Money Market

Topics: Monetary policy, Central bank, Money supply Pages: 52 (18914 words) Published: January 14, 2013
Chapter 1: Introduction To Money Market Content: * Introduction * Meaning * Definitions|

The money market is a key component of the financial system as it is the fulcrum of monetary operations conducted by the central bank in its pursuit of monetary policy objectives. It is a market for short-term funds with maturity ranging from overnight to one year and includes financial instruments that are deemed to be close substitutes of money. The money market performs three broad functions. One, it provides an equilibrating mechanism for demand and supply of short-term funds. Two, it enables borrowers and lenders of short term funds to fulfill their borrowing and investment requirements at an efficient market clearing price. Three, it provides an avenue for central bank intervention in influencing both quantum and cost of liquidity in the financial system, thereby transmitting monetary policy impulses to the real economy. The objective of monetary management by the central bank is to align money market rates with the key policy rate. As excessive money market volatility could deliver confusing signals about the stance of monetary policy, it is critical to ensure orderly market behavior, from the point of view of both monetary and financial stability. Thus, efficient functioning of the money market is important for the effectiveness of monetary policy. In order to meet these basic functions efficiently, money markets have evolved over time spawning new instruments and participants with varying risk profiles in line with the changes in the operating procedures of monetary policy. Changes in financial market structures, macroeconomic objectives and economic environment have called for shifts in monetary regimes, which, in turn, have necessitated refinements both in the operating instruments and procedures and in institutional arrangements by central banks. In India, although the ultimate goals of monetary policy, viz., growth and price stability, have remained unchanged over the years, the Reserve Bank has modified its operational and intermediate objectives of monetary policy several times in response to changes in the economic and financial environment. For instance, in the mid-1980s, the Reserve Bank formally adopted monetary targeting with feedback as a nominal anchor to fight inflation, partly induced by the large scale monetisation of fiscal deficits. The operating procedure in this regime was modulation of bank reserves by varying reserve requirements. In order to meet reserve requirements, banks borrowed primarily from the inter-bank (call money) market. Hence, these transactions were reflective of the overall liquidity in the system. Accordingly, the Reserve Bank focused on the money market, in particular, the call money market by using various direct instruments of monetary control to signal the policy stance consistent with the overall objectives of achieving growth and price stability. As interest rates were regulated, monetary management was undertaken mainly through changes in the cash reserve ratio (CRR), which was used to influence indirectly the marginal cost of borrowing by having an initial impact on the call money market. As the success of this strategy was crucially dependent on the stability of the call money market and its inter-linkages with other money market segments, reforms since the late 1980s, along with changes in the reserve maintenance procedures, have aimed at developing various money market segments through introduction of new instruments, increased participation and improved liquidity management in the system. Financial sector reforms since the early 1990s have provided a strong impetus to the development of financial markets, which, along with interest rate deregulation, paved the way for introduction of market-based monetary policy instruments. With financial innovations, money demand was seen as less stable and the disequilibrium in money...
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