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MONETARY POLICY

GOKHALE EDUCATION SOCIETYS

SHRI BHAUSAHEB VARTAK ARTS,COM. & SCI. COLLEGE


(Gokhale mahavidyalay marg, off gorai road, near MHB colony, Borivali (w.), Mumbai-400 091.

Student Name
Namrata Surve Urmila Sawant Pooja Ghadi Tanvi Tirotkar Aprna Vaiti

Roll No
42 39 13 49 45

ACKNOWLEDGEMENT
We are Commerce students of Gokhale College, Borivali (W), Mumbai studying in F.Y.B (B&I). We have done the Project of Monetary policy. We understood that, monetary policy deals with the management of money supply in the economy. Monetary policy aims to achieve sustained economic growth in a different sector of the economy. We are thankful to Dr.Mrs.S.V.Sant for her co-operation. We welcome comments and suggestions from the teachers and students for the improvement in the quality and utility of our presentation.

INDEX
Sr. No.
1 2 3 4 5 6 7 8

Topic

Page No.
1-6 7 8-13 14 15 16-18 19-20 21-24

Meaning & Objective Modern Monetary policy Effectiveness Process History Types Inflation Targets Tools

MEANING OF MONETARY POLICY


Monetary Policy is an important macro-economic instrument through which the macro-economic objective of a country is sought to be achieved. The broad objectives of monetary policy are to obtain economic growth, price stability, full employment, exchange rate stability and equilibrium in the balance of payment. Monetary policy influences the supply of money and the rate of interest in order to stabilize the economy and full employment or near full employment level by changing the level of aggregate demand in the economy. Business cycles are sought to be controlled with the help of the tools of monetary policy. Thus during recession, money supply in increased and interest rate brought down to increase the level of aggregate demand in economy because it is the level of aggregate demand that determines the level of employment, output and income economy. Similarly, during the times of high inflation, price rise is sought to be controlled by reducing the money supply and raising the interest rates which brings about a fall in the aggregate demand and prices. In context of developing country like India monetary policy aims to achieve sustained economic growth in a different sector of the economy.

Every modern country has a center bank and reserve bank which formulates and implements the monetary policy. For instance, in India, it is the Reserve Bank of India which is the apex monetary authority of the Indian monetary system. In UK, it is the Bank of England, whereas in USA, it is the Federal Reserve Bank, popularly known as the Fed. The objectives of the Fed are no different from the India, the Feds objectives include economic growth according to the employment, stable prices and moderate long term interest rates .The objective of the reserve bank of India as according to the chakravarty committee Report is economic expansion and inflation control. While economic expansion ensures growing level of employment, inflation control ensures price stability moderate interest rate. The reserve bank of India established on 1st April 1935. The government of free India felt that a state-owned Central bank will be more conductive to pursue the macro-economic objective of the government and hence the RBI was nationalized on 1st January 1949.

Objective of monetary policy


The basic objective of monetary policy is to achieve sustained economic growth with a fair amount of price stability. The monetary policy is a part of government economic policy. The macroeconomic objective depends upon the state of the economy i.e. both the general economy condition and the sectoral and sub-sectoral economic environment. While broadly, goal of monetary policy are identical in all capitalist countries, they may be fine tuned to specific requirements of different countries as different countries at different stages of economy development. Therefore, the broad and general objectives of monetary policy are economic growth, full employment, price stability, exchange rate stability and equilibrium in the balance of payments. These objectives are discussed below:

1. ECONOMIC GROWTH:
Sustained economic growth is the basic as well as the prime objective of monetary policy in all countries, rich as well as the poor. Sustained economic growth refers to a continuous growth in productive capacity of the economy resulting in a continuous growth in the total quantity of goods and

services produced in an economy. Such a growth process will be reflected by a continuous rise in the national income as well as the per capital income of the country.

2. FULL EMPLOYMENTS:
The central bank monetary policy must be geared to achieve full employment of all the available productive resources in the economy. However, the term full employment refers to near full employment of productive resources or less than full employment. It has been accepted by the economists that about three percent unemployment is actually full employment and that absolute full employment is only a theoretical possibility propounded by the classical economists like J.B Say and others.

3. Price stability:
A capitalist economy is vulnerable to cyclical fluctuations or business cycles. Monetary policy must aim at avoiding or neutralising both the peaks and troughs of the business cycles. The monetary authorities must prevent the economy from being caught in an inflationary spiral and going down in a deflationary spin. Both inflation and deflation are inimical to the health of the economy.

4. Exchange Rate stability:


Stability in the foreign exchange rate imparts international confidence in the value of the domestic currency and promotes a sustained growth in the international trade. A persistent fall in the exchange rate would encourage speculative activity in foreign exchange market and a break-down of international confidence in the international value of a currency may also result in the flight of capital, thus plunging the economy into a currency crisis.

5. Equilibrium in the Balance of Payments:


Exchange Rate stability and equilibrium in the balance of payments are interlinked. A country having a deficit in the balance of payments can pursue a contractionary monetary policy and correct the deficit in the balance of payments. A contrationary monetary policy would reduce the money supply in the economy and thus reduce the demand for imports.

Monetary Policy in a Less Developed Economy:


In a general, monetary policy was relegated to a secondary place, the primary place being given to fiscal policy. So if monetary policy plays only a secondary role in an advanced country in maintaining full employment or in bringing about price stability, its role in a less developed country will naturally be still more limited. The banking and credit system is not fully developed in less developed countries. The money market serves only a few large industries, business units and export houses and almost completely neglects the small farmers, traders and artisans. The money market itself may be dominated by an unorganized market which is outside the control of the central bank.

Modern Monetary Policy


Modern central banking dates back to the aftermath of great depression of the 1930s. Governments, led by the economic thinking of the great John Maynard Keynes, realized that collapsing money supply and credit availability greatly contributed to the savagery of this depression. This realization that money supply affected economic activity led to active government attempts to influence money supply through "monetary policy". At this time, nations created central banks to establish "monetary authority". This meant that rather than accepting whatever happened to money supply, they would actively try to influence the amount of money available. This would influence credit creation and the overall level of economic activity. Modern monetary policy does not involve gold to a great extent. In 1968, the United States rescinded its promise to pay in gold and effectively removed itself from the "gold standard". Since then, it has been the job of the Federal Reserve to control the amount of money and credit in the U.S. economy. I doing this, it wants to maintain the purchasing power of the U.S. dollar and its comparative worth to other currencies. This might sound easy, but it is a complex task in an information age where huge an amount of money travels in electronic signals in microseconds around the world.

The Effectiveness of Monetary Policy


Economists debate the relevant measures of money supply. "Narrow" money supply or M1 is currency in circulation and the currency in easily accessed chequing and savings accounts. "Broader" money supply measures such as M2 and M3 include term deposits and even money market mutual funds. Economists debate the finer points of the implementation and effectiveness of monetary policy but one thing is obvious. At the extremes, monetary policy is a potent force. In countries such as the Russian Republic, Poland or Brazil where the printing presses run full tilt to pay for government operations, money supply is expanding rapidly and the currency becomes rapidly worthless compared to goods and services it can buy. Very high levels of inflation or hyperinflation are the result. With 30-40% monthly inflation rates, citizens buy hard goods as soon as they receive payment in the currency and those on fixed income have their investments rendered worthless. At the other extreme, restrictive monetary policy has shown its effectiveness with considerable force. Germany, which experienced hyperinflation during the Weimar Republic and never forgot, has maintained a very stable monetary regime and resulting low levels of inflation. When Chairman Paul Volcker of the U.S. Federal Reserve applied the monetary brakes during the high inflation 1980s, the result was an economic downturn and a large drop in inflation. The Bank of Canada headed by John Crow, targeted 0-3% inflation in the early 1990s and curtailed economic activity to such an extent that Canada actually experienced negative inflation rates in several months for the first time since the 1930s. Without much debate, the effectiveness of monetary policy, its

timing and its eventual impacts on the economy are not obvious. That central banks attempt influence the economy through monetary is a given. In any event, insights into monetary policy are very important to the investor. The availability of money and credit are key considerations in the pricing of an investment.

Operations of a Modern Central Bank


The Central Bank attempts to achieve economic stability by varying the quantity of money in circulation, the cost and availability of credit, and the composition of a country's national debt. The Central Bank has three instruments available to it in order to implement monetary policy: 1.Open market operations 2.Reserve requirements 3.The 'Discount Window' 1. Open market operations are just that, the buying or selling of Government bonds by the Central Bank in the open market. If the Central Bank were to buy bonds, the effect would be to expand the money supply and hence lower interest rates; the opposite is true if bonds are sold. This is the most widely used instrument in the day to day control of the money supply due to its ease of use, and the relatively smooth interaction it has with the economy as a whole. 2. Reserve requirements are a percentage of commercial banks', and other depository institutions', demand deposit liabilities (i.e. chequing accounts) that must be kept on deposit at the Central Bank as a requirement of Banking Regulations. Though seldom used, this percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks, and depository institutions, demand deposits to be held by the Central Bank, thus taking them out of supply. As a result, an increase in reserve requirements would increase interest rates, as less currency is available to borrowers. This type of action is only

performed occasionally as it affects money supply in a major way. Altering reserve requirements is not merely a short-term corrective measure, but a long-term shift in the money supply. 3. Lastly, the Discount Window is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), there by affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over. By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates ,and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

Monetary policy process:


It is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.[1] The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being expansionary, or a contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and a contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. Monetary policy is contrasted with fiscal policy, which refers to: taxation, government spending, and associated borrowing.

History of monetary policy


Monetary policy is primarily associated with interest rate and credit. For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. During the 1870-1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.[6] By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs.

Types of monetary policy


In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions. 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.

Monetary Policy:

Inflation Targeting Price Level Targeting Monetary Aggregat es

Fixed Exchange Rate

Target Market Variabl e: Interest rate on overnig ht debt Interest rate on overnig ht debt The growth in money supply The spot price of the currenc y The spot price of gold

Long Term Objective : A given rate of change in the CPI A specific CPI number A given rate of change in the CPI The spot price of the currency Low inflation as measured by the gold price

Gold Standard

Mixed Policy

Usually interest rates

Usually unemploy ment + CPI change

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 exactly the same variables (such as a harmonized consumer price index).

Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[14]

The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Czech Republic, the Eurozone, New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Monetary policy tools


Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank", the Bank of Canada and the Federal Reserve Bank in the United States. Central banks have not always existed. In early economies, governments would supply currency by minting precious metals with their stamp. No matter what the creditworthiness of the government, the worth of the currency depended on the value of its underlying precious metal. A coin was worth its gold or silver content, as it could always be melted down to this. A country's worth and economic clout was largely to its holdings of gold and silver in the national treasury. Monarchs, despots and even democrats tried to skirt this inviolate law by filing down their coinage or mixing in other substances to make more coins out of the same amount of gold or silver. They were inevitably found out by the traders, money lenders and others who depended on the worth of that currency. This reason that movies show pirates

and thieves biting Spanish dubloons to ascertain the value of their booty and loot. 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.

Discount window lending Discount window lending is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market

rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), there by affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over. 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 of control of economy-wide interest rates. In the United States, 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 that pegs the monetary base of one country to another, the 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.