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Monetary Policy in India

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Monetary Policy in India
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,
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