MONETARY POLICY

MEANING
A bank is a financial institution that provides banking and other financial services to their customers. A bank is generally understood as an institution which provides fundamental banking services such as accepting deposits and providing loans. There are also nonbanking institutions that provide certain banking services

without meeting the legal definition of a bank. Banks are a subset of the financial services industry. A banking system also referred as a system provided by the bank which offers cash management services for customers, reporting the transactions of their accounts and portfolios, throughout the day. The banking system in India should not only be hassle free but it should be able to meet the new challenges posed by the technology and any other external and internal factors. For the past three decades, Indias banking system has several outstanding achievements to its credit. The Banks are the main participants of the financial system in India. The Banking sector offers several facilities and opportunities to their customers. All the banks safeguards the money and valuables and provide loans, credit, and payment services, such as checking accounts, money orders, and cashiers cheques. The banks also offer investment and insurance products. As a variety of models for cooperation and integration among finance industries have emerged, some of the traditional distinctions between banks, insurance companies, and securities firms have diminished. In spite of these changes, banks continue to maintain and perform their primary roleaccepting deposits and lending funds from these deposits.

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DEFINITION
According to Section 5(b) of The Banking Regulation Act, 1949 defines Banking as:The accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, otherwise. and withdrawable by cheque, draft, or order or

Banking Regulation Act, 1949 (sec. 5(c)), has defined

the banking company as, Banking Company means any company which transacts business of banking in India.

HISTORY

The first bank in India, though conservative, was established in 1786. From 1786 till today, the journey of Indian Banking System can be segregated into three distinct phases: Early phase of Indian banks,

from 1786 to 1969 Nationalization of banks and the banking sector reforms, from 1969 to 1991 New phase of Indian banking system, with the reforms after 1991

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Phase 1
The first bank in India, the General Bank of India, was set up in 1786. Bank of Hindustan and Bengal Bank followed. The East India Company established Bank of Bengal (1809), Bank of Bombay (1840), and Bank of Madras (1843) as independent units and called them Presidency banks. These three banks were amalgamated in 1920 and the Imperial Bank of India, a bank of private shareholders, mostly Europeans, was established. Allahabad Bank was established, exclusively by Indians, in 1865. Punjab National Bank was set up in 1894 with headquarters in Lahore. Between 1906 and 1913, Bank of India, Central Bank of India, Bank of Baroda, Canara Bank, Indian Bank, and Bank of Mysore were set up. The Reserve Bank of India came in 1935. During the first phase, the growth was very slow and banks also experienced periodic failures between 1913 and 1948. There were approximately 1,100 banks, mostly small. To streamline the functioning and activities of commercial banks, the Government of India came up with the Banking Companies Act, 1949, which was later changed to the Banking Regulation Act, 1949 as per amending Act of 1965 (Act No. 23 of 1965). The Reserve Bank of India (RBI) was vested with extensive powers for the supervision of banking in India as the Central banking authority. During those days, the general public had lesser confidence in banks. As an aftermath, deposit mobilization was slow. Moreover, the savings bank facility provided by the Postal department was comparatively safer, and funds were largely given to traders.

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Phase 2
The government took major initiatives in banking sector reforms after Independence. In 1955, it nationalized the Imperial Bank of India and started offering extensive banking facilities, especially the RBI in and rural to and handle semi-urban banking areas. The of government the Union constituted the State Bank of India to act as the principal agent of transactions government and state governments all over the country. Seven banks owned by the Princely states were nationalized in 1959 and they became subsidiaries of the State Bank of India. In 1969, 14 commercial banks in the country were nationalized. In the second phase of banking sector reforms, seven more banks were nationalized in 1980. With this, 80 percent of the banking sector in India came under the government ownership.

Phase 3
This phase has introduced many more products and facilities in the banking sector as part of the reforms process. In 1991, under the chairmanship of M Narasimham, a committee was set up, which worked for the liberalization of banking practices. Now, the country is flooded with foreign banks and their ATM stations. Efforts are being put to give a satisfactory service to customers. Phone banking and net banking are introduced. The entire system became more convenient and swift. Time is given importance in all money transactions. The financial system of India has shown a great deal of resilience

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BANKING IN INDIA
In India, banks are segregated in different groups. Each group has its own benefits and limitations in operations. Each has its own dedicated target market. A few of them work in the rural sector only while others in both rural as well as urban. Many banks are catering in cities only. Some banks are of Indian origin and some are foreign players. Banks in India can be classified into: Public Sector Banks Private Sector Banks Cooperative Banks Regional Rural Banks Foreign Banks One aspect to be noted is the increasing number of foreign banks in India. The RBI has shown certain interest to involve more foreign banks. This step has paved the way for a few more foreign banks to start business in India.

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CHARACTERISTICS / FEATURES OF A BANK

1. Dealing in Money: Bank is a financial institution which deals with other people's money i.e. money given by depositors. 2. Individual / Firm / Company: A bank may be a person, firm or a company. A banking company means a company which is in the business of banking. 3. Acceptance of Deposit: A bank accepts money from the people in the form of deposits which are usually repayable on demand or after the expiry of a fixed period. It gives safety to the deposits of its customers. It also acts as a custodian of funds of its customers. 4. Giving Advances: A bank lends out money in the form of loans to those who require it for different purposes. 5. Payment and Withdrawal: A bank provides easy payment and withdrawal facility to its customers in the form of cheques and drafts; it also brings bank money in circulation. This money is in the form of cheques, drafts, etc. 6. Agency and Utility Services: A bank provides various banking facilities to its customers. They include general utility services and agency services. 7. Profit and Service Orientation: A bank is a profit seeking institution having service oriented approach.

MONETARY POLICY 8. Ever increasing Functions: Banking is an evolutionary concept. There is continuous expansion and diversification as regards the functions, services and activities of a bank. 9. Connecting Link: A bank acts as a connecting link between borrowers and lenders of money. Banks collect money from those who have surplus money and give the same to those who are in need of money. 10. Banking Business: A bank's main activity should be to do business of banking which should not be subsidiary to any other business. 11. Name Identity: A bank should always add the word "bank" to its name to enable people to know that it is a bank and that it is dealing in money.

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RESERVE BANK OF INDIA

The central bank of the country is the Reserve Bank of India (RBI). It was established in April 1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the Hilton Young Commission. The share capital was divided into shares of Rs. 100 each fully paid which was entirely owned by private shareholders in the beginning. The Government held shares of nominal value of Rs. 2, 20,000. Reserve Bank of India was nationalised in the year 1949. The general superintendence and direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor and four Deputy Governors, one Government official from the Ministry of Finance, ten nominated Directors by the Government to give representation to important elements in the economic life of the country, and four nominated Directors by the Central Government to represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi. Local Boards consist of five members each Central Government appointed for a term of four years to represent territorial and economic interests and the interests of co-operative and indigenous banks. The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank.

MONETARY POLICY The Bank was constituted for the need of following:

To regulate the issue of banknotes To maintain reserves with a view to securing monetary stability and To operate the credit and currency system of the country to its advantage.

FUNCTIONS OF RBI
Issue of Currency Notes Banker to The Government Bankers bank And Lender of Last Resort Controller of Credit Exchange control And Custodian of Foreign Reserve Collection and Publication Of Data Regulatory and Supervisory Functions Clearing House Functions Development and Promotional Functions Of this the main function of RBI is to control the credit or supply of money in the market credit created by banks. The RBI through its various quantitative and qualitative techniques regulates total supply of money and bank credit in the interest of economy. RBI pumps in money during busy season and withdraws money during slack season.

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INTRODUCTION TO MONETARY POLICY

Monetary policy 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. The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and 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 Influences On:

Monetary policy influences the SUPPLYOF MONEY AND RATE OF INTEREST in order to stabilize the economy at full employment or near full employment.

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MEANING
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). It is important for policymakers to make credible

announcements. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise. If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages. To achieve this low level of inflation, policymakers must have credible announcements; that is, private agents must believe that these announcements will reflect actual future policy. If an
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MONETARY POLICY announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect. If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs private the marginal cost of inflation); expectations, however, they assuming that agents have rational know

policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.

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MONETARY POLICY

DEFINITION
Definition of 'Monetary Policy'

The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves).

Monetary Policy as per U.S Government,

In the United States, the Federal Reserve is in charge of monetary policy. Monetary policy is one of the ways that the U.S. government attempts to control the economy. If the money supply grows too fast, the rate of inflation will increase; if the growth of the money supply is slowed too much, then economic growth may also slow. In general, the U.S. sets inflation targets that are meant to maintain a steady inflation of 2% to 3%.

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FEATURES OF MONETARY POLICY

1. Active Policy: Before the advent of planning in India in 1951, the monetary policy of the Reserve Bank was a passive, cheap and easy policy. It means that Reserve Bank did not use the measures of monetary policy to regulate the economy. For example from 1935 to 1951, the bank rate remained stable at 3%. But since 1951, the Reserve Bank has been following an active monetary policy. It has been using all the measures of credit control.

2. Overall Expansion: An important feature of Reserve Banks monetary policy is that of overall expansion of money supply. In the words of S.L.N. Sinha, The Reserve Banks responsibility is not merely one of credit restriction. In a growing economy there has to be continuous expansion of money supply and bank credit and the central bank has the duty to see that legitimate credit requirements are met. In fact, the overall, trend of money supply has been one of the expansions along with an almost continuous rise in price level. 3. Seasonal Variations: The monetary policy is characterized by the changing behavior of busy and slack seasons. These seasons are tied to the agricultural seasons. In the busy season there is an expansion of funds on account of the seasonal needs of financing production, and inventory building of agricultural commodities. On the other hand, the slack season is characterized by the contraction of funds due to the return flow. The main reason behind this changing pattern is the requirement of additional funds by the industrial sector. Thus, during busy

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MONETARY POLICY season the Reserve Bank adopts an expansionary credit policy and tightens the liquidity pressures during the slack season. 4. Tight and Dear Monetary Policy: In order to restrain inflation the Reserve Bank has often adopted a tight and dear monetary policy. A tight monetary policy implies that the rate of growth of money supply is lowered. A dear money policy refers to increase in bank rate. This increase in bank rate leads to an increase in the interest rates charged by the banks. 5. Investment and Saving Oriented: The monetary policy adopted by the Reserve Bank is both investment and saving oriented. To encourage investment, adequate funds were made available for productive purposes at reasonable rates of interest. The Reserve Bank has also kept the interest on deposits at a reasonable rate to attract savings. 6. Imbalance in Credit Allocation: The monetary policy is biased towards industrial sector. Agriculture does not get the required institutional finances. Consequently, it has to depend upon money lenders to a considerable extent for its credit needs. The agricultural sector has to pay high rate of interest and even then does not get required amount of capital. A large part of funds flows to large industries. Even small scale industries suffer from the inadequacy of finances. Thus monetary policy has resulted in imbalances in credit allocation.
7.

Wide Range of Methods of Credit Control: The

Reserve Bank has used a wide range of instruments of credit control. It has adopted all the measures of quantitative and qualitative credit controls to meet the needs of a complex and varying economic situation.
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OBJECTIVES OF MONETARY POLICY

The main objective of monetary policy in India is growth with stability. Monetary Management regulates availability, cost and use of money and credit. It also brings institutional changes in the financial sector of the economy. Following are the main objectives of monetary policy in India:-

1. RAPID ECONOMIC GROWTH:It is the most important objective of monetary policy. The monetary policy can influence the economic growth by controlling real interest rate and its resultant impact on the investment. Example: if RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged.

2. PRICE STABILITY:All the economics suffer from inflation and deflation; it can also be called as price stability. Both are harmful to economy. Thus monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. Example: - when the economy suffers from recession the monetary policy should be an easy money policy but when there is inflationary situation there should be dear money policy.

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MONETARY POLICY

3. EXCHANGE RATE STABILITY:Exchange rate stability should be there into the economy to bring in confidence to other countries for trading purpose. However, to maintain exchange rate stability, internal price stability needs to be maintained. A fall in exchange rate is caused by an excess demand for foreign exchange over its supply. In other words, if demand for imports is greater than the demand for exports. The exchange rate will rise at the international value of the currency will fall. To maintain stability in the international value of currency, a restrictive monetary policy will have to be adopted to bring about a reduction in money supply and the imports.

4. BALANCE OF PAYMENT EQUILIBRIUM:Many developing countries like India suffer from the disequilibrium in the balance of payment. The RBI through its monetary policy tries to maintain equilibrium in the balance of payment. Aspects: 1. BOP surplus. (Excess money supply in the domestic economy). 2. BOP deficit. (Stringency of money).

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MONETARY POLICY

5. FULL EMPLOYMENT:These days, the most important objective of monetary policy is attainment of full employment with consideration of inflation. The objectives of price and exchange rate stability have been given a secondary importance these days. The policy of full employment can be pursued measures through as they can monetary help in

achieving and maintaining the rates of savings and investment at a level, which would ensure full employment. For this, monetary policy may help in raising the aggregate rate of savings and proper channelization of savings to desirable directions of investments. Several monetary measures can be adopted for raising the level of savings. The rates of interest may be increased and banking facilities may be expanded. Similarly, for boosting investment, bank credit may be offered for investment. Besides, monetary instruments may be, used to ensure that the banking system contributes to financing the planned public investments. For example, in India SLR is used to ensure that a good part of the savings mobilized by the banking system are invested in Government securities and approved securities for financing vital investment projects. Example: if monetary policy is expansionary then credit supply can be encouraged. It could help in creating more jobs in different sectors of the economy.

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6. NEUTRALITY OF MONEY:Economists such as Wicksted, Robertson have always considered money as a passive factor. According to them, money should only play a role of medium of exchange and not more than that. Therefore monetary policy should regulate the supply of money. The change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize the effect of monetary expansion. However this objective of monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability.

7. EQUAL INCOME DISTRIBUTION:Monetary policy can make special

provisions for the neglect supply such as agriculture, small scale industries; village industries etc. and provide them cheaper credit for longer term. Thus monetary policy helps in reducing economic inequalities among different sections of society.

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MONETARY POLICY

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 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).

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Inflation Targeting
Under this policy approach the target is to keep inflation, under a particular 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. definition such as Consumer Price Index, within a

Price Level Targeting

Price level targeting is similar to inflation targeting except that growth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Uncertainty in price levels can
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MONETARY POLICY create uncertainty around price and wage setting activity for firms and workers, and undermines any information that can be gained from relative prices, as it is more difficult for firms to determine if a change in the price of a good or service is because of inflation or other factors, such as an increase in the efficiency of factors of production, if inflation is high and volatile. An increase in inflation also leads to a decrease in the demand for money, as it reduces the incentive to hold money and increases transaction costs and shoe leather costs.

Monetary Aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman. This approach is also sometimes called monetarism. While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

Fixed Exchange Rate:

This policy is based on maintaining a fixed fixed exchange exchange rate with rates, a foreign can be currency. There are varying degrees of which ranked in relation to how rigid the fixed exchange rate is with the anchor nation.

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MONETARY POLICY Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate. Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.) These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.

Gold Standard:
The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government's promise to buy or sell gold at a fixed
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MONETARY POLICY price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting. The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base. Today this type of monetary policy is no longer used by any country, although the gold standard was widely used across the world between the mid-19th century through 1971. Its major advantages were simplicity and transparency. The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value. Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time.

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INSTRUMENTS OF MONETARY POLICY

The instruments of monetary policy are devise which are used by the monetary authority in order to attain some predetermined objectives. There are two types of instruments of the monetary policy as shown below:

(A)

Quantitative Instruments or General Tools: The Quantitative Instruments are also known as the General

Tools of monetary policy. These tools are related to the Quantity or Volume of the money. The Quantitative Tools of credit control are also called as General Tools for credit control. These methods maintain and control the total quantity or volume of credit or money supply in the economy. These methods are indirect in nature and are employed for influencing the quantity of credit in the country. The general tool of credit control comprises of following instruments. Bank Rate Policy (BRP) The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at which the central bank (i.e. RBI) rediscounts bills and provides advance to commercial banks against approved securities. It is "the standard rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase under the RBI Act". The Bank Rate affects the actual availability and the cost of the credit. Any change in the bank rate necessarily brings out a
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MONETARY POLICY resultant change in the cost of credit available to commercial banks. If the RBI increases the bank rate than it reduce the volume of commercial banks borrowing from the RBI. It deters banks from further credit expansion as it becomes a more costly affair. On the other hand, if the RBI reduces the bank rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit creation. Thus any change in the bank rate is normally associated with the resulting changes in the lending rate and in the market rate of interest.

Open Market Operation (OMO) The open market operation refers to the purchase and/or sale of short term and long term securities by the RBI in the open market. This is very effective and popular instrument of the monetary policy. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. It is important to understand the working of the OMO. If the RBI sells securities in an open market, commercial banks and private individuals buy it. This reduces the existing money supply as money gets transferred from commercial banks to the RBI. Contrary to this when the RBI buys the securities from commercial banks in the open market, commercial banks sell it and gets back the money they had invested in them. Obviously the stock of money in the economy increases. This way when the RBI enters in the OMO transactions, the actual stock of money gets changed. Normally during the inflation period in order to reduce the purchasing power, the RBI sells securities and during the recession or depression phase she buys securities and makes more money available in the economy through the banking system.

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MONETARY POLICY Variation in the Reserve Ratios (VRR) The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of these cash reserves are also to be kept with the RBI for the purpose of maintaining liquidity and controlling credit in an economy. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of commercial bank's net demand and time liabilities which commercial banks have to maintain with the central bank and SLR refers to some percent of reserves to be maintained in the form of gold or foreign securities. In India the CRR by law remains in between 3-15 percent while the SLR remains in between 25-40 percent of bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out by a change varying in VRR commercial positions. Thus banks reserves

commercial banks lending capacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves of commercial banks and thus it can affect the banks credit creation multiplier. RBI increases VRR during the inflation to reduce the purchasing power and credit creation. But during the recession or depression it lowers the VRR making more cash reserves available for credit expansion.

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(B) Qualitative Instruments or Selective Tools

The Qualitative Instruments are also known as the Selective Tools of monetary policy. These tools are not directed towards the quality of credit or the use of the credit. They are used for discriminating between different uses of credit. It can be discrimination favoring export over import or essential over nonessential credit supply. This method can have influence over the lender and borrower of the credit. The Selective Tools of credit control comprises of following instruments:CEILING ON CREDIT: The RBI has imposed ceiling on bank credit against the security of certain commodity. This imposes a limit on the amount of credit to different sectors like hire-purchase and installment sale of consumer goods. Under this method the down payment, installment amount, loan duration, etc. is fixed in advance. Such measures ensure financial discipline in the banking sector. FIXING MARGIN REQUIREMENTS: The margin refers to the "proportion of the loan amount which is not financed by the bank". Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. A change in a margin implies a change in the loan size. This method is used to encourage credit supply for the needy sector and discourage it for other non-necessary sectors. This can be done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors. Example: - If the RBI feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given.

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MONETARY POLICY PUBLICITY: This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public and banks can use it for attaining goals of monetary policy.

CREDIT RATIONING: Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit exposure to unwanted sectors. MORAL SUASION: It implies to pressure exerted by the RBI on the Indian banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through a monetary policy. Under moral suasion central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes.

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MONETARY POLICY CONTROL THROUGH DIRECTIVES: Under this method the central bank issue frequent directives to commercial banks. These directives guide commercial banks in framing their lending policy. Through a directive the central bank can influence credit structures, supply of credit to certain limit for a specific purpose. The RBI issues directives to commercial banks for not lending loans to speculative sector such as securities, etc. beyond a certain limit. DIRECT ACTION: Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess to their capital. Central bank can penalize a bank by changing some rates. At last it can even put a ban on a particular bank if it does not follow its directives and work against the objectives of the monetary policy.

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MONETARY POLICY

MONETARY POLICY TOOLS

DIRECT POLICY TOOLS

These tools are used to establish limits on interest rates, credit and lending. These include direct credit control, direct interest rate control and direct lending to banks as lender of last resort, but they are rarely used in the implementation of monetary policy by the Bank. Interest rate controls The Bank has the power to announce the minimum and maximum rates of interest and other charges that commercial banks may impose for specific types of loans, advances or other credits and pay on deposits. Currently, the Bank does not set any interest rate levied by commercial banks except for the minimum interest rate payable on savings deposits. The Bank has opted not to use this as a tool of monetary policy but to let market forces determine interest rate. Credit controls The Bank has the power to control the volume, terms and conditions credit of commercial through bank credit, including or installment extended loans, advances

investments. The Bank has not exercised such controls in its implementation of monetary policy. Lending to commercial banks The Bank may provide credit, backed by collateral, to commercial banks to meet their shortterm liquidity needs as lender of last resort. The interest is set at a punitive rate to encourage banks to manage their liquidity efficiently.
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MONETARY POLICY

INDIRECT POLICY TOOLS

Used more widely than direct tools, indirect policy tools seek to

alter liquidity conditions. While the use of reserve requirements has been the traditional monetary tool of choice, more recently, the Bank shifted towards the use of open market operations to manage liquidity in the financial system and to signal its policy stance. Reserve requirements The Bank uses reserve requirements to limit the amount of funds that commercial banks can use to make loans to its customers. Commercial banks are required to hold a proportion of customers deposits in approved liquid assets. An increase in the reserve ratios should reduce commercial banks lending and, therefore, the demand for hard currency, while a decrease should yield the opposite effect. The secondary reserve requirement is a certain percentage of commercial banks deposit liabilities that is to be held in approved liquid assets. It should be freely and readily convertible into cash without significant loss, free from any charge, lien or encumbrance. The cash reserve requirement, also called primary reserve requirements, is a percentage of commercial banks average deposit liabilities that must be held at the Bank in a non-interest bearing account. Cash reserves are a component of the secondary reserve requirements. To encourage the development of the government securities market, a securities requirement was instituted on 1 May 2010, requiring commercial banks to hold a proportion of their average deposit liabilities in the form of Treasury bills. The securities

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MONETARY POLICY requirement is also a component of the secondary reserve requirements. Open market operations The conduct of open market

operations refers to the purchase or sale of government securities by the Bank to the banking and non-banking public for liquidity management purposes. When the Bank sells securities, it reduces commercial banks reserves (monetary base), and when it buys securities, it increases banks reserves. 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), thereby 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.

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MONETARY POLICY

KEY RATES OF MONETARY POLICY

CASH RESERVE RATIO (CRR)

It is a percentage of cash every bank has to maintain with RBI. The percentage is fixed by RBI. It is calculated based on the net demand and time liabilities of a bank. Demand liability is a type of liability in which the amount must be paid on demand. For example, Current Account is a demand liability i.e., the bank must pay the amount (a customer wishes to withdraw) whenever he demands the amount he has in his Current Account. Time Liability is a type of liability in which the amount becomes payable only on a certain point of time in future. For example, Fixed Deposit is a time liability i.e., the bank must pay the amount (a customer has in his fixed deposit) only on the date it gets matured.

STATUTORY LIQUIDITY RATIO (SLR)

It is a percentage of cash / gold / approved securities that a bank must maintain with itself before lending to the customers. It is calculated based on the total demand and time liabilities of a bank. There is a difference between net demand and time liabilities and total demand time liabilities. The methods of calculating both are different which are prescribed by RBI. The difference between CRR and SLR is that in CRR, banks has to maintain Cash balance with RBI whereas in SLR, banks can maintain themselves the prescribed percentage (by RBI) of reserve not only in Cash but also in gold or approved securities. Both CRR
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MONETARY POLICY and SLR are tools of monetary policy. But the SLR makes banks to invest some portion of money in Government Securities (gilt e dged securities) which are totally risk-free. The purpose of both CRR and SLR are to curb the lending ability of banks and suck out excess money from the economy.

REPO RATE AND REVERSE REPO RATE

REPO stands for Re-Purchase Option. In our country, both the REPO Rate and the Reverse REPO Rate are viewed only from the angle of RBI which fixes both the rates. Hence, when banks give the securities they hold to RBI and borrow money, the interest rate paid by the banks to RBI is REPO Rate. When the RBI gives the securities it holds to the banks and borrows money, the interest rate paid by RBI is Reverse REPO Rate. RBI employs both these rates to suck out excess money in short-term. Also for RBI, there is no need to money borrow money from banks. But it does so to absorb the excess money circulating in the economy. When REPO Rate is high, banks will not borrow much from RBI and vice-versa. When Reverse REPO Rate is high, banks will find RBI an attractive destination to place their excess money (as RBI will pay more interest to banks). Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks

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MONETARY POLICY

PRIME LENDING RATE (PLR)

Prime Lending Rate or Prime Rate is an interest rate banks

lend money to their most favored and credit-worthy customers.

BASE RATE
It is the minimum rate of interest that an individual bank is allowed to charge from its customers. Unless mandated by the government, RBI rule stipulates that no bank can offer loans at a rate lower than Base Rate to any of its customers. Your home loan will always be equal to or more than the Base Rate but never lower than Base Rate. So, the method of computation of interest rate for various sectors becomes transparent

BANK RATE
This is the rate (long term) at which central bank (RBI) lends money to other banks or financial institutions. If the bank rate goes up, long-term interest rates also tend to move up, and vice-versa. When bank rate is hiked, banks hike their own lending rates.

MARGINAL STANDING FACILITY (MSF)

Marginal Standing Facility (MSF) is the rate at which scheduled banks could borrow funds overnight from the Reserve Bank of India (RBI) against approved government securities. The basic difference between Repo and MSF scheme is that in MSF banks can use the securities under SLR to get loans from RBI and hence MSF rate is 1% more than repo rate.

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MONETARY POLICY

Sr. Rates / % No Reserve Ratios 1 Bank Rate 9.50 % 2 3 4 5 6 7 Repo Rate Reverse Repo Rate Cash Reserve Ratio (CRR) Statutory Liquidity Ratio (SLR) MSF Rate Base rate 7.5 % 6.50% 4.00% 23% 9.50% 9.70/10.25 %

W.e.f 20th sept.2013 20th sept.2013 20th sept.2013 20th sept.2013 20th sept.2013 20th sept.2013 20th sept.2013

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MONETARY POLICY

1)

Deepak Mohanty (2010) discusses the global financial crisis

and monetary policy response in India. 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 uptake in inflation, though largely from the supply side, which could engender inflationary expectations. Now, the RBIs measures should help anchor inflationary expectations, he opines, by reducing the overhang of liquidity without jeopardizing the growth process as market liquidity remains comfortable.

2)

Robert Nobay and David Peel (2003) consider optimal objective function. The results show that under

monetary policy in the context of the central bank adopting an asymmetric asymmetric preferences, many of the extent results on the time consistency problem need no longer hold. In this paper, they have investigated the implications for optimal discretionary policy of assuming that the central bank has an asymmetric loss function. The results presented in this paper underline the fact that even limited realism beyond the conventional approach to modeling the authorities preferences can deliver results that are substantively at variance with the results obtained under quadratic preferences.
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MONETARY POLICY

3)

According to Shankar Acharya (2002), conceptualization

and practice of monetary policy has clearly undergone a sea change during the nineties. According to him, monetary policy at the end of the decade was a far more sophisticated operation than at its beginning. However, some of the old problems and dilemmas remain. In particular, the efficacy of monetary policy continued to be constrained by an excessively loose fiscal policy as well as an insufficiently responsive financial system. 4) According to Errol DSouza, 2003. The RBI has been using

open market operations to sterilize the inflows of foreign capital so as to contain domestic monetary expansion. At the same time, it is intervening in foreign exchange markets. With downward price rigidity and shocks such as declining foreign interest rates and declining import tariffs as the economy integrates into the world economy, it is imperative to revise the money supply target so as to enable the economy to adjust to these shocks better. The current policy of sterilization and containment of the money supply restricts the process of income generation and macroeconomic adjustment in the force of these shocks.

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MONETARY POLICY

REFORMS IN THE INDIAN MONETARY POLICY DURING 1990s

The Monetary Policy of the RBI has undergone massive changes during the economic reform period. After 1991 the Monetary Policy is disassociated from the Fiscal Policy. Under the reform period an emphasis was given to the stable macro-economic situation and low inflation policy. The major changes in the Indian Monetary Policy during the decade of 1990 are given below: Reduced Reserve Requirements: During 1990s both the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR) were reduced to considerable extent. The CRR was at its highest 15% plus and additional CRR of 10% was levied, however it was now reduced by 4%. The SLR is reduced from 38.5% to a minimum of 25%. Increased Micro Finance: In order to strengthen the rural finance the RBI has focused more on the Self Help Group (SHG). It comprises small and marginal farmers, agriculture and nonagriculture labour, artisans and rural sections of the society.

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MONETARY POLICY Changed Interest Rate Structure: During the 1990s, the interest rate structure was changed from its earlier administrated rates to the market oriented or liberal rate of interest. Interest rate slabs are now reduced up to 2 and minimum lending rates are abolished. Similarly, lending rates above Rs. 2 lakhs are freed. Changes in Accordance to the External Reforms: During the 1990, the external sector has undergone major changes. It comprises lifting various controls on imports, reduced tariffs, etc. The Monetary policy has shown the impact of liberal inflow of the foreign capital and its implication on the domestic money supply. Higher Market Orientation for Banking: The banking sector got more autonomy and operational flexibility. More freedom to banks for methods for assessing working funds and other functioning has empowered and assured market orientation. Expectation

as

Channel

of

Monetary

Transmission: Traditionally, there were four key channels of

monetary policy transmission:-Interest rate, credit availability, asset prices and exchange rate channels. Interest rate is the most dominant transmission channel as any change in monetary policy has immediate effect on it. In recent years fifth channel, Expectation has been added. Future expectations about asset prices, general price and Income levels influence the four traditional channels.

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MONETARY POLICY

LIMITATIONS OF MONETARY POLICY

Huge

Budgetary Deficits: RBI makes every possible

attempt to control inflation and to balance money supply in the market. However Central Government's huge budgetary deficits have made monetary policy ineffective. Huge budgetary deficits have resulted in excessive monetary growth. Coverage of Only Commercial Banks: Instruments of monetary policy cover only commercial banks so inflationary pressures caused by banking finance can be controlled by RBI, but in India, inflation also results from deficit financing and scarcity of goods on which RBI may not have any control. Problem of Management of Banks and Financial

Institutions: The monetary policy can succeed to control

inflation and to bring overall development only when the management of banks and financial institutions are efficient and dedicated. Many officials of banks and financial institutions are corrupt and inefficient which leads to financial scams in this way overall economy is affected. Unorganized Money Market: Presence of unorganized sector of money market is one of the main obstacles in effective working of the monetary policy. As RBI has no power over the unorganized sector of money market, its monetary policy becomes less effective.

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MONETARY POLICY Less Accountability: At present time, the goals of monetary policy in India are not set out in specific terms and there is insufficient freedom in the use of instruments. In such a setting, accountability tends to be weak as there is lack of clarity in the responsibility of governments and RBI. Black Money: There is a growing presence of black money in the economy. Black money falls beyond the purview of banking control of RBI. It means large proposition of total money Supply in a country remains outside the purview of RBI's monetary management. Increase Volatility: The integration of domestic and foreign exchange markets could lead to increased volatility in the domestic market as the impact of exogenous factors could be transmitted to domestic market. The widening of foreign exchange market and development of rupee - foreign exchange swap would reduce risks and volatility. Lack of Transparency: According to S. S. Tarapore, the monetary policy formulation, in its present form in India, cannot be continued indefinitely. For a more effective policy, it would be necessary to have greater transparency in the policy formulation and transmission process and the RBI would need to be clearly demarcated.

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MONETARY POLICY

CHAPTER - 5 CONCLUSION & RECOMMENDATIONS

The research concludes that we have come to know many new and important things about Monetary Policy which are made by RBI. It is the central bank of India, plays an important role for proper maintenance of Financial System in India. In India the objectives of monetary policy evolved as

maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy, with the progressive liberalization additional and increasing objective. globalization Thus, of the policy economy, in India maintaining orderly conditions in the financial markets emerged as policy monetary endeavors to maintain a judicious balance between price stability, economic growth and financial stability. If inefficient institutional environment increases the cost of bank lending, banks may conduct lending activity in a manner that weakens the effects of monetary policy actions on the supply of loans by using reserves as a buffer to sustain their lending to lowcost customers and to avoid lending to high-cost customers when the central bank loosens credit conditions Monetary policy is very essential for the economic

development of the country. If correct monetary measures are taken at the right time it will help the country to survive even in the difficult situation. If monetary measures are not taken properly it may destroy the economic position of the country.

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MONETARY POLICY In short we can say that monetary policy is a tool if it is used properly it will help the country to grow smoothly. If not it is more dangerous than an Atom Bomb. The Reserve Bank recommends that the relative importance of its objectives in a given context in a transparent manner, emphasizes a consultative approach in policy formulation as well as autonomy in policy operations and harmony with other elements of macroeconomic policies. Improving transparency in our decisions and actions is a constant endeavor at the Reserve Bank.

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BY INDIA TODAY GROUP dated 13th September, 2013

RBI to keep monetary policy tight till rupee stabilizes: PMEAC

The Reserve Bank must continue its tight monetary policy until stability in the rupee value is achieved, Prime Minister's key economic advisor C Rangarajan said. The current stance of monetary policy has to continue until stability in the rupee is achieved. Thereafter, if the current trend in the moderation of wholesale price inflation continues, which is in fact expected, the monetary authorities can switch to a policy of easing. The time frame for this is difficult to specify and much depends on stability in the foreign exchange markets, he said. The rupee depreciated to 63.50 against the dollar on Thursday from 54.99 on December 31. Raghuram Rajan, who took over as RBI Governor on September 4, said that apart from monetary stability, the Central Bank has the mandate for inclusive growth and development as well as financial stability. The Chairman of the Prime Minister's Economic Advisory Council (PMEAC) said "there is a big dilemma facing the RBI because controlling inflation, maintaining price stability, is one of the major objectives of the monetary authority. He said that it has to be taken into account the impact on growth and what is happening in the real sector, but the primary responsibility of price stability rests with the Reserve Bank of India

And he added that " the dominant factor influencing the monetary authority will be the stability in the foreign exchange markets and if
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MONETARY POLICY the stability in the foreign exchange markets continues, it will give greater room for the monetary authorities to act.

By MUMBAI (Reuters) dated 12th September, 2013

RBI sets up panel to examine monetary policy framework

The Reserve Bank of India on Thursday announced the details of its committee constituted to examine the current monetary policy framework and recommend ways to revise and strengthen it to make it more transparent and predictable. RBI Governor Raghuram Rajan, who took over on September 4, had announced the committee would be headed by Deputy Governor The other members in the committee are: P.J. Nayak, Chetan Ghate, Associate Professor, economics and planning unit at Indian Statistical Institute; Peter J. Montiel, professor of economics, Williams College, USA; Sajjid Z. Chinoy, Chief Economist and Executive Director at JP Morgan; Rupa Nitsure, Chief Economist at Bank of Baroda; Gangadhar Darbha, Executive Director, Nomura Securities; Deepak Mohanty, Executive Director, RBI. The panel will review the objectives, structure, operating framework and instruments of monetary policy, particularly the multiple indicator approach and the liquidity management framework, the RBI said. It will also identify regulatory, fiscal and other impediments to monetary policy transmission, and recommend measures to improve transmission.

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MONETARY POLICY

Reforms at RBI: A route to effective monetary

policy
If RBI has to efficiently perform its investment banking function for the government, it has to sell bonds at high prices. The Public Debt Management Agency of India Bill seeks to take away the debt management function from the Reserve Bank of India (RBI) and assign it to an independent agency. This will eliminate one of the many conflicting interests of the central bank and is in keeping with the best practice scenario offered by the most recent studies on optimizing the role of the central bank. If RBI has to efficiently perform its investment banking function for the government, it has to sell bonds at high prices. This obviously means that it will have a bias towards keeping interest rates low when performing the monetary policy function. Some of the other issues causing conflict of interest are examined in depth by researchers at the National Institute of Public Finance and Policy. Liberal economics argues that when the government runs a monopoly and simultaneously has regulatory powers over that sector, it leads to a great loss of efficiency and dynamism. This is the situation with RBI when it comes to the negotiated dealing system, subsidiary general ledger and the payments system. RBI is a monopolistic entity and the regulator in each of these areas. The Securities and Exchange Board of India (SEBI) has shown the way forward on the issue of conflicting interests in market regulation. SEBI is pure regulator and does not trade on the market nor does it run an exchange or a depository. Hence, shifting the regulatory functions of the bond market and the currency market to SEBI will create a regulatory architecture that is as good as that of the equity market. There are other conflicts of interest owing to RBI exercising banking regulation as well as supervision. Bonds could be
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MONETARY POLICY sold more effectively for the government by distorting rules for banks. Alternatively, if banks are poorly regulated and are carrying maturity mismatches and thus interest rate risk, the monetary policy function of RBI might be loath to raise rates since this would make life difficult for these banks. Sometimes, the costs of implementing monetary policy are borne by banks sometimes, banks benefit from the use of levers of monetary policy (e.g., keeping interest rates low so as to ensure that banks with interest rate exposure do not go bankrupt). Banking regulation and supervision, hence, should be separated into a banking regulatory and development authority which should also takeover regulation and supervision of all deposit-taking institutions. This will help RBI focus on monetary policy. Monetary policy itself needs to be freed from the election cycle. There is now ample evidence that independent central banks deliver better monetary policy which is much more stable in nature and helps in lowering inflation. However, independence also requires fresh effort to infuse greater transparency. The report recommends more regular policy meetings on a pre-announced schedule since it would be helpful in giving markets a direction at predictable intervals. For more effective communication, RBI could provide more information to the public about its forecasting and simulation models, which could in fact be useful for the central bank in getting feedback from the academic and market communities that could help improve the models. These steps will not only enhance credibility of RBI but also of the government.

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MONETARY POLICY

QUESTIONNAIRE

1. What is the impact of monetary policy in functioning of banks? 2. Why the certain reserves are have to be necessarily maintained by banks? 3. What all the penalties borne by you for not following RBI Rules? 4. What are the challenges banks face at the time of change in monetary policy by RBI? 5. Does banks profitability affects due to changes in monetary policy every 45 days? 6. What extent the banks are given autonomy in monetary policies? 7. On what basis banks make changes in the interest rates?

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BIBLIOGRAPHY
Laws Governing Banking and Insurance (Sheth Publications,
Dr.Sumathi Gopal)

Environment and Management

of Financial Services
(P.K. Bandgar, Vipul Prakashan)

Newspapers(The Hindu, Financial

Express)

WEBLOGRAPHY
http://in.finance.yahoo.com/new s/rbis-priorities-may-seesignificant-183900462.html http://in.finance.yahoo.com/new s/rbis-priorities-may-seesignificant-183900462.html http://profit.ndtv.com/news/economy/article-there-is-no-case-forindias-rating-downgrade-rangarajan-327126 http://en.wikipedia.org/wiki/Monetary_policy_of_India http://study-material4u.blogspot.in/2012/07/chapter-3monetarypolicy-of-reserve.html

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