LOGO
Business Environment
UNIT-III
Business & Government
Course Coordinator: Dr. Saboohi Nasim
FMS&R, AMU
Unit –III (Syllabus)
❖Economic Role of Government
❖Economic Planning
❖Monetary Policy & its Implications for Business
❖Fiscal Policy & Budget
Monetary Policy
&
its Implications for
Business
Monetary Policy
…Basics
❖Monetary policy is the process by which
monetary authority of a country (generally a central bank)
❖controls the supply of money in the economy
❖by exercising its control over interest rates
❖ in order to maintain price stability and achieve high economic growth.
What is Monetary Policy?
❖ Monetary policy rests on the relationship between the rates of interest (price at which money can be borrowed) in an economy and the total supply of money.
❖ 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
What is Monetary Policy?..
❖Monetary theory provides insight into how to craft optimal monetary policy, which can be either:
• Expansionary
• Contractionary
Basic Approach to Monetary Policy
❖An expansionary policy increases the total supply of money in the economy more rapidly than usual
❖It is traditionally used to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.
Basic Approach to Monetary Policy…
❖Contractionary policy expands the money supply more slowly than usual or even shrinks it, by raising the interest rate.
❖It is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.
Basic Approach to Monetary Policy…
History of Monetary Policy
❖For many centuries there were only two forms of monetary policy decisions:
▪ (i) Decisions about coinage;
▪ (ii) Decisions to print paper money to create credit.
❖Interest rates, (while now thought of as a potent
tool of monetary authority) , were not generally
coordinated with monetary policy .
History of Monetary Policy…
❖The idea of monetary policy, (independent of executive action), started with the creation of the Bank of England in 1694, (which acquired the responsibility to print notes and back them with gold).
❖Central banks, as part of the gold standard,
began setting the interest rates which they
charged from borrowers who required
liquidity.
❖ During the 1870-1920 period, the industrialized nations set up central banking systems, with the role of the central bank as the "lender of last resort”.
❖ Economists, later, evolved ways to control money for financial stability & growth.
❖ Classical economists / Monetarists emphasized
‘money supply’ where as Keynesian economists emphasized the ‘interest rate’ channel.
History of Monetary Policy…
Considerations for Monetary Policy
Monetary decisions today take into account a wider range of factors/monetary variables, such as:
▪ short term interest rates;
▪ long term interest rates;
▪ velocity of money through the economy;
▪ exchange rates;
▪ credit quality;
▪ bonds and equities (corporate ownership and debt);
▪ government versus private sector spending/savings;
▪ international capital flows of money on large scales;
▪ financial derivatives such as options, swaps, futures contracts, etc.
Types of Monetary Policy
Monetary Policy: Target Market Variable: Long Term Objective:
Inflation Targeting Interest rate on overnight debt
A given rate of change in the CPI
Price Level Targeting
Interest rate on overnight
debt A specific CPI number
Monetary Aggregates
The growth in money supply
A given rate of change in the CPI
Fixed Exchange Rate The spot price of the currency
The spot price of the currency
Gold Standard (not
used anymore) The spot price of gold Low inflation as measured by the gold price
Mixed Policy Usually interest rates+
multiple indicators
Usually unemployment + CPI change
INSTRUMENTS OF MONETARY POLICY
❖ Bank Rate of Interest
❖ Cash Reserve Ratio
❖ Statutory Liquidity Ratio
❖ Open market Operations
❖ Margin Requirements
❖ Various other Innovative measures
Bank Rate of Interest
❖ Rate fixed by the Central bank; controls the lending capacity of Commercial banks.
❖ During Inflation, RBI increases the bank rate of interest due to which borrowing power of commercial banks reduces which thereby reduces the supply of money or credit in the economy.
❖ When money supply reduces, it reduces the purchasing
power, and thereby curtailing consumption and
lowering prices.
Cash Reserve Ratio
❖
CRR, (Cash Reserve Ratio), refers to a portion of deposits (as cash) which banks have to keep/maintain with the Central bank (RBI).
❖ During Inflation RBI, increases the CRR due to which commercial banks have to keep a greater portion of their deposits with the RBI.
❖ This serves two purposes:
▪
It ensures that a portion of bank deposits is totally risk-free▪ It enables RBI to control liquidity in the system, and thereby inflation.
Statutory Liquidity Ratio?
❖ Banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements.
❖ If SLR increases the lending capacity of
commercial banks decreases thereby
regulating the supply of money in the
economy.
Open Market Operations(OMO)?
❖It refers to the buying and selling of Govt.
securities in the open market .
❖ During inflation, RBI sells securities in the open market which leads to transfer of money to RBI, thus controlling money supply in the economy.
❖ The two traditional type of OMO's used by RBI:
▪ Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent).
▪ Repurchase agreement (REPO): Is short term, and are subject to repurchase.
Margin Requirements
❖During Inflation, RBI fixes a high rate of margin on the securities kept by the public for loans.
❖If the margin increases the
commercial banks will give less
amount of credit on the securities
kept by the public thereby controlling
inflation.
Currency Board
❖ A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation.
❖ It essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate.
❖ Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board.
❖ Currency boards have advantages
for small, open economies that would find independent monetary policy difficult to sustain (e.g. Estonia established a currency board pegged to the Deutschmark; Bulgaria, Hong Kong, Argentina?…etc)
Unconventional Monetary Policy Tools (At the zero bound-0% interest rates)
❖When interest rates are at or near 0% and there are concerns about deflation or deflation is occurring; this requires a different approach
❖Unconventional monetary policy tools include
• Credit easing
• Quantitative easing
• Signaling .
Unconventional Monetary Policy Tools….
❖ Credit easing or Quantitative easing (QE) are unconventional monetary policy tool used by central banks to stimulate the economy, when conventional monetary policy becomes ineffective
.
❖ Credit Easing
, involves increasing the money supply by the purchase of private sector assets such as corporate bonds and residential mortgage-backed securities.▪ Central bank purchases private sector assets, in order to improve liquidity and access to credit.
▪ In 2010, the Federal Reserve purchased $1.25 trillion of mortgage- backed securities (MBS) in order to support the sagging mortgage market.
Unconventional Monetary Policy Tools….
❖ In quantitative easing a central bank purchases financial assets from banks and other private sector businesses with newly created money.
▪ The tem quantitative easing was used for the first time by a Central Bank in Japan in March 2001
▪ Have been used extensively by USA, UK and the Euro zone during the Financial crisis of 2007–2010 ; the expression "QE2" became a
"ubiquitous nickname" in 2010, referring to the second round of QE
❖ Signaling can be used to direct market expectations for future interest rates.
Monetary Policy
of India
The Agenda
Monetary Policy
Formulation
Monetary Policy
Framework
Monetary Policy
Objectives
Monetary Policy
Implementation
Highlights of Recent Monetary Policy
Monetary Policy in India
Formulation, Framework
& Objectives
Monetary Authority in India?
❖ Two monetary authorities in India: the Central
government and the RBI. Central government is more powerful.
❖ The central monetary authority is the Reserve Bank of India (RBI)
❖RBI formulates, monitors and regulates
the monetary policy , which aims at financial stability in
the country.
❖The process of monetary policy formulation in India had traditionally been largely internal.
❖The process has, over time, become more consultative and participative with an external orientation.
❖Wide range of inputs taken from various stakeholders??
Monetary Policy Formulation in India
❖Three research departments provide independent technical inputs and assessment
▪ Monetary Policy Department (MPD)
▪ Department of Economic and Policy Research (DEPR) and
▪ Department of Statistics and Information Management (DSIM)
❖Meeting chaired by the RBI Governor and attended by the top management.
Monetary Policy Formulation in India…
❖ Consultations are held with
▪ 20 large commercial banks
▪ Indian Banks Association (IBA),
▪ Urban and Rural Co-operative banks/credit associations
▪ Association of non-banking financial companies (NBFCs).
❖ Reserve Bank constituted a Technical Advisory Committee (TAC) on monetary policy with outside (foreign) experts, though its role had been advisory (Not binding on the RBI)
❖ Since RBI Act amendment in 2016, Monetary Policy Committee (MPC) is entrusted with the task of fixing the benchmark policy interest rate (repo rate) (Binding on the RBI)
Monetary Policy Formulation in India…
❖Monetary policy framework/Approach is a continuously evolving process, based on the
▪ Level of development of financial markets and institutions
▪ Degree of global integration.
❖Has undergone significant transformation over time.
Monetary Policy Framework in India
❖ During the mid-1980s till 1997-98, India followed a Monetary Targeting Framework under which Broad Money (money supply-M3)?? was used as an intermediate target for monetary policy.
❖ Money supply is the stock of liquid assets held by public which can be freely exchanged for goods and services; RBI uses three measures of monetary aggregates/supply
▪ M1: Currency with public + Demand deposit with the banking system + other deposits with RBI
▪ M2: M1+Savings deposit with post office savings of public
▪ M3 (broad money): M2+Time deposits of public with the banking system
Monetary Policy Framework in India…
❖ RBI switched to a Multiple Indicator Approach in 1998- 99, recognizing the challenges posed by financial liberalization.
❖ Under the Multiple Indicator Approach, while broad money continued to remain an information variable, greater emphasis is placed on rates of interest for monetary policy formulation.
❖ Urijit Patel Committee report suggested ‘Inflation
Targeting’ (Jan 2014); Currently CPI based ‘Inflation Targeting’ framework is followed
Monetary Policy Framework in India…
❖ Amendments to the Reserve Bank of India (RBI) Act
(came into force on June 27, 2016)to empower the conduct of monetary policy in India.
❖ For the first time in its history, the RBI has been explicitly provided the legislative mandate to operate the monetary policy framework of the country.
❖ This Amendment provides for the constitution of a Monetary Policy Committee (MPC) that shall determine the policy rate required to achieve the Inflation target, another landmark in India’s monetary history
Recent Changes in Monetary Policy Framework…2016
❖ India's new Monetary Policy architecture – a six member MPC- for setting interest rates ends the RBI Governor's role as sole arbiter .
❖ Three Govt nominees:
have a 4 year term▪ Chetan Ghate, Associate professor at Indian Statistical Institute;
▪ Pami Dua, Director, Delhi School of Economics
▪ Ravindra H Dholakia, Professor (Economics) IIM-A
❖ Three Reserve Bank members
▪ RBI Governor (having a casting vote).
▪ Deputy Governor- in charge of monetary policy
▪ Michael Patra- Executive director.
Recent Changes in Monetary Policy Framework…2016
Recent Changes in Monetary Policy Framework in India…
Diagram
PRICE STABILITY
Objectives of MP
ECONOMIC GROWTH
Objectives of Monetary Policy of India
The primary objective of MP defined explicitly for the first time –
“to maintain price stability while keeping in mind the objective of growth.”
(Amendments to the Reserve Bank of India (RBI) Act June , 2016)
FINANCIAL STABILITY
❖ Price stability does not necessarily mean a constant price level, but a low and stable inflation.
❖ Inflation targets for price stability
• 2 per cent for developed countries
• 3.5 per cent for developing countries
❖ Chakravarty Committee (1985) had defined an annual inflation rate of 4 per cent as the tolerable level; Recent studies suggest that the threshold inflation could be in the range of 4-6 per cent.
❖ MPC since Oct, 2016 has set an inflation rate of 4%
(tolerable limit of +-2%)
Objectives of Monetary Policy of India
❖ India has been a moderate inflation country
❖ The long-term average inflation rate
▪ 1970-71 till the end of 2000s had remained in a single digit of about 7.5 per cent.
▪ During the 2000s was even lower at 5.5 per cent.
❖ Almost double-digit inflation persisting since the beginning 2010-11 posed a challenge for monetary policy in India
(2012- 10%; 2013- 9.4%)
❖ Inflation rate has dropped to 5.8% (2014), 4.9% (2015), 4.5%
(2016), 3.8% (2017); 4.6% (Feb 2019) ; Currently 6.58 % (Feb 2020)
Objectives of MP: Price Stability & Inflation
❖ Global financial crisis demonstrated that low levels of inflation and high levels of growth do not guarantee ‘financial stability’ (Resilience of the financial system to stress).
❖ There has been an increasing emphasis that financial stability should also be an explicit objective of central banks besides price stability and growth.
❖ In India, financial stability has been recognised as an important objective of monetary policy. Financial Stability Reports(FSR) is published by RBI semi-annually since Dec 2010 (www.rbi.org.in)
❖ Recently, RBI issued its 20th issue of FSR in Dec 2019;
Expects Bank NPAs to rise to 9.9% by Sep 2020 from 9.3%
in early 2019 (www.rbi.org.in)
Objectives of MP: Financial Stability??
Ojectives of the Monetary Policy of India
❖Price Stability
❖Controlled Expansion of Bank Credit
❖Promotion of Fixed Investment
❖Desired Distribution of Credit
❖Equitable Distribution of Credit
❖To Promote Efficiency for better Asset Quality….
lower GNPA etc..❖Restriction of Inventories
❖Promotion of Exports and Food Procurement Operations
Objectives of Monetary Policy of India: Financial Stability includes….
Monetary Operations in India:
Implementing Monetary Policy
Implementation of Monetary Policy
❖For effective implementation of monetary policy, monetary policy framework needs a supporting operating procedure.
❖ An operating procedure is defined as day-to-day management of monetary conditions consistent with the overall stance/approach of monetary policy.
❖ Generally, it involves:
(i) defining an operational target, generally an inflation rate;
(ii) setting a policy rate which could influence the operational target;
(iii) setting the width of corridor for short-term market interest rates;
(iv) conducting liquidity operations to keep the operational target interest rate stable within the corridor; and
(v) signaling of policy intentions.
Operating Procedure of Monetary Policy…
❖Monetary policy operating procedure has also evolved in India; Traditionally, CRR and open market operations (OMO) have been the active instruments of monetary policy.
❖The two traditional type of OMO's used by RBI:
•Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent).
•Repurchase agreement (REPO): Is short term, and are subject to repurchase.
❖ The introduction of Liquidity Adjustment Facility
(LAF) with REPO as key policy rate in 2000 (revised
in 2004, 2011, 2016) has emerged as the most active
instrument of monetary policy.
Operating Procedure: Liquidity Adjustment Facility (LAF)
❖Liquidity Adjustment Facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements.
❖It is used to aid banks in adjusting
the day to day mismatches in
liquidity. It consists of repo and
reverse repo operations.
Repo Rate and Reverse Repo Rate??
❖ Repo or Repurchase Option is a collaterised lending by RBI i.e. banks borrow money from Reserve bank of India to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date.
❖ The rate charged by RBI for this transaction is called the repo rate. Repo operations, therefore, inject liquidity into the system.
❖ Reverse repo operation is when RBI borrows money from banks by lending securities. The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo
operation, therefore, absorbs the liquidity in the system.
Repo Rate and Reverse Repo Rate
Operating Procedure: Liquidity Adjustment Facility (LAF)
❖Repo and reverse repo rates were announced separately until 2011
❖This procedure had two major drawbacks.
•lack of a single policy rate
• lack of a firm corridor (the excess of repo rate over reverse repo)
•Recognizing these shortcomings, a new
operating procedure was put in place in May
2011.
New Operating Procedure (2011)
The new operating procedure retained the essential features of the earlier LAF framework with the following key modifications.
1. The weighted average overnight call money rate was explicitly recognised as the operating target of monetary policy.
2. The repo rate was made the only one
independently varying policy rate.
New Operating Procedure (2011)…
3.
A new Marginal Standing Facility (MSF) was instituted in 2011 under which scheduled commercial banks (SCBs) could borrow overnight by pledging approved govt.
securities
• SCBs could borrow up to 1% (increased to
2% in 2012; increased to 3% on 27
thMarch 2020) of their respective net
demand and time liabilities (NDTL) at 100
basis points above the repo rate.
New Operating Procedure(2011)…
4.
The corridor was defined with a fixed width of 200 basis points. The repo rate was placed in the middle of the corridor, with the reverse repo rate 100 basis points below it and the MSF rate 100 basis points above it.
REPO RATE MSF
1% above Repo rate(2011)
REVERSE REPO
1% below Repo rate(2011)
Corridor width reduced to
100 bps in
April, 2016, 50 bps in 2017
Corridor width further
reduced to 65 bps on 27th March
2020
MSF Rate Vs LAF-Repo Rate??
In case of borrowing under the marginal standing facility (MSF), banks can borrow
overnight funds, against govt securities- up to 2%(3% in March 2020) of their net demand and
time liabilities(NDTL), within the statutory liquidity requirements.
However, banks can borrow from RBI at the Repo-rate by pledging
government securities over and above the
statutory liquidity requirements.
•Liquidity adjustment facility (LAF) has emerged as the principal
operating instrument for modulating short term liquidity in the economy.
•Repo rate has become the key policy rate which signals
the monetary policy stance of the economy.
Key Monetary Policy Measures
Current Repo, Reverse Repo & MSF Rate
As per Seventh Bi-monthly Monetary Policy Statement, 2018-19 Resolution of the Monetary Policy Committee (MPC) (announced on 27th Feb 2019)
REPO RATE
MSF & Bank Rate
0.25% above Repo rate
REVERSE REPO
0.25% below Repo rate
6.25 % 6.5%
6.00%
Sixth Bi-Monthly Monetary Policy Statement 2018-19 announced on 7th Feb 2019
Current Repo, Reverse Repo & MSF Rate
As per Seventh Bi-monthly Monetary Policy Statement, 2019-20 (announced on 27th March 2020)
REPO RATE
MSF & Bank Rate
(25 bps above)
REVERSE REPO (40 bps lower)
4.4%
4.65%
4.0%
Seventh Bi-Monthly Monetary Policy Statement 2019-20 Preponed and measures announced on 27th March 2020 in view
of COVID-19
Trends in Repo Rate
Repo rate as on Feb 2018 was 6% and 6.25%
in Feb 2019
Cash Reserve Ratio
❖ RBI is empowered to vary CRR between 15 percent and 3 percent.
❖ Accepting Narshimam committee Report the CRR was reduced from 15% in the 1990 to 5% in 2002.
❖ Current CRR is 3% (27th March 2020)
(4% Since Feb 2013; reduced from 4.25% in Oct-2012; 4.75% in Mar 2012, 4% Feb 2019)
Statutory Liquidity Ratio
❖ Ratio of the liquid assets to time and demand liabilities
is termed
as Statutory Liquidity Ratio.
❖ There was a reduction from 38.5%(1990) to 25% (2002) because of the suggestion by Narshimam Committee.
❖ The current SLR is 18.5%
(27th March 2020)
(23% in Mar 2014; reduced to 20% in 2017; 19.5% in Feb 2018)
Bank Rate Policy
❖ Bank rate is the rate of interest charged by the RBI for providing funds or loans to the banking system.
❖ Increase in Bank Rate increases the cost of borrowing by commercial banks hence reduces the supply of money.
❖ Increase in the bank rate is the symbol of tightening of RBI monetary policy. Bank rate is also known as Discount rate.
❖The current Bank rate is 4.65 % (reduced on
27
thmarch 2020 in view of Covid-19 pandemic)
Highlights of
Monetary Policy
Statements
Trends in Monetary Policy Announcement
❖ Earlier Monetary Policy Statements were announced on an annual basis (usually in May);
Reviews were conducted on quarterly basis.
❖ Last Annual Monetary Policy Statement of India 2013-14 presented by D. Subbarao in May 2013
❖ Raghuram G Rajan
, (Sep 2013 – Sep 2016) introduced
the system of Bi-monthly announcement of
Monetary Policies since April 2014; Six Bi-Monthly
Reports are to be Submitted every year.
Trends in Monetary Policy Announcement..
❖Urijit Patel, assumed charge in Sep, 2016 as RBI’s 24
thGovernor but resigned in Dec 2018, citing personal reasons amidst rising tension between RBI and GOI.
❖ Shantikanta Das , current RBI Governor replaced Urijit Patel in Dec, 2018
❖ He recently presented the Seventh Bi-monthly
Policy Statement for the year 2019-20 on March 27,
2020; preponing the scheduled meeting in view of
COVID-19 pandemic.
Structure of Monetary Policy Statements
❖ Six Bi-Monthly Monetary Policy Statements announced every year (since April 2014)
❖ Detailed Monetary Policy Reports (MPR) are presented on a six monthly basis (April & Oct)
❖ Monetary Policy Reports (MPR) is presented in five chapters:
I. Macroeconomic outlook (Inflation, growth..etc) II. Prices & Costs (CPI trends, costs..)
III. Demand and Output (aggregate demand, supply…) IV. Financial Markets and Liquidity conditions
V. External environment (global economic conditions; Monetary policy stance..etc)
❖ Key economic highlights (inflation & growth) and Monetary measures (key policy rates & other measures) are presented as a part of every Bi-monthly MP statement
Group presentation on
Monetary Policy Statement
2019-20
(six Bi-monthly policy statements) +Seventh Bi-monthly Monetary Policy Statement to be Announced in on 27th March 2020
https://www.rbi.org.in
