5 Monetary Policy .pdf

Business Environment PGEMP Dr. Pallavi Mody Email: [email protected] @SPJIMR Courage. Heart  Monetary Policy @SPJIMR Courage. Heart  What is...

Business Environment PGEMP Dr. Pallavi Mody Email: [email protected] @SPJIMR Courage. Heart  Monetary Policy @SPJIMR Courage. Heart  What is Monetary Policy? Monetary policy refer to steps taken by the central bank of a country (RBI in India) to regulate cost and supply of money in order to achieve the Socio Economic Objectives 1. Price Stabilization 2. Maintaining Higher Economic Growth 3. Managing the value of currency The three objectives conflict and so very often central banks face a policy trilemma. The dilemma between growth and inflation is tricky; when the central bank tries to control inflation, it may hurt growth and vice versa. Price stabilization, that is inflation management remains the prime objective @SPJIMR Courage. Heart  What is price stability? Price stability does not mean keeping prices constant or targeting zero inflation. It means targeting low and stable inflation. Modest inflation is healthy for the economy. Thus Central Banks target for inflation In advanced economies at 1-2% In developing economies at 4-6 % @SPJIMR Courage. Heart  What is the relation between money supply and prices? There is a direct relationship between money supply and prices. If the supply of money is in excess, it leads to rising prices, inflation and overheating. If the supply of money is less, it leads to falling prices, deflation and recession. A right dose of money supply should be given to the economy to maintain economic growth and stable prices. @SPJIMR Courage. Heart  How does the RBI determine the required dose of money supply? RBI’s objective is to provide the required dose of liquidity in the economy on the basis of Real economic growth and Inflation Tolerance RBI has been following monetary target approach and multiple indicator approach to determine the right dose of money supply. In a simplified economy 2023 2024 Growth assumptions Wheat 100 107 7% (Real GDP) Price 100 105 5% (Inflation) Money required for 10,000 11,235 12.3% (Money supply) transactions @SPJIMR Courage. Heart  What does monetary policy do? GDP = C + I + G + NX GNI = C + I + G + NX+ NR Since inflation occurs due to AD>AS, MP attempts to control AD by influencing C and I in the aggregate demand function through the mechanism of “interest rate”. @SPJIMR Courage. Heart  What are interest rates? Interest Rate is the price one pays for the use of money How are interest rates determined? The demand and supply of money determine the interest rates in the economy. @SPJIMR Courage. Heart  What is demand for money? Money is a stock and hence an asset, a small part of the total wealth that people choose to hold in form of liquid cash Money is in demand for the convenience it provides. It is demanded by Consumers Businesses Government The demand for money is known as community’s liquidity preference. It is inversely related with interest rates, hence the demand curve is downward sloping @SPJIMR Courage. Heart  Who supplies money? Savers Foreign Investors RBI Supply of money from savers and foreign investors is interest elastic but RBI arbitrarily (with respect to MP objectives) determines the supply of money and therefore the supply curve of money is vertical RBI’s objective is to provide the required dose of liquidity in the economy on the basis of ‘real economic growth’ and ‘inflation tolerance’. @SPJIMR Courage. Heart  How does money multiply through the banking system? Money multiplies in the banking sector. The money multiplier = 1/Reserve Ratio (RR)*100 Lower the reserve ratio, the banks capacity to lend out increases and thereby increases the capacity to multiply the money. @SPJIMR Courage. Heart  How does the monetary policy function? Policy Variables Target Variables Money supply Inflation Liquidity conditions Interest rate Interest rate Real GDP Employment Consumption Savings Investment @SPJIMR Courage. Heart  What instruments does the Monetary Policy use? Instruments that target Liquidity in the system Instruments that target Cost of Credit (interest rate) Cash Reserve Ratio (CRR) Repo Rate Statutory Liquidity Ratio (SLR) Reverse Repo Rate Liquidity Adjustment Facility (LAF) Marginal Standing Facility Open Market Operation (OMO) Market Stabilization Scheme (MSS) @SPJIMR Courage. Heart  Monetary Policy in India: Liquidity management RBI controls liquidity in the system through Reserve Ratios: Cash Reserve Ratio (CRR) and Statutory Reserve Ratio (SLR) CRR is the percentage of bank deposits banks need to keep with the RBI, currently at 4.5% SLR is percentage of bank deposits, the banks need to invest in government securities. Currently at 18% RBI directly participates in currency market through Open Market Operations to buy or sell government securities and to stabilize the market. @SPJIMR Courage. Heart  Monetary Policy to manage boom-bust cycle For a recession hit economy: Lower Reserve Requirements Lower interest rates Buy Government Securities There remains the risk of rising prices, creation of asset price bubble and weakening currency. For an overheated economy: Raise Reserve Requirements Raise interest rates Sell Government Securities There remains the risk of pulling the economy into recession. MPC in India targets 4-6% inflation as tolerance level @SPJIMR Courage. Heart  Active use of Monetary Policy as a tool A case study of Fed Rate by US-Federal Reserve @SPJIMR Courage. Heart  Effective use of Monetary Policy to revive the recession hit economy US Fed used cheap money policy and lowered the interest rate (6% to 1%) to activate the economy that was in recession post bursting of technology bubble and terrorist attack (2001-04). The economy recovered; the GDP growth increased from 0.3% in 2001 to 4.4% in 2004. The cheap money encouraged the Consumption and Investment in the economy but led to overheating. @SPJIMR Courage. Heart  Bernanke used the Monetary Policy to cool the overheated economy The signs of overheating in US economy were seen as there was rising current account deficit and forming of property balloon. The Fed Rate was raised for 17 times (1% to 5.25%) in the period (2004-06) to cool the overheated economy. The growth in GDP slowed down (4% to 2.6%) in the period (2004-2006). @SPJIMR Courage. Heart  Interest rates in response to Financial Crisis 2008, Pandemic 2020 and Inflation 2023 Fed followed cheap money policy and lowered the interest rate (5.25% to 0.25%) in the period (Sept 07- Dec 08) to save the economy from the financial crisis. Fed kept the Rate at 0.25% till Dec 15, for almost 7 years to cure the Great Recession. The rate moved up from Dec 2015 to come down in 2020 in response to pandemic. In response to an unprecedented high inflation in 2022, the rate was raised from 0.5% to 5% @SPJIMR Courage. Heart  Monetary Policy is an effective instrument, widely used world over to save the economy from the extremities of boom-bust cycle. Monetary Policy creates conducive environment for the participants in the economy to behave in the desired directions. However, its effects and success is subject to the behaviours of households, firms and government @SPJIMR Courage. Heart