Monetary Policy in India

Only available on StudyMode
  • Download(s) : 52
  • Published : March 27, 2012
Open Document
Text Preview
Monetary Policy in India
Ila Patnaik Ajay Shah

DEA, July 2007

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

1 / 48

Part I What is monetary policy and how does it work?

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

2 / 48

What is monetary policy?

Monetary policy is the management of money supply and interest rates by central banks to influence prices and employment. Monetary policy works through expansion or contraction of investment and consumption expenditure.

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

3 / 48

The uses of monetary policy

Monetary policy cannot change long-term trend growth. There is no long-term tradeoff between growth and inflation. (High inflation can only hurt growth). What monetary policy – at its best – can deliver is low and stable inflation, and thereby reduce the volatility of the business cycle. When inflationary pressures build up: raise the short-term interest rate (the policy rate) which raises real rates across the economy which squeezes consumption and investment. The pain is not concentrated at a few points, as is the case with government interventions in commodity markets.

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

4 / 48

How central banks of mature market economies work
Election cycle in interest rates Hence, political independence for the narrow task of monetary policy The central bank sets the short rate The market either explicitly or implicitly knows the inflation target of the central bank. The short rate is unambiguously set by the central bank and is known to everyone. The “monetary transmission” : the market process through which changes to the short rate lead to changes in all other interest rates and financial prices. There is no contradiction between financial sector development and an effective monetary policy! Key words: focus, independence, transparency, predictability, accountability. Ila Patnaik, Ajay Shah () Monetary Policy in India DEA, July 2007 5 / 48

Money creation

Reserve money is created when the central bank either lends to the government, or buys foreign exchange thus adding to reserves. Reserve money (M0 ) induces broad money (M3 ) through the ‘money multiplier’. India’s long-term reform agenda: drop CRR and SLR, which would increase the money multiplier.

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

6 / 48

Instruments of monetary policy in India

Net loans to central government (i.e. open market operations) Net purchase of foreign currency assets Change in cash reserve ratio Changes in repo rate and reverse repo rate Bank rate

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

7 / 48

Part II Impossible trinity

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

8 / 48

Monetary policy in an open economy

Impossible trinity: Open capital account Pegged currency regime Independent monetary policy

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

9 / 48

Monetary policy in an open economy

Example Let us say you have inflation and so want a contractionary monetary policy. You raise interest rates. Since the capital account is open, capital flows in from abroad in response to the higher interest rates. This puts a pressure on the rupee to appreciate.

Ila Patnaik, Ajay Shah ()

Monetary Policy in India

DEA, July 2007

10 / 48

But the exchange rate is pegged

Example The Central Bank buys up the dollars coming in to prevent rupee appreciation. This leads to an expansion in net foreign exchange assets of the Central Bank and and thus of money supply. Classic symptom of impossible trinity difficulties: raising interest rates but money supply growth is surging. An expansion in money supply will lower interest rates. You cannot raise rates, and keep the exchange rate pegged...
tracking img