changes in CRR & SLR.

Easing of Monetary policy since Nov 1996:

In 1996-97, the rate of inflation sharply declined. In the later half 1996-97, industrial

recession gripped the Indian economy. To encourage the economic

Growth & to tackle the recessionary trend, the RBI eased its monetary policy.

1. Introduction of Repo rate. This instrument was consistently used in the monitorypolicy as a result of rapid industrial growth during 2005-06.

2. Reverse Repo rateThrough RRR, RBI mops up liquidity from the banking system.3. Flow of credit to Agriculture had increased.4. Reduction in Cash Reserve Ratio (CRR).5. Lowering Bank rate.

MONETARY POLICY REFORMS SINCE 1991

The first important step was introduction of an auction system for the central governments

market borrowings in June 1992. This enabled an increasing proportion of the fiscal deficit

to be financed by borrowings at market related rates of interest this in turn enabled the

reserve bank to scale down the SLR.


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WAYS AND MEANS ADVANCES (WMA) REPLACE TREASURY

BILLS:

Following an agreement between the government and the reserve bank in September 1994,the automatic monetization of the centres fiscal deficit was eliminated by gradually phasing

out ad hocs by April 1997. A system of ways and means advances (WMA) to the central

government subject to mutually agreed limits at market related rates, was put in place

instead to meet mismatches in cash flows. Since the reserve bank reserves the right to trigger

floatation of fresh government loans as and when the actual utilization crosses 75% of the

limit, the WMA doesnt acquire the cumulative character of ad hocs. This enables the

reserve bank to accommodate the government at its direction and helps impose a market a

discipline on fiscal activism.

REACTIVATION of the BANK RATE:

Another major step towards a market based monetary policy was the reactivation of the bank

rate. In April 1997, the interest rate on the majority of the accommodation extended by the

reserve bank was initially linked to the bank rate. As the price of primary money is now

increasingly market determined, essentially at rates emerging out of the LAF auctions, the

bank rate is now used, more or less, as a signaling instrument of monetary policy in line

with the evolving macroeconomic and liquidity conditions.

DEREGULATION OF INTEREST RATE:

Deregulation of interest rates was central to the new market-oriented monetary strategy in

terms of rejuvenating the price discovery process. The process of interest rate liberalization

began in September 1991 with the discontinuation of sector specific and programmed

specific prescriptions excepting for a few areas like agriculture, and small industries. Loans

above Rs.2 Lakh were freed from various prescriptions, subject to the minimum lending rate

prescribed by the reserve bank. The process of deregulation was carried forward with the

withdrawal of the minimum lending rates in October 1994, thereby providing banks full

freedom to determine lending rates for loans above 2 lakhs.


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DEREGULATION OF CREDIT:

The reforms in credit regulation which began in the mid-1980, intensified in the 1990s with

a shift in focus from micro regulation towards macro management of credit. These included

a scaling down of pre-emptions in the form of statutory stipulations to expand the pool of

lendable resources, rationalization of priority sector requirements, phasing out direct credit

programmes and relaxation of balance sheet restrictions to improve the credit delivery

system

OBJECTIVES OF MONETARY POLICY

The objectives are to maintain price stability and ensure adequate flow of credit to

the productive sectors of the economy. Stability for the national currency (after

looking at prevailing economic conditions), growth in employment and income are

also looked into. The monetary policy affects the real sector through long and variable

periods while the financial markets are also impacted through short-term implications.

There are four main 'channels' which the RBI looks at:

Quantum channel: money supply and credit (affects real output and price levelthrough changes in reserves money, money supply and credit aggregates).

Interest rate channel. Exchange rate channel (linked to the currency). Asset price.

Monetary decisions today take into account a wider range of factors, such as:

short term interest rates; long term interest rates; velocity of money through the economy; exchange rate credit quality bonds and equities (corporate ownership and debt) government versus private sector spending/savings


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international capital flow of money on large scales financial derivatives such as options,swaps and future contracts etc.

FUNCTIONS OF MONETARY POLICY

Preparation of Reserve Bank's Annual Policy Statement and its Reviews ineach quarter.

Conduct of Technical Advisory Committee meetings on Monetary Policy ineach quarter before the announcement of Policy Statement/Reviews or at any

other time as and when needed.

Conduct of pre-policy consultation meetings with the bankers, marketparticipants, trade bodies, self-regulatory organisations and economists and

journalists to facilitate the policy formulation process.

Periodical meetings with banks on resource management. Conduct of Governors meetings with banks to announce Policy. Policy regarding monetary policy framework and instruments - Design and

Operations.

Monetary projections and preparation of monetary budget. Monitoring and review of developments in macroeconomic conditions, prices

and inflation, key monetary and banking aggregates, financial markets

including interest rates.

Monitoring and review of maintenance of CRR and SLR by scheduledcommercial banks.

Monitoring of relevant global developments, including monetary policydevelopments in select major economies.

Sanctioning and monitoring of refinance limits/utilisation in respect ofscheduled commercial banks.

Issue of Master Circular on Export Credit Refinance Facility every year inJuly.

Preparation of a Memorandum for the Central Board of Directors twice a yearreviewing the monetary and credit developments and policy measures taken

during the period.


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TYPES OF MONETARY POLICIES

In practice, all types of monetary policy involve modifying the amount of base

currency (M0) in circulation. This process of changing the liquidity of base currency

through the open sales and purchases of (government-issued) debt and credit

instruments is called open market operations.

Constant market transactions by the monetary authority modify the supply of currency

and this impacts other market variables such as short term interest rates and the

exchange rate.The distinction between the various types of monetary policy lies

primarily with the set of instruments and target variables that are used by the

monetary authority to achieve their goals

The different types of policy are also called monetary regimes, in parallel to exchange

rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold

standard results in a relatively fixed regime towards the currency of other countries on

the gold standard and a floating regime towards those that are not. Targeting inflation,

the price level or other monetary aggregates implies floating exchange rate unless the

management of the relevant foreign currencies is tracking the exact same variables

(such as a harmonized consumer price index).



money in the economy, and a contractionary policy decreases the total money

supply.Let us understand the detail difference between the two:

Expansionary monetary policy

It increases the total supply of money in the economy Used to overcome a depression gap. Is mainly introduced when demand falls It decreases the cost & increases availability of credit in the money market

thereby improving economy.


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It is traditionally used to combatunemploymentin a recessionby loweringinterest rates

Contractionary monetary policy

It decreases the total money supply in the economy A policy designed to curtail aggregate demand. When demand of goods &services rises the RBI starts restrictive monetary

policy thereby reducing consumption

It increases the cost & decreases availability of credit in the money marketthereby controlling inflationary pressures.

Contractionary policy has the goal of raising interest rates to combat inflation(or cool an otherwise overheated economy).

Guides To Monetary Policy

Although the goals of monetary policy are clearly spelled out in law,

the means to achieve those goals are not. Changes in the FOMCs target federal funds

rate take some time to affect the economy and prices, and it is often far from obvious

whether a selected level of the federal funds rate will achieve those goals. For this

reason, some have suggested that the Federal Reserve pay close attention to guides

that are intermediate between its operational targetthe federal funds rateand the

economy.

Concept of Money

Money defined as a generally acceptable means of payment or of settling debt, fulfils

three main functions; as a medium of exchange between buyers and sellers; as a unit

of account (for accounts, debts, financial assets, etc.) involving no exchange; and as a

store of value or of purchasing power, enabling income-earners to set aside a part of

their income to yield future consumption.
http://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Unemploymenthttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Interest_rateshttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Unemployment


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These components of money supply, when expressed in the Indian context, are constituted

of the following. Currency consists of notes and coins. From it one should exclude the cash

on hand with the banks. As a result, one is left with currency with the public.

Four Measures:

The Reserve Bank of India uses four measures of money supply. These are designated as

M1, M2, M3, M4.

M1: It consists of currency(currency notes and coins) with the public, demand deposits with

banks and other deposits with the Reserve Bank of India.

M1= Currency (currency notes and coins) with the public+ demand deposits with banks

(commercial and cooperatives)+ other deposits with RBI

M2: It constitutes of M1 plus post office savings and banks deposits.

M2= M1+ Post office savings bank deposits

M3: It is made up of M1 and time deposits with banks.

M3= M1+ time deposits with banks (commercial and cooperatives)

M4: It is M3plus total deposits with the post office savings organization.

M4= M3+ total deposits with the post office saving organisation


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Monetary policy tools

Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This

directly changes the total amount of money circulating in the economy. A central

bank can use open market operations to change the monetary base. The central bank

would buy/sell bonds in exchange for hard currency. When the central bank

disburses/collects this hard currency payment, it alters the amount of currency in the

economy, thus altering the monetary base.

Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be

implemented by changing the proportion of total assets that banks must hold in

reserve with the central bank. Banks only maintain a small portion of their assets as

cash available for immediate withdrawal; the rest is invested in illiquid assets like

mortgages and loans. By changing the proportion of total assets to be held as liquid

cash, the Federal Reserve changes the availability of loanable funds. This acts as a

change in the money supply. Central banks typically do not change the reserve

requirements often because it creates very volatile changes in the money supply due

to the lending multiplier.

Discount window lending

Many central banks or finance ministries have the authority to lend funds to financialinstitutions within their country. By calling in existing loans or extending new loans,

the monetary authority can directly change the size of the money supply.

Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the

nominal interest rates. Monetary authorities in different nations have differing levels


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of control of economy-wide interest rates. The Federal Reserve can set the discount

rate, as well as achieve the desired Federal funds rate by open market operations. This

rate has significant effect on other market interest rates, but there is no perfect

relationship. In the United States open market operations are a relatively small part of

the total volume in the bond market. One cannot set independent targets for both the

monetary base and the interest rate because they are both modified by a single tool

open market operations; one must choose which one to control.

In other nations, the monetary authority may be able to mandate specific interest rates

on loans, savings accounts or other financial assets. By raising the interest rate(s)

under its control, a monetary authority can contract the money supply, because higher

interest rates encourage savings and discourage borrowing. Both of these effects

reduce the size of the money supply.

Currency board

A currency board is a monetary arrangement which pegs the monetary base of a

country to that of an anchor nation. As such, it essentially operates as a hard fixed

exchange rate, whereby local currency in circulation is backed by foreign currency

from the anchor nation at a fixed rate. Thus, to grow the local monetary base an

equivalent amount of foreign currency must be held in reserves with the currency

board. This limits the possibility for the local monetary authority to inflate or pursue

other objectives. The principal rationales behind a currency board are three-fold:

1. To import monetary credibility of the anchor nation;2. To maintain a fixed exchange rate with the anchor nation;3. To establish credibility with the exchange rate (the currency board

arrangement is the hardest form of fixed exchange rates outside of

dollarization).

In theory, it is possible that a country may peg the local currency to more than one

foreign currency; although, in practice this has never happened (and it would be a

more complicated to run than a simple single-currency currency board).


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MONETARY POLICY OF INDIA

Monetary policy in India underwent significant changes in the 1990s as the

Indian Economy became increasing open and financial sector reforms were put in

place. in the 1980s,monetary policy was geared towards controlling the qunatam,cost

and directions.

Of credit flow in the economy. the quantity variables dominated as the transmission

Channel of monetary policy. Reforms during the 1990s enhanced the sensitivity of

price

Signals of price signals from the central bank, making interest rates the increasingly

Dominant transmission channel of monetary policy in India.

The openness of the economy, as measured by the ratio of merchandise

trade(exports Plus imports) to GDP, rose from about 18% in 1993-94 to about 26% by

2003-04. Including services trade plus invisibles, external transactions as a proportion

of GDP Rose from 25% to 40% during the same period. Along with the increase in

trade as a Percentage of GDP, capital inflows have increased even more sharply

,foreign currency.

Assets of the reserve bank of India(RBI) rose from USD 15.1 billion in the

march 1994 To over USD 140 billion by march 15,2005.these changes have affected

liquidity and Monetary management. Monetary policy has responded continuously to

changes in Domestics and international macroecomic conditions. In this process, the

current monetary operating framework has relied more on outright open market

operations and Daily repo and reserve repo operations than on the use of direct

instruments. Overnight Rate are now gradually emerging as the principal operating

target.

The Monetary and Credit Policy is the policy statement, traditionally

announced twice a year, through which the Reserve Bank of India seeks to ensure


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price stability for the economy. These factors include - money supply, interest rates

and the inflation.

Objectives:-

The objectives are to maintain price stability and ensure adequate flow of

credit to the Productive sectors of the economy. Stability for the national currency

(after looking at prevailing economic conditions), growth in employment and income

are also looked into. The monetary policy affects the real sector through long and

variable periods while the financial markets are also impacted through short-term

implications.

There are four main 'channels' which the RBI looks at:

Quantum Channel: Money supply and credit (affects real output and price level

through changes in reserves money, money supply and credit aggregates).

Bank Rate: Bank rate is the minimum rate at which the central bank provides loans tothe commercial banks. It is also called the discount rate.

Usually, an increase in bank rate results in commercial banks increasing their lending

rates. Changes in bank rate affect credit creation by banks through altering the cost of

credit.

Cash Reserve Ratio: All commercial banks are required to keep a certain amount of

its deposits in cash with RBI. This percentage is called the cash reserve ratio. The

current CRR requirement is 8 per cent.

CRR, or cash reserve ratio, refers to a portion of deposits (as cash) which bank have

to keep/maintain with the RBI. This serves two purposes. It ensures that a portion of

bank deposits is totally risk-free and secondly it enables that RBI controlling equidity

in the system, and thereby, inflation. Besides the CRR, banks are required to invest a


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portion of their deposits in government securities as a part of their statutory liquidity

ratio(SLR) requirements.

The government securities (also known as gilt-edged securities or gilts) are

bonds issued by the Central government to meet its revenue requirements. Although

the bonds are long-term in nature, they are liquid as they can be traded in the

secondary market. Since 1991, as the economy has recovered and sector reforms

increased, the CRR has fallen from 15 per cent in March 1991 to 5.5 per cent in

December 2001. The SLR has fallen from 38.5 per cent to 25 per cent over the past

decade.

Bank rate: 6 %

CRR; 8 %

Repo rate: 7.75%

Reverse Repo rate; 6 %

Monetary policy in different years

The monetarist statistical regularities have weakened for the 1970-90 period, in

comparison with the 1960-79 period where the influences of current and past business

activity on the money supply were weak, while the predictive value of changes in the

money stock for future output was large

National income and saving play vital role on formulation of monetary policy. As the

income increases the spending will also increase, thus monetary will be less

intensively required and same is the case with increase in saving .chart shows how the

finance systems generate the real money and nominal money .The existence of long-

run equilibrium

relationship among money and income represented by a money demand function also

has significant implications for monetary policy.


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The New Functions of Monetary Policies that have emerged

To reinforce the emphasis on price stability and well-anchored inflationexpectations while ensuring a monetary and interest rate environment that

supports export and investment demand in the economy so as to enable

continuation of the growth momentum.

To re-emphasize credit quality and orderly conditions in financial marketsfor securing macroeconomic and, in particular, financial stability while

simultaneously pursuing greater credit penetration and financial inclusion.

To respond swiftly with all possible measures as appropriate to the evolvingglobal and domestic situation impinging on inflation expectations and the

growth momentum.

Challenges before Monetary Policy :

Financial markets are unperturbed: with the flattening of yield curves, thecompression of risk spreads and the search foryields continues unabated.

Global imbalances have actually increased with no fears ofhard landing, but with some sense of readying for a bumpy soft landing.

Movements in major exchange rates are not reflecting fundamentals in an

environment of generalised elevation in asset prices and abundant liquidity.

Strong global economic growth could be accompanied by emerging pressureson core inflation the challenge facing us is to judge the compatibility of the

current pace of growth with non-accelerating inflation. In the event of a

judgment that the current growth momentum is more cyclical than structural,

the stance of monetary policy would need to reflect a sensitivity to the


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inevitability of a downturn. On the other hand, the judgment that structural

factors predominate would warrant a different policy stance.

An overriding concern faced by the Reserve Bank is the persistently highgrowth of bank credit, with attendant worries relating to the quality of bank

credit The sharp increase in credit to sectors such as housing, commercial real

estate and retail loans have also been worrisome on account of the

vulnerability of banks to credit concentration risks. It is difficult to arrive at a

clear judgment as to what rate of credit growth is too high in relation to

potential growth.

Some of the models integrate policy behavior with the banking system, thedemand for a broad monetary aggregate, and a rich array of goods and

financial market variables, providing a more complete understanding of the

monetary transmission mechanism.

Weak economic assumptions and large models combine to reveal difficultieswith sorting out policy effects that other approaches fail to bring out


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Instruments of monetary policy in India

The monetary policy is nothing but controlling the supply ofMoney. The big Daddy, i.e. the

RBI takes a look at the present levels and also takes a call on what should be the desired level

to promote growth, bring stability of price(low inflation) and foreign exchange.

The various instruments of monetary policy that the RBI

has and can use are:

A. Quantitative measures:

1. Open Market operations: Here, the RBI enters into sale and purchase ofgovernment securities and treasury bills. So the RBI can pump money into

circulation by buying back the securities and vice versa. In absence of an

independent security market (all Banks are state owned), this is not really

effective in India.

2. Bank rate policy: Popularly known as repo rate and reverse repo rate, it is therate at which the RBI and the Banks buy or exchange money. This resuts into

the flow of bank credit and thus effects the money supply.

3. Cash Reserve ratio (CRR): This is the percentage of total deposits that thebanks have to keep with RBI. And this instrument can change the money

supply overnight.

4. Statutory Liquidity Requirement (SLR): This is the proportion of depositswhich Banks have to keep liquid in addition to CRR. This also has a bearing

on money supply.

B. Qualitative measures:

1. Credit rationing: Imposing limits and charging higher/lower rates of interests inselective sectors is what you see is being done by RBI.

2. Moral suasion: We hear of RBI's directive of priority lending in Agriculturesector. Seems more of a directive rather than persuasion.


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How effective is monetary policy in India

(A critical analysis)

The specter of inflation has led the Reserve Bank of India (RBI) to repeatedly raise

interest rates and increase banks reserve requirements in classic monetary policy

responses. The RBI also faces the challenge of simultaneously managing the

exchange rate in the face of porous controls on international capital flows.

While the exchange rate has depreciated recently as capital inflows have cooled, the

hot button issue just a few months ago was whether the exchange rate should be kept

from appreciating. Some economists argued for preventing exchange rate

appreciation, and managing the inflationary impact of capital inflows by selling

government bonds, thus soaking up excess liquidity. Others favored an export-

competitive exchange rate policy, but also argued that monetary policy was

irrelevant as current inflationary symptoms were arising from temporary supply-side

shocks.

The radical position (at least by Indian policy standards) has been that the RBI

should focus on fighting inflation, but give itself more room to do so by allowing the

exchange rate to adjust to market conditions. One version of this stance is that raising

the interest rate is less effective as an inflation-fighting policy than allowing the rupee

to appreciate, as financial repression and underdeveloped financial markets keep

interest rate changes from rippling through the economy strongly enough.

There are several empirical analyses of the monetary transmission mechanism in

India. These suggest that the interest rate channel of monetary policy has strengthened

since 1998, which should not come as a surprise since there has been considerable

financial liberalization, accompanied by a revision of the RBIs policy approach. This

result comes out in an interesting fashion in a 2005 IMF study.The responses of firms

to monetary tightening vary by size and, while greater in the period 1998-2003 versus


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the prior half-decade, seem to involve a reversal of initial cutbacks in corporate debt.

Still, interest rates do affect firm borrowing behavior.

A better feel for the aggregate impacts of monetary policy comes from an economy

wide analysis. This suggests the interest rate is an effective inflation-fighting tool in

India even though, as the authors say, the financial market in India is not yet

matured.

The results even indicate that output recovers with a lag in the face of such interest

rate increases. All this sounds quite good from the perspective of what policymakers

are currently doing, though there is no modeling of inflation expectations in India.

Indian monetary policy is still very accommodative and interest rates need to rise

more to prevent global supply-side shocks from seeping into the broader economy.

Wholesale price inflation, the most widely watched measure in India, touched 8.24

percent in mid-May, far above the central bank's comfort zone of 5.5 percent for

2008/09.

The central bank held off outright rate increases for a year, opting instead to keep cash

availability tight, as prices pressures largely came from supply constraints and record

commodity prices rather than demand. The twin objectives of monetary policy in

India have evolved as maintaining price stability and ensuring adequate flow of credit

to facilitate the growth process.


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MONETARY POLICY AND THE ECONOMY

Being one of the most influential government policies, monetary policy aims

at affecting the economy through the Fed's management of money and interest rates.

As generally accepted concepts, the narrowest definition of money is M1, which

includes currency, checking account deposits, and traveler's checks. Time deposits,

savings deposits, money market deposits, and other financial assets can be added to

M1 to define other monetary measures such as M2 and M3. Interest rates are simply

the costs of borrowing. The Fed conducts monetary policy through reserves, which

are the portion of the deposits that banks and other depository institutions are required

to hold either as cash in their vaults, called vault cash, or as deposits with their home

FRBs. Excess reserves are the reserves in excess of the amount required. These

additional funds can be transacted in the reserves market (the federal funds market) to

allow overnight borrowing between depository institutions to meet short-term needs

in reserves. The rate at which such private borrowings are charged is the federal funds

rate.

Monetary policy is closely linked with the reserves market. With its policytools, the Fed can control the reserves available in the market, affect the federal funds

rate, and subsequently trigger a chain of reactions that influence other short-term

interests rates, foreign-exchange rates, long-term interest rates, and the amount of

money and credit in the economy. These changes will then bring about adjustments in

consumption, affect saving and investment decisions, and eventually influence

employment, output, and prices.

How Monetary Policy Affects The Economy

The initial link in the chain between monetary policy and the economy is the

market for balances held at the Federal Reserve Banks. Depository institutions have

accounts at their Reserve Banks, and they actively trade balances held in these

accounts in the federal funds market at an interest rate known as the federal funds

rate. The Federal Reserve exercises considerable control over the federal funds rate


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through its influence over the supply of and demand for balances at the Reserve

Banks.

The FOMC sets the federal funds rate at a level it believes will foster financial and

monetary conditions consistent with achieving its monetary policy objectives, and it

adjusts that target in line with evolving economic developments.

A change in the federal funds rate, or even a change in expectations about the

future level of the federal funds rate, can set off a chain of events that will affect other

short-term interest rates, longer-term interest rates, the foreign exchange value of the

dollar, and stock prices. In turn, changes in these variables will affect households and

businesses spending decisions, thereby affecting growth in aggregate demand and the

economy.

IMPLEMENTATION OF MONETARY POLICY

Since the early 1980s, the Fed has been relying on the overnight federal funds

rate as the guide to its position in monetary policy. The Fed has at its disposal three

major monetary policy tools:

Reserve Requirements

Under the Monetary Control Act of 1980, all depository institutions, including

commercial banks, savings and loans, and others, are subject to the same reserve

requirements, regardless of their Fed member status. As of March 1999, the basic

structure of reserve requirements is 3 percent for all checkable deposits up to $46.5

million and 10 percent for the amount above $46.5 million. No reserves are requiredfor time deposits (data from Federal Reserve Bank of Minneapolis, 1999).

Reserve requirement affects the so-called multiple money creation. Suppose,

for example, the reserve requirement ratio is 10 percent. A bank that receives a $100

deposit (bank 1) can lend out $90. Bank 1 can then issue a $90 check to a borrower,

who deposits it in bank 2, which can then lend out $81. As it continues, the process

will eventually involve a total of $1,000 ($100 + $90 + $81 + $72.9 $1,000) in


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deposits. The initial deposit of $100 is thus multiplied 10 times. With a lower (higher)

ratio, the multiple involved is larger (smaller), and more (less) reserves can be

created.

Reserve requirements are not used as often as the other policy tools. Since

funds grow in multiples, it is difficult to administer small adjustments in reserves with

this tool. Also, banks always have the option of entering the federal funds market for

reserves, further limiting the role of reserve requirements.

The Discount Rate

Banks may acquire loans through the "discount window" at their home FRB.

The most important credit available through the window is the adjustment credit,

which helps depository institutions meet their short-term needs against, for example,

unexpected large withdrawals of deposits. The interest rate charged on such loans is

the basic discount rate and is the focus of discount policy. A lower-rate encourages

more borrowing. Through money creation, bank deposits increase and reserves

increase. A rate hike works in the opposite direction. However, since it is more

efficient to adjust reserves through open-market operations (discussed below), the

amount of discount window lending has been unimportant, accounting for only a

small fraction of total reserves. Perhaps a more meaningful function served by the

discount rate is to signal the Fed's stance on monetary policy, similar to the role of the

federal funds rate.

By law, each FRB sets its discount rate every two weeks, subject to the

approval of the Board of Governors. However, the gradual nationalization of thecredit market over the years has resulted in a uniform discount rate. Its adjustments

have been dictated by the cyclical conditions in the economy, and the frequency of

adjustments has varied. In the 1990s, for example, the Fed cut the rate seven times

from 7 percent to 3 percentduring the recession from December 1990 to July 1992.

Later, from May 1994 to February 1995, the rate was raised four timesfrom 3

percent to5.25 percentto counter possible economic overheating and inflation. In

January 1996, the rate was lowered to 5 percent and it stayed there for the next thirty-


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two months, during which the U.S. economy experienced a solid and consistent

growth with only minor inflation. From October to November 1998, the Fed cut the

rate twice, first to 4.75 percent and then to 4.5 percent, anticipating the threat from the

global financial crisis that had began in Asia in mid-1997 (data from "United States

Monetary Policy," 1999).

Open-Market Operations

The most important and flexible tool of monetary policy is open-market

operations (i.e., trading U.S. government securities in the open market). In 1997, the

Fed made $3.62 trillion of purchases and $3.58 trillion of sales of Treasury securities(mostly short-term Treasury bills). As of September 1998, the Fed held $458.13

billion of Treasury securities, roughly 8.25 percent of the total Federal debt

outstanding

The FOMC directs open-market operations (and also advises about reserve

requirements and discount-rate policies). The day-to-day operations are determined

and executed by the Domestic Trading Desk (the Desk) at the FRB of New York.

Since 1980, the FOMC has met regularly eight times a year in Washington, D.C. At

each of these meetings, it votes on an intermeeting target federal funds rate, based on

the current and prospective conditions of the economy. Until the next meeting, the

Desk will manage reserve conditions through open-market operations to maintain the

federal funds rate around the given target level. When buying securities from a bank,

the Fed makes the payment by increasing the bank's reserves at the Fed. More

reserves will then be available in the federal funds market and the federal funds rate

falls. By selling securities to a bank, the Fed receives payment in reserves from the

bank. Supply of reserves falls and the funds rate rises.

The Fed has two basic approaches in running open-market operations. When a

shortage or surplus in reserves is likely to persist, the Fed may undertake outright

purchases or sales, creating a long-term impact on the supply of reserves. However,

many reserve movements are temporary. The Fed can then take a defensive position

and engage in transactions that only impose temporary effects on the level of reserves.


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A repurchase agreement (a repo) allows the Fed to purchase securities with the

agreement that the seller will buy back them within a short time period, sometimes

overnight and mostly within seven days.

The repo creates a temporary increase in reserves, which vanishes when the

term expires. If the Fed wishes to drain reserves temporarily from the banking system,

it can adopt a matched sale-purchase transaction (a reverse repo), under which the

buyer agrees to sell the securities back to the Fed, usually in less than seven days.

Policy Of Various Nations:

Australia - Inflation targeting Brazil - Inflation targeting Canada - Inflation targeting Chile - Inflation targeting China - Monetary targeting and targets a currency basket Eurozone - Inflation targeting Hong Kong - Currency board (fixed to US dollar) India - Multiple indicator approach New Zealand - Inflation targeting Norway - Inflation targeting Singapore - Exchange rate targeting South Africa - Inflation targeting Switzerland - Inflation targeting Turkey - Inflation targeting United Kingdom - Inflation targeting, alongside secondary targets on 'output

and employment'.

United States - Mixed policy (and since the 1980s it is well described by the"Taylor rule," which maintains that the Fed funds rate responds to shocks in

inflation and output).


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Interaction between monetary and fiscal policies-

How is monetary policy affected by Fiscal Policy

Fiscal policies have a significant impact on economic growth and inflation. It is

therefore important for

monetary authorities to follow fiscal policy developments closely. There are many

channels through which fiscal

policy affects the economy and prices. The level and composition of government

expenditure and revenue,

as well as budget deficits and public debt, are key variables in this process.

Budgetary policies remain the exclusive competence of the Member

States in Stage . In particular, the Treatys excessive deficit procedure, further

developed and clarified in the Stability and Growth Pact, aims to limit the risks to

price stability that might otherwise arise from national fiscal policies. For example, an

excessive increase in government spending at a time when the economy is already

operating at close to full capacity could, by stimulating aggregate demand, lead to

bottlenecks and generate inflationarypressures. Fiscal imbalances, with large budget deficits and mounting public debt,

have characterized many inflationary episodes in history. Fiscal discipline is therefore

a basic component of macroeconomic

stability. As well as unbalanced budgets, high levels of government debt can also be

detrimental. If a government has to meet sizeable interest expenses every year, the

fiscal situation can become unsustainable and this may endanger price stability .High

levels of debt may also have adverse effects on the real economy and the financial

environment. In particular, excessive recourse to capital markets by governments

tends to raise the cost of capital and this may reduce private investment (crowding

out). Given the potential problems associated with fiscal imbalances, the avoidance

of excessive deficits represents an important commitment

to maintaining fiscal policies conducive to overall macroeconomic stability.


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Fiscal policies affects the monetary policies in elements of transmission in short term.

In long term it affects the sustainability of monetary policies.

In monetary transmission include the following transmission channels

Domestic demand:

In every household the spending for total year has been decided and if in this situation

if the fiscal policies has been changed by the government then the there will be

change in household spending and change in domestic demand. So the change in

fiscal policies affect the monetary transmission channel in short run. Thus the

spending effects the interest rates .

Capital market :

If from the capital market money is taken by the government in big way ,then it leads

to increase in return on investment on new projects .Thus, the private firm will

become disinterested to fund the new projects .

Indirect taxes:

If government increases the taxes on indivaiual then it will lead to increase in the

interest rates and inflation will also rise.The rise in inflation will lead to decrease in

the demand .The government has to come to rescue the people by consolidation of

economy.The consolidation will be done by the higher wages and lower nominal

interest rates .Thus inflation rise causes extra pressure on wages.


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MUNDELLFLEMING MODEL

The MundellFleming model, also known as the IS-LM-BoP model, is

an economic model first set forth (independently) by Robert Mundell and Marcus

Fleming. The model is an extension of the IS-LM Model. Whereas the traditional IS-

LM Model deals with economy underautarky (or a closed economy), the Mundell

Fleming model describes an open economy.

The MundellFleming model portrays the short-run relationship between an

economy's nominal exchange rate, interest rate, and output (in contrast to the closed-

economy IS-LM model, which focuses only on the relationship between the interest

rate and output). The MundellFleming model has been used to argue that an

economy cannot simultaneously maintain a fixed exchange rate, free capital

movement, and an independent monetary policy. This principle is frequently called

the "impossible trinity," "unholy trinity," "irreconcilable trinity," "inconsistent trinity"

or the "MundellFleming trilemma."

Basic set-up

Variables

This model uses the following variables:

Yis GDP Cis consumption Iis physical investment G is government spending (an exogenous variable) Mis the nominal money supply Pis the price level i is the nominal interest rate L is liquidity preference (real money demand) Tis taxes
http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Robert_Mundellhttp://en.wikipedia.org/wiki/Marcus_Fleminghttp://en.wikipedia.org/wiki/Marcus_Fleminghttp://en.wikipedia.org/wiki/IS-LM_modelhttp://en.wikipedia.org/wiki/Autarkyhttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Free_movement_of_capital_and_paymentshttp://en.wikipedia.org/wiki/Free_movement_of_capital_and_paymentshttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Impossible_trinityhttp://en.wikipedia.org/wiki/Trilemmahttp://en.wikipedia.org/wiki/GDPhttp://en.wikipedia.org/wiki/Consumption_(economics)http://en.wikipedia.org/wiki/Fixed_investmenthttp://en.wikipedia.org/wiki/Government_spendinghttp://en.wikipedia.org/wiki/Exogenous_variablehttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Price_levelhttp://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Money_demandhttp://en.wikipedia.org/wiki/Taxeshttp://en.wikipedia.org/wiki/Taxeshttp://en.wikipedia.org/wiki/Money_demandhttp://en.wikipedia.org/wiki/Interest_ratehttp://en.wikipedia.org/wiki/Price_levelhttp://en.wikipedia.org/wiki/Money_supplyhttp://en.wikipedia.org/wiki/Exogenous_variablehttp://en.wikipedia.org/wiki/Government_spendinghttp://en.wikipedia.org/wiki/Fixed_investmenthttp://en.wikipedia.org/wiki/Consumption_(economics)http://en.wikipedia.org/wiki/GDPhttp://en.wikipedia.org/wiki/Trilemmahttp://en.wikipedia.org/wiki/Impossible_trinityhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Free_movement_of_capital_and_paymentshttp://en.wikipedia.org/wiki/Free_movement_of_capital_and_paymentshttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Autarkyhttp://en.wikipedia.org/wiki/IS-LM_modelhttp://en.wikipedia.org/wiki/Marcus_Fleminghttp://en.wikipedia.org/wiki/Marcus_Fleminghttp://en.wikipedia.org/wiki/Robert_Mundellhttp://en.wikipedia.org/wiki/Economics


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Equations

The MundellFleming model is based on the following equations.

The IS curve:

whereNXis net exports.

The LM curve:

A higher interest rate or a lower income (GDP) level leads to lower money demand.

The BoP (Balance of Payments) Curve:

where BoP is the balance of payments surplus, CA is the current account surplus,

andKA is the capital account surplus.

IS components

whereE() is the expected rate ofinflation. Higher disposable income or a lower real

interest rate (nominal interest rate minus expected inflation) leads to higher

consumption spending.

where Y-1 is GDP in the previous period. Higher lagged income or a lower real interest

rate leads to higher investment spending.

whereNXis net exports,e is the nominal exchange rate (the price of domestic

currency in terms of units of the foreign currency), Yis GDP, and Y* is the combined

GDP of countries that are foreign trading partners. Higher domestic income (GDP)

leads to more spending on imports and hence lower net exports; higher foreign

income leads to higher spending by foreigners on the country's exports and thus
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higher net exports. A highere (more expensive domestic currency in terms of foreign

currency, and equivalently less expensive foreign currency in terms of domestic

currency) leads to more purchasing of foreign goods due to the lesser cost of

acquiring the foreign currency to pay for them, and also leads to less purchasing of the

country's exports by foreigners since they find it more costly to acquire the country's

currency with which to pay for them; for both reasons, highere leads to lower net

exports.

Balance of payments (BoP) components

where CA is the current account andNXis net exports. That is, the current account is

viewed as consisting solely of imports and exports.

where is the foreign interest rate, kis the exogenous component of financial capital

flows,zis the interest-sensitive component of capital flows, and the derivative of the

functionzis the degree of capital mobility (the effect of differences between domestic

and foreign interest rates upon capital flowsKA). This derivative is positive if there is

any capital mobility (since a higher relative domestic interest rate makes funds more

prone to flow into the country), and it is infinitely positive if there is perfect capital

mobility.

Variables determined by the model

After the subsequent equations are substituted into the first three equations above, one

has a system of three equations in three unknowns, two of which are GDP and the

domestic interest rate. Underflexible exchange rates, the exchange rate is the

third endogenous variable while BoP is set equal to zero. In contrast, under fixed

exchange rates e is exogenous and the balance of payments surplus is determined by

the model.
http://en.wikipedia.org/wiki/Exchange_rate_flexibilityhttp://en.wikipedia.org/wiki/Endogeny#Economics_and_financehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Fixed_exchange_ratehttp://en.wikipedia.org/wiki/Endogeny#Economics_and_financehttp://en.wikipedia.org/wiki/Exchange_rate_flexibility


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Under both types of exchange rate regime, the nominal domestic money supplyMis

exogenous, but for different reasons. Under flexible exchange rates, the nominal

money supply is completely under the control of the central bank. But under fixed

exchange rates, the money supply in the short run (at a given point in time) is fixed

based on past international money flows, while as the economy evolves over time

these international flows cause future points in time to inherit higher or lower (but

pre-determined) values of the money supply.

Mechanism of the model

The model's workings can be described in terms of an IS-LM-BoP graph with the

domestic interest rate plotted vertically and real GDP plotted horizontally.

The IS curve is downward sloped and the LM curve is upward sloped, as in the closed

economy IS-LM analysis; the BoP curve is upward sloped unless there is perfect

capital mobility, in which case it is horizontal at the level of the world interest rate.

In this graph, under less than perfect capital mobility the positions of both

the IS curve and the BoP curve depend on the exchange rate (as discussed below),

since the IS-LM graph is actually a two-dimensional cross-section of a three-

dimensional space involving all of the interest rate, income, and the exchange rate.

However, under perfect capital mobility the BoP curve is simply horizontal at a level

of the domestic interest rate equal to the level of the world interest rate.

Under a flexible exchange rate regime

In a system of flexible exchange rates, central banks allow the exchange rate to be

determined by market forces alone.

Changes in the money supply

An increase in money supply shifts the LM curve to the right. This directly reduces

the local interest rate relative to the global interest rate. This depreciates the exchange

rate of local currency through capital outflow. (To the extent that funds are

internationally mobile, they flow out to take advantage of the interest rate abroad,

which has become relatively more attractive, and hence the currency depreciates.) The

depreciation makes local goods cheaper compared to foreign goods, and this increases

exports and decreases imports. Hence, net exports are increased. Increased net exports
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lead to the shifting of the IS curve (which is Y = C + I + G + NX) to the right,

partially or entirely mitigating the initial decline in the domestic interest rate. At the

same time, the BoP curve shifts rightward, since with a depreciated currency it takes a

lower interest rate or higher income level to give a zero balance of payments surplus

(which is what the curve describes). The combined effect of these three curves

shifting is to increase the economy's income.

A decrease in the money supply causes the exact opposite process.

Changes in government spending

An increase in government expenditure shifts the IS curve to the right. The shift

causes both the local interest rate and income (GDP) to rise. The increase in the local

interest rate causes increased capital inflows, and the inflows make the local currency

stronger compared to foreign currencies. On the other hand, the higher GDP increases

spending on imports, tending to make the currency weaker. Assuming the BoP curve

is not as steep as the LM curve (i.e., assuming that capital mobility is relatively

strong), the former effect will dominate and the currency will become stronger. The

stronger exchange rate also makes foreign goods cheaper compared to local goods.

This encourages greater imports and discourages exports, so net exports become

lower. As a result of this exchange rate change, the IS curve shifts back toward its

original location. The stronger currency also shifts the BoP curve upward, as higher

levels of the interest rate would now be consistent with a zero payments surplus in the

presence of the stronger currency exchange rate. The LM curve is not at all affected in

the short run. The net effect of all this is that, if there is perfect capital mobility, the

level of income of the local economy is unchanged from originally, while it has gone

up if capital is less than perfectly mobile.

A decrease in government expenditure reverses the process.

Changes in the global interest rate

An increase in the global interest rate shifts the BoP curve upward and causes capital

flows out of the local economy. This depreciates the local currency and boosts net

exports, shifting the IS curve to the right. Under less than perfect capital mobility, the


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depreciated exchange rate shifts the BoP curve somewhat back down. The net effect is

an increase in income and the local interest rate.

Under perfect capital mobility, the BoP curve is always horizontal at the level of theworld interest rate. When the latter goes up, the BoP curve shifts upward by the same

amount, and stays there. The exchange rate changes enough to shift the IS curve to the

location where it crosses the new BoP curve at its intersection with the

unchanged LM curve; now the domestic interest rate equals the new level of the

global interest rate.

A decrease in the global interest rate causes the reverse to occur.

Under a fixed exchange rate regime

In a system of fixed exchange rates, central banks announce an exchange rate (the

parity rate) at which they are prepared to buy or sell any amount of domestic

currency. Thus net payments flows into or out of the country need not equal zero; the

exchange rate e is exogenously given, while the variable BoP is endogenous.

Under the fixed exchange rate system, the central bank operates in the foreign

exchange market to maintain a specific exchange rate. If there is pressure to

depreciate the domestic currency's exchange rate because the supply of domestic

currency exceeds its demand in foreign exchange markets, the local authority buys

domestic currency with foreign currency to decrease the domestic currency's supply in

the foreign exchange market. This keeps the domestic currency's exchange rate at its

targeted level. If there is pressure to appreciate the domestic currency's exchange rate

because the currency's demand exceeds its supply in the foreign exchange market, the

local authority buys foreign currency with domestic currency to increase the domestic

currency's supply in the foreign exchange market. Again,this keeps the exchange rate

at its targeted level.

Changes in the money supply

In the very short run the money supply is normally predetermined by the past history

of international payments flows. If the central bank is maintaining an exchange rate

that is consistent with a balance of payments surplus, over time money will flow into

the country and the money supply will rise (and vice versa for a payments deficit). If
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the central bank were to conduct open market operations in the domestic bond market

in order to offset these balance-of-payments-induced changes in the money supply

a process called sterilization, it would absorb newly arrived money by decreasing its

holdings of domestic bonds (or the opposite if money were flowing out of the

country). But under perfect capital mobility, any such sterilization would be met by

further offsetting international flows.

Changes in government expenditure

An increase in government spending forces the monetary authority to supply the

market with local currency to keep the exchange rate unchanged. Shown here is the

case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE

curve) is horizontal.

Increased government expenditure shifts the IS curve to the right. The shift results in

an incipient rise in the interest rate, and hence upward pressure on the exchange rate

(value of the domestic currency) as foreign funds start to flow in, attracted by the

higher interest rate. However, the exchange rate is controlled by the local monetaryauthority in the framework of a fixed exchange rate system. To maintain the exchange

rate and eliminate pressure on it, the monetary authority purchases foreign currency

using domestic funds in order to shift the LMcurve to the right. In the end, the

exchange rate stays the same but the general income in the economy increases. In

the IS-LM-BoP graph, the IS curve has been shifted exogenously by the fiscal

authority, and the IS and BoP curves determine the final resting place of the system;

the LM curve merely passively reacts.
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The reverse process applies when government expenditure decreases.

Changes in the global interest rate

To maintain the fixed exchange rate, the central bank must accommodate the capital

flows (in or out) which are caused by a change of the global interest rate, in order to

offset pressure on the exchange rate.

If the global interest rate increases, shifting the BoP curve upward, capital flows out

to take advantage of the opportunity. This puts pressure on the home currency to

depreciate, so the central bank must buy the home currencythat is, sell some of its

foreign currency reservesto accommodate this outflow. The decrease in the money

supply resulting from the outflow, shifts the LM curve to the left until it intersect

the IS and BoP curves at their intersection. Once again, the LM curve plays a passive

role, and the outcomes are determined by theIS-BoP interaction.

Under perfect capital mobility, the new BoP curve will be horizontal at the new world

interest rate, so the equilibrium domestic interest rate will equal the world interest

rate.

If the global interest rate declines below the domestic rate, the opposite occurs.

The BoP curve shifts down, foreign money flows in and the home currency is

pressured to appreciate, so the central bank offsets the pressure by selling domestic

currency (equivalently, buying foreign currency). The inflow of money causes

the LM curve to shift to the right, and the domestic interest rate becomes lower (as

low as the world interest rate if there is perfect capital mobility).

Differences from IS-LM

It is worth noting that some of the results from this model differ from those of the IS-

LM model because of the open economy assumption. Results for a large open

economy, on the other hand, can be consistent with those predicted by the IS-

LM model. The reason is that a large open economy has the characteristics of both an

autarky and a small open economy. In particular, it may not face perfect capital

mobility, thus allowing internal policy measures to affect the domestic interest rate,
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and it may be able to sterilize balance-of-payments-induced changes in the money

supply (as discussed above).

In the IS-LM model, the domestic interest rate is a key component in keeping both themoney market and the goods market in equilibrium. Under the MundellFleming

framework of a small economy facing perfect capital mobility, the domestic interest

rate is fixed and equilibrium in both markets can only be maintained by adjustments

of the nominal exchange rate or the money supply (by international funds flows).

Example

The MundellFleming model applied to a small open economy facing perfect capital

mobility, in which the domestic interest rate is exogenously determined by the world

interest rate, shows stark differences from the closed economy model.

Consider an exogenous increase in government expenditure. Under the IS-LM model,

the IS curve shifts upward, with the LM curve intact, causing the interest rate and

output to rise. But for a small open economy with perfect capital mobility and a

flexible exchange rate, the domestic interest rate is predetermined by the

horizontal BoP curve, and so by the LM equation given previously there is exactly

one level of output that can make the money market be in equilibrium at that interest

rate. Any exogenous changes affecting the IS curve (such as government spending

changes) will be exactly offset by resulting exchange rate changes, and the IS curve

will end up in its original position, still intersecting the LM and BoP curves at their

intersection point.

The MundellFleming model under a fixed exchange rate regime also has completely

different implications from those of the closed economy IS-LM model. In the closed

economy model, if the central bank expands the money supply the LM curve shifts

out, and as a result income goes up and the domestic interest rate goes down. But in

the MundellFleming open economy model with perfect capital mobility, monetary

policy becomes ineffective. An expansionary monetary policy resulting in an incipient

outward shift of the LM curve would make capital flow out of the economy. The

central bank under a fixed exchange rate system would have to instantaneously

intervene by selling foreign money in exchange for domestic money to maintain the


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exchange rate. The accommodated monetary outflows exactly offset the intended rise

in the domestic money supply, completely offsetting the tendency of the LM curve to

shift to the right, and the interest rate remains equal to the world rate of interest.

Conclusion:-

To sum up, despite sound fundamentals and no direct exposure to the sub-prime

assets, India was affected by global financial crisis reflecting increasing globalization

of the Indian economy. The policy response has been swift. While fiscal stimulus

cushioned the deficiency in demand, monetary policy augmented both domestic and

foreign exchange liquidity. The expansionary policy stance of the Reserve Bank wasmanifested in significant reduction in CRR as well as the policy rates.

The contraction of the Reserve Banks balance sheet resulting from the decline in its

foreign assets necessitated active liquidity management aimed at expanding domestic

assets, which was ensured through OMO including regular operations under the LAF,

unwinding of MSS securities, introduction of new and scaling up of existing refinance

facilities. In addition, sharp reductions in CRR besides making available primary

liquidity raised the money multiplier and ensured steady increase in money supply.

The liquidity injection efforts of the Reserve Bank could be achieved without

compromising either on the eligible counterparties or on the asset quality in the

Reserve Banks balance sheet. Moreover, the Reserve Banks balance sheet did not

show any unusual increase, unlike that of several other central banks.

At present, the focus around the world and also in India has shifted from managing

the crisis to managing the recovery. The key challenge relates to the exit strategy that

needs to be designed, considering that the recovery is as yet fragile but there is an up

tick in inflation, though largely from the supply side, which could engender

inflationary expectations. Thus, the Reserve Bank has initiated the first phase of exit

in its October 2009 Review of monetary policy in a calibrated manner mainly by

withdrawal of unconventional measures taken during the crisis.

Documents

monetary policy with respect to BOP